Exchange rate policy and macroeconomic adjustment 8 - Columbia ...

Exchange rate policy
and macroeconomic
adjustment8
China’s exchange rate policy and what it
means for the dollar
Geng Xiao
The debate over the exchange rate between the renminbi (RMB) and the US
dollar is usually framed in terms of global imbalances: excessive US consumption
beyond its savings on the one hand and excessive Chinese production and
savings beyond its own spending on the other. This quickly leads to the view
that the United States should export and save more and China should import and
spend more. The debate centres on how to achieve this rebalancing. The focus
in the West is on short-term appreciation of the renminbi, while the emphasis in
China is on longer-term structural and institutional reform (Xiao 2008). 1
Leaders in the United States would like the renminbi to appreciate significantly
and quickly to encourage an expansion of US exports and employment. Chinese
leaders, however, regard the pressure to revalue the renminbi and various
protectionist trade policies from the West as unfair, and believe they threaten
China’s development. 2 What accounts for this considerable gap between the
views of China and the West? What is the economic rationale for China’s
insistence on a stable renminbi?
The argument for a sustained appreciation of the renminbi is rooted not only in
short-term concerns about China’s large current account surplus, but in longerterm
trends of China’s economic fundamentals, including high growth, rapid
urbanisation and industrialisation, low national debt and low fiscal deficits.
These trends are the result of three decades of reform in China that have opened
the country to trade with the rest of the world and led to strong productivity
gains. Based on the experience of other fast-growing industrialising economies,
these forces will increase Chinese wages, the value of the renminbi and China’s
price level—over time.
1 Some of the key results are summarised and restated in this chapter.
2 On 30 November 2009, in his meeting with European leaders, Chinese Premier, Wen Jiabao, said some
countries on the one hand demanded renminbi appreciation and on the other hand adopted various trade
protection meaures.
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China: The Next Twenty Years of Reform and Development
China’s stance
China views its renminbi peg with the US dollar as a crucial link for its trade
and investment flows with US and world markets. China is concerned that a
premature end to this nominal link with the dollar would bring about financial
instabilities such as speculative capital inflows, associated asset bubbles and
short-term nominal shocks to employment and business in the external sector.
China has not forgotten how the large appreciation of the Japanese yen brought
about by the 1985 Plaza Accord created massive asset bubbles that burst in 1989,
creating a two-decade-long period of sustained deflation without eliminating
Japan’s trade surplus.
China is also wary of how currency appreciation might encourage destabilising
capital inflows. From 2005 to 2008, the renminbi appreciated steadily against
the United States dollar by over 5 per cent a year and China’s stock-market
index increased from about 1500 to 6000 before falling to 2000 because of large
speculative capital inflows especially from Hong Kong. If China were to use
renminbi appreciation to reach a balance in trade and to stop speculative capital
inflows, the renminbi could overshoot its equilibrium level, leading to bubbles
and deflation.
Another reason for not having predictable renminbi appreciation relates to
China’s outward investment. For a country with a large net surplus savings
and trade surplus, a well-functioning financial system should support orderly
private or non-state capital outflows of the same order of magnitude as the trade
surplus. Private firms and financial institutions would, however, be reluctant
to buy dollar assets if they were likely to continually depreciate in terms of
the renminbi. Because fear of dollar depreciation—and the near-zero short-term
interest rates in the United States—reduces outward investment by privatesector
investors, the People’s Bank of China (PBOC) has to finance virtually all
of China’s trade surplus by building up official exchange reserves, making its
monetary control difficult. 3
In any case, it is not clear that nominal renminbi appreciation is necessary.
The real exchange rate between the renminbi and the US dollar should be selfadjusting.
This is because the change in China’s price level relative to that in
the United States (the ‘real exchange rate’) is technically the sum of renminbi
appreciation against the dollar and China’s extra inflation above US inflation.
This real exchange rate is determined largely by China’s productivity growth.
If China appreciates its currency in excess of its productivity gains, it will
3 See a series of articles by Ronald McKinnon about the exchange-rate policy in Japan and China—
particularly McKinnon et al. (2009).
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Exchange rate policy and macroeconomic adjustment
experience deflation. If, however, China refuses nominal appreciation against
its productivity gains, the country will experience some structural inflation
related to the increase of wages and prices in the non-tradable sector, which will
keep the real exchange rate compatible with its productivity changes. If China
experiences inflation higher than its productivity gains, the renminbi will face
depreciation pressure.
Indeed, if China makes the mistake of continually appreciating the renminbi
against the dollar—ostensibly to reflect its higher productivity growth in
manufacturing—then wage growth could well slow by roughly the amount
of the anticipated exchange appreciation. Manufacturing firms would risk
bankruptcy if they raised wages in the face of an ever-higher renminbi. Indeed,
in Japan’s very high growth phase in the 1950s and 1960s, when the yen was
fixed at 360 to the dollar, Japanese wages grew very rapidly—at about the same
pace as domestic productivity growth in manufacturing. Then, when Japan
was forced by the US government to appreciate in the 1970s and afterwards,
wage growth slumped to virtually zero and remains at zero today. 4 China does
not want to repeat Japan’s experience of deflationary stagnation by allowing
excessive renminbi appreciation.
It should also be noted that recent research by Hong Qiao (2007) has shown that
currency appreciation has an ambiguous impact on the net trade balance. Qiao’s
(2007) research is clearly consistent with Japan’s experiences and supports
China’s current exchange-rate policy.
When it comes to rebalancing, what really matters is the real exchange rate:
the relative price levels between economies in international currency, which
determine the relative costs of production, exports and imports of trading
partners. Hence, if China pegs the renminbi to the dollar, it can still achieve a
rapid increase in its real exchange rate against the United States by having an
inflation rate 5 percentage points higher than that of the United States. Many
formerly fast-growing industrialising economies—such as Japan, South Korea,
Taiwan and Hong Kong—kept inflation about 5–8 per cent during their fastgrowth
phases as a way to make nominal wages and general price levels converge
towards global standards.
Hence, both inflation and nominal appreciation can adjust the real exchange
rate. The Chinese approach to exchange-rate stability thus far has focused on
inflation first and appreciation second, which makes the longer-term objectives of
creating employment, productivity gains, wage growth and price liberalisation
the priorities rather than addressing trade imbalances through adjustments for
exchange-rate change.
4 See detailed analysis in McKinnon (2006).
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China: The Next Twenty Years of Reform and Development
Policy alternatives
Given the fact that China is cautious about using large nominal appreciation to
rebalance the Chinese and global economies—at least for the time being—it is
important to consider some alternative policy options. A widely held view in
China is that the rebalancing should focus on reducing the net savings surplus
by shifting disposable income to households, paying corporate dividends,
increasing governments’ fiscal spending, and so on—and not simply on
adjusting the exchange rate.
China is well known for its high savings rate, which reached about 55 per
cent of gross domestic product (GDP), with a current account surplus of about
10 per cent of GDP, during 2007–08. One of the key sources of China’s high
national savings rate is its state-owned enterprises (SOEs), as corporate savings
contribute about half of China’s national savings (Prasad 2009). Historically,
these large SOEs could not pay high salaries or wages to their employees due to
tight control by the government. They did not distribute dividends. Even after
they were reformed into a modern corporate format in the 1990s, the primary
focus was on reducing losses, not sharing dividends. They also did not generate
private purchasing power when the prices of their shares increased, which
created huge capital gains with, as it happens, only small wealth effects on
consumption. The high savings of SOEs are prone to investment in sectors with
tendencies to overcapacity. Hence, privatisation and deregulation are necessary
to reduce savings and inefficient investment by the large SOEs. 5
While China clearly must increase its current consumption, consumption is
ultimately limited by income. China has a long way to go in raising the wages
and productivity of its workforce. Right now, household income accounts for
only 35 per cent of national income. The low disdposable income is especially
acute for migrant workers, who do not receive high-quality education in rural
villages. Their wages were stagnant at a level of about US$120–200 a month for
the first several decades of reform due to steady high underemployment for
unskilled labour.
Chinese savings are also high because the average Chinese household is faced
with a very high return on investment, such as in residential property. In one
of our studies (Sun et al. 2009) of the comparative long-term return on capital
for China, Japan and the United States, we found that China’s return on capital
is about 20 per cent, compared with about 10 per cent for Japan and 5 per cent
for the United States in the past three decades. Moreover, Chinese households
save to meet very high future expenditures, such as college education for their
single child and medical and retirement expenditures.
5 For more on China’s SOEs, see the discussion by Xiao et al. (2009).
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Addressing the West’s concerns
Exchange rate policy and macroeconomic adjustment
Chinese and foreign observers alike have expressed concerns about inefficient
investment in China’s export-manufacturing sector and in some local
government-sponsored projects. As a result, China’s central government has
recently tightened monitoring and control of all new projects, especially those
likely to lead to overcapacity. The Chinese authorities have not, however,
changed their overall stimulus policy and continue to focus on generating more
efficient investment, employment and imports so as to contribute positively to
global rebalancing and global recovery.
For those who worry about China’s US$2.2 trillion foreign exchange reserves, it
is worth looking at a case that illustrates China’s need for foreign exchange. The
number of self-financed Chinese students studying abroad increased from 102
247 in 2002 to 161 600 in 2008, which is a compound rate of about 8 per cent a
year. If we assume the number of such students will increase 8 per cent a year
for the next 10 years, the number of students studying abroad will reach 348
882 by 2018. If each outgoing student spends four years overseas, with US$60
000 in expenditure per annum for tuition, living expenses and travel, the total
accumulated expenditure for those Chinese students going abroad will reach
US$606.8 billion—amounting to about 30 per cent of China’s current foreign
exchange reserves. It is no secret that even high and middle-income Chinese
parents need to save for many years or decades to pay for their children’s
expensive overseas education.
Price distortions and global rebalancing
One of the key factors driving the global imbalances has been cheap money,
which, together with weak regulation of high-risk investment, led to property
and stock-market bubbles in the United States and other economies. The
bubbles brought temporary capital gains that reduced Americans’ savings and
increased their consumption to levels beyond their sustainable income. This
is well known now; but what has been overlooked in the public discussion
is that this same cheap money also flowed into China through foreign direct
investment (FDI) and other capital flows. Cheap foreign money, combined with
cheap Chinese land, energy and natural resources, has led to huge overcapacity
in China’s manufacturing sector, driving down the prices of made-in-China
products.
The United States’ current zero-interest-rate policy might be necessary for
the US economy now, but it is likely to create a carry trade as a by-product—
that is, where investors borrow currencies with low interest rates and invest
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China: The Next Twenty Years of Reform and Development
in currencies with high interest rates to make profits when the interest rate
differential is larger than the anticipated exchange rate change. This brings
capital flows into China in anticipation of higher investment returns compared
with the United States. If managed well, China can combine this foreign capital
and its own savings to improve the efficiency of its investment, so as to allow
higher levels of domestic investment for future domestic consumption. This
would certainly help global rebalancing.
Rising Chinese household income and large official reserves mean that there will
be rising demand for diversification by Chinese investors into foreign assets.
Over time, the amount of cross-border capital flows could be much larger than
the amount of trade flows. To facilitate these future cross-border capital flows,
it would be helpful for China to maintain a stable exchange rate and large
foreign exchange reserves—both of which are critical in reducing the Chinese
and foreign investors’ uncertainty that would result from a volatile exchange
rate. Having a stable exchange rate to facilitate cross-border investment is
also important for the large number of US multinational corporations with
extensive and growing investments in China that generate high value-added
complementary jobs in the United States.
The future for China and the dollar
The biggest challenge for Chinese policymakers now is how to deal with the
property and stock-market bubbles being formed by cheap money in China
and around the world. As asset prices and the consumer price index (CPI)
rise, it is important for China to raise its interest rate—as India has done very
successfully—to keep the real interest rate at a stable and positive level. A
higher interest rate would attract greater capital inflows. It is therefore necessary
for China to improve its capital-control mechanisms, to allow orderly crossborder
capital flows for more efficient investments with higher returns both
domestically and internationally, while limiting the speculative flow of capital
and the inefficient and low-return investments.
So what does China’s policy stance mean for the dollar? There are some clear
implications.
Given the institutional and structural constraints in China, it does not seem
likely that nominal renminbi appreciation will become a key policy variable
in rebalancing China and the global economy in the near future. This means it
will be difficult for the United States to pursue a weak-dollar policy. Without
depreciation against the renminbi, any further depreciation of the dollar against
the euro and yen would do little to help global rebalancing—and could instead
cause shocks to the European and Japanese economies.
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Exchange rate policy and macroeconomic adjustment
Given the huge potential for cross-border investment and debt financing
between the United States and China, a stable renminbi–dollar exchange rate
seems to fit both countries’ long-term national interest. If the United States
and China can cooperate effectively in maintaining the stability of the exchange
rate and orderly cross-border flows of capital, there is little reason to believe
the dollar-based international currency system will collapse in the foreseeable
future.
In the longer term—certainly after 2020 and perhaps during 2025–35—the
renminbi is likely to become an international currency when it becomes fully
convertible and the Chinese economy completes its structural and institutional
transformation into a fully modernised market economy with a more democratic
political system. By that time, the integration of the US, European, Japanese
and Chinese economies will be so deep that the dollar, euro, yen and renminbi
are likely to become leading reserve currencies of the world, with fully floating
exchange rates.
Rebalancing the world economy can be accomplished without revaluing the
renminbi. For this to happen without major dislocations, however, structural
and institutional reforms must occur both in China and in the United States.
Higher inflation in China and deflation or lower inflation in the United States
can bring about the needed adjustment in real, rather than nominal, exchange
rates. This implies a stronger dollar, but also requires de-leveraging in the
United States, including reduction of US fiscal deficits.
Challenges in the next two decades
During the next 20 years of reform and development, the key macroeconomic
challenge is to determine how to manage the exchange rate, interest rate and
inflation rate in order to facilitate sustainable, stable, efficient and harmonious
growth of China’s real economy in the context of a world economy in which the
weight of the Western economies will shrink relative to the emerging market
economies.
To appreciate the extent of this challenge, it is essential to recognise that China’s
high growth in the past 30 years is a story largely of rapid productivity growth
and catching up. The productivity story is likely to continue for the next two
decades if China continues its market-oriented reform and its trend of rapid
industrialisation and urbanisation. As a result, China’s non-tradable goods
prices—such as wages for unskilled labour and property prices—are likely to
continue to rise (see the chapter in this volume by Ross Garnaut), relative to the
prices of tradable goods, which are set by global markets.
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China: The Next Twenty Years of Reform and Development
In the next two decades, rising non-tradable goods prices in China will lead
to a gradual but steady convergence of China’s price levels towards those in
Hong Kong and the United States, through structural inflation or structural
renminbi appreciation—or both. It is essential for China’s policymakers and
Chinese people to tolerate the structural inflation and/or currency appreciation
associated with this productivity catch-up.
More importantly, since inflation and currency appreciation can cause
distortions, shocks and income redistribution, it is necessary for policymakers
to use appropriate policy mixes to mitigate potential dislocation that might be
created in the adjustment process.
For example, when structural inflation emerges, it will be critical to raise
nominal interest rates so as to avoid asset bubbles that are caused by negative
real interest rates as well as to protect the value of bank deposits held by the lowincome
households who cannot afford to invest or speculate in property markets
in order to hedge against the structural inflation. Since 1991, China’s urban
residential real estate prices have grown on average about 9 per cent a year, but
the mortgage rate is only about 5 per cent and the one-year fixed-deposit rate
is only about 2 per cent. The structural inflation in property and low mortgage
and deposit rates implies a very serious problem of negative real interest rates in
terms of investing in property. This is the root of China’s property bubbles and
the associated huge income redistribution from depositors (usually the poor) to
mortgage holders (usually the rich).
If China cannot maintain a positive real interest rate, its boom and bust cycles
in the property sector are likely to continue, leading to serious inefficiency
in investment as well as social instability. On the other hand, if China does
raise interest rates to a level higher than its structural inflation, it then needs
adequate capital control to deal with speculative capital inflows.
The importance of keeping the real interest rate positive cannot be
overemphasised for China in the next two decades, as China’s key challenge
in macroeconomic adjustment is to improve its investment and consumption
efficiency so that it can absorb more of its current account surplus. Otherwise,
China will face serious international trade protection pressure.
On the other hand, this chapter shows that it is not necessary for China to
rely only on nominal exchange rate flexibility to facilitate its rising price level
if it can instead tolerate higher structural inflation and the associated real
appreciation. In fact, it is much easier for China to implement a flexible exchange
rate regime when it allows reasonable structural inflation. With inflation, there
will be potential for the currency to depreciate when inflation runs beyond
productivity growth. So, a mixture of inflation and nominal appreciation could
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Exchange rate policy and macroeconomic adjustment
create a regime in which the market exchange rates could go up or down—
reducing the incentive for massive speculative holdings of the renminbi, which
has become one of the key drivers of China’s foreign exchange reserve bubble.
It should also be pointed out that when China pegs its renminbi to the US
dollar, it should not worry too much about runaway inflation since the peg has
the stabilisation function. If the inflation rate goes beyond China’s underlying
productivity growth, the market will expect the renminbi to depreciate, which
will lead to capital outflows and the tightening of money supply. Given China’s
huge foreign exchange reserves, it is easy for China to defend its peg and avoid
runaway inflation.
As soon as China starts to tolerate reasonable structural inflation and the
associated real appreciation, the pressure for nominal appreciation will be
reduced.
This chapter has also highlighted the fact that the exchange rate is a price not
just for trade but for assets. In fact, the volume of the asset markets is much
bigger than that of trade. Maintaining stable exchange rates for facilitating stable
and efficient cross-border capital flows could be more important than using the
exchange rate to balance trade. It could be more productive to use trade policies
such as reducing the transaction costs for imports to balance China’s trade.
References
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Economic Review, vol. 6, no. 2, pp. 427–31.
McKinnon, R. Lee, B. and Wang, Y. D. 2009, The global credit crisis and China’s
exchange rate, Stanford Center for International Development Working Paper
no. 391, Stanford University, Calif.
Prasad, E. 2009, ‘Rebalancing growth in Asia’, Finance & Development, vol. 46,
no. 4, pp. 19–22.
Qiao, H. 2007, ‘Exchange rates and trade balances under the dollar standard’,
Journal of Policy Modeling, vol. 29, no. 5, pp. 765–82.
Sun, W., Yang, X. and Xiao, G. 2009, Investment rate and FDI: a comparative
analysis of return to capital among China, US and Japan, Paper presented at
the joint symposium of US–China Advanced Technology Trade and Industrial
Development, Beijing, 23–24 October.
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China: The Next Twenty Years of Reform and Development
Xiao, G. 2008, ‘China’s exchange rate and monetary policies: structural and
institutional constraints and reform options’, Asian Economic Papers, vol. 7,
no. 3, pp. 31–49.
Xiao, G., Yang, X. and Janus, A. 2009, ‘State-owned enterprises in China: reform
dynamics and impacts’, in R. Garnaut, L. Song and W. T. Woo (eds), China’s
New Place in a World in Crisis: Economic, geopolitical and environmental
dimensions, ANU E Press, Canberra, pp. 155–78.
Acknowledgments
This chapter consists of two sections. Section one is a reprint of an article by the
author published on 13 January 2010 at ‘What Matters’ web forum hosted by
the McKinsey Quarterly (). Section two
includes additional comments prepared specially for this chapter. The author
is grateful to the McKinsey Quarterly for permission to include the previously
published contents in this chapter. The author would also like to thank Ronald
McKinnon, Andrew Sheng, Pieter Bottelier, Wing Thye Woo, Jeffrey Sachs, Barry
Bosworth, Harry Broadman, David Dollar, David Loevinger, David Meale, David
Skilling, Jonathan Woetzel, Kenneth Lieberthal, Cheng Li, Xingdong Chen,
Chunlai Chen, Min Zhu, Qiren Zhou and Hong Liang for helpful comments and
discussions on this work. Jonathan Delikat and Will Hobbs provided excellent
research assistance.
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4
Facing protectionism generated by trade disputes
Facing protectionism generated
by trade disputes
China’s post WTO blues
Wing Thye Woo and Geng Xiao
The escalation of friction between China and its trading partners
China’s current account in the balance of payments has been in surplus since
1994 and it has shown a clear upward trend, reaching US$184 billion in 2006, or
9 per cent of gross domestic product (GDP). As China’s capital account is also
in persistent surplus because of the large inflows of foreign direct investment
(FDI) and capital controls on outflows, its foreign exchange reserves reached
US$1.07 trillion in 2006—the largest in the world. China also became the secondlargest
holder of US Treasury securities, holding as much as US$353.6 billion,
trailing only Japan, which holds US$648.8 billion.
At the time of writing (June 2007), China’s overall trade surplus, the China–US
trade surplus and the China–EU trade surplus continued to soar, 1 causing a
marked escalation in concern about China’s unfair trading practices and the gross
undervaluation of the renminbi. In February 2007, the US Trade Representative
(USTR) had filed a case with the World Trade Organization (WTO) against
prohibited subsidies in China. This action was followed by two more WTO cases
against China in April 2007—challenging market access restrictions on products
of copyright-intensive industries and challenging weaknesses in the legal regime
for protection and enforcement of copyrights and trademarks. 2
In order to appreciate adequately the high intensity of the sound and the fury
of the anti-China rhetoric—and the global character of these criticisms—it is
worthwhile to quote a number of news reports from the barrage of press articles
on the trade imbalance issue that appeared on 13 June 2007. 3
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China—Linking Markets for Growth
The Financial Times (2007a) reported
Peter Mandelson, the EU trade commissioner…called various aspects of
China’s trade policy ‘illogical, indefensible’ and ‘unacceptable and accused
[China] of doing nothing to rein in rampant counterfeiting…Mr Mandelson
also refused to grant China market economy status…[because it had] fulfilled
[only] one of five criteria. 4
The Straits Times (2007) of Singapore reported
Peter Mandelson proclaimed that the…[EU] trade deficit with China was no
longer ‘tolerable’ and warned that relations with Beijing were now at a ‘crossroads’…[Trade
is] so skewed that the EU now exports more to Switzerland…
than to the entire Chinese market.
USA Today (2007) reported that
[a]fter years of inconclusive skirmishing, trade tensions between the United
States and China are about to intensify. ‘We are competing not only with a
country with low wages but with very high and heavy subsidies and a rigging
of their currency,’ says Rep. Sander Levin, D-Mich., chairman of the House
trade subcommittee. ‘I hate the term trade war because it is always used
when you try to get a fair break…Sometimes pressure works.’
In confirmation of the growing perception of—and deepening dissatisfaction
about—unfair Chinese trading practices, the media on 13 June 2007 also
contained reports on the actions being undertaken by the Bush administration
and the Chinese government to forestall protectionism.
The Standard (2007) of Hong Kong reported
US lawmakers plan to introduce legislation today seeking to pressure
China to raise the value of the yuan to stem a ballooning trade imbalance…
Sponsored by Democratic senator Charles Schumer, the bill will lay out
the US response whenever countries ‘unfairly undervalue their currency’.
Currently, there are half a dozen measures before the US Congress aimed
at China, including proposals to apply sanctions unless it allows the yuan to
appreciate by at least 10 per cent.
The Wall Street Journal (2007b) reported
[t]urning aside growing congressional anger over the US trade deficit with
China, President George Bush’s administration today will reject demands
that it formally accuse Beijing of ‘manipulating’ its currency to give Chinese
companies an edge over American businesses. ‘There might be an initial sigh
of relief in the markets that the Treasury has not taken a more confrontational
line, but protectionist pressures are only likely to build’, Julian Jessop, chief
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Facing protectionism generated by trade disputes
international economist at Capital Economics in London, warned clients in
a note yesterday. Meanwhile Beijing took steps yesterday apparently aimed,
at least in part, at defusing US concerns. Chinese authorities permitted an
unusually large rise in its tightly controlled currency.
The International Herald Tribune (2007) reported that ‘the yuan had the biggest
gain since the end of a dollar link in July 2005. The yuan rose 0.26 per cent to
7.6436 against the dollar…[yielding a cumulative gain of] 8.3 per cent since…July
2005.’
Events then moved quickly. On 14 June 2007, Senators Max Baucus
(Democrat from Montana), Charles E. Grassley (Republican from Iowa), Charles
E. Schumer (Democrat from New York) and Lindsey Graham (Republican from
South Carolina) introduced legislation ‘to punish China if it did not change its
policy of intervening in currency markets to keep the exchange value of the
currency, the yuan, low’ (New York Times 2007).
On 19 June 2007, the International Monetary Fund (IMF) adopted a new
country surveillance framework that set out
…a catch-all obligation on countries not to adopt policies that undermine the
stability of the international system, and lists a set of objective criteria that
will be used to indicate whether a country is complying with its commitments.
Warning lights will include large-scale currency intervention, the
accumulation of reserves and ‘fundamental exchange rate misalignment’—a
term that mirrors language in a bill before the US Congress that would
impose penalties on nations that fail to correct such misalignments. Rodrigo
Rato, managing director of the IMF, said: ‘This decision is good news for the
IMF reform programme and good news for the cause of multilateralism…
[because this new framework] gives clear guidance to our members on how
they should run their exchange rate policies, on what is acceptable to the
international community and what is not’ (Financial Times 2007b).
The above developments were warnings that China, Europe and the United
States could be marching towards a trade war. In this chapter, we examine the
reasons for the trade friction with China and propose policies to reduce that
friction. Our discussion will focus on four questions
1 What are the problems caused by trade imbalances?
2 What are the problems revealed by the appearance of trade imbalances?
3 Is a large yuan appreciation the best cure for trade friction?
4 What is to be done?
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China—Linking Markets for Growth
What are the problems caused by trade imbalances?
It is not uncommon to encounter allegations that the US–China trade deficit
represents the export of unemployment from China to the United States. A
recent study by Robert Scott (2007), of the Economic Policy Institute, used
an input–output model to arrive at the claim that the bilateral trade deficit of
US$49.5 billion in 1997 caused the loss of 597,300 jobs that year and the 2006
bilateral trade deficit of US$235.4 billion caused the loss of 2,763,400 jobs—and
that every state had suffered a net loss of jobs from the rise in the bilateral trade
deficit during 1997–2006. The alleged job losses in 2006 from the bilateral trade
deficit implied that the 2006 unemployment rate was 1.21 percentage points
higher than if the bilateral trade balance had been zero. 5
There are two major problems with the Scott (2007) study. First, the overall
unemployment rate in the United States did not grow in line either with the
widening overall US trade deficit or with the widening US–China trade deficit.
The average unemployment rate of 4.9 per cent in the 1998–2006 period was
lower than the average unemployment rates in the previous periods of 1980–88
and 1989–97, which were 7.5 per cent and 6 per cent respectively. In reality, the
US economy was a highly successful job-creation machine in the 1997–2006
period.
Second, in the face of the strong demand for labour in the US economy
during the period of growing trade deficit, a substantial amount of the so-called
job losses could have been voluntary departures by workers—rather than
involuntary displacement of workers—from import-competing industries that
paid low wages or had potentially low wage growth in the future.
The more sophisticated complaint against the growing trade deficit is that
the displacement of workers adds to the downward pressure on US wages
created by globalisation. This downward wage pressure comes from the post
1990 integration of the labour force in the former Soviet Union, India and
China into the international division of labour. The number of workers already
engaged in the international division of labour was 1.08 billion in 1990, and the
combined labour force of the former Soviet Union, India and China was 1.23
billion (Table 1). The division of labour in 1990 was certainly an unnatural one
because half of the world’s workforce had been kept out of it voluntarily by the
autarkic policies of the former Soviet Union, India and China.
The economic isolation of the Soviet bloc started crumbling when the
new non-communist Solidarity government of Poland began marketisation
and internationalisation of its economy on 1 January 1990. The economic
transition and political disintegration of the Soviet bloc became irreversible
when President Boris Yeltsin replaced Mikhail Gorbachev as the unambiguous
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Facing protectionism generated by trade disputes
leader of Russia in August 1991 and implemented market-oriented reforms in
January 1992. 6
For the Chinese élite, the events in the Soviet Union confirmed that there did
not exist a third way in the capitalism versus socialism debate. In early 1992,
Deng Xiaoping led a successful campaign to put China firmly on the path of
convergence to a private market economy (Sachs and Woo 2000, 2003). Today,
under the heading of a socialist market economy with Chinese characteristics,
the Chinese constitution gives private property the same legal status as public
property, and the Chinese Communist Party accepts capitalists as members.
In 1991, India faced a balance-of-payments crisis, and it responded by going
well beyond administration of the standard corrective macroeconomic medicine
of fiscal monetary tightening and exchange-rate devaluation into comprehensive
adjustments of microeconomic incentives. The trade regime was deregulated
significantly, restrictions on foreign investment were relaxed, reform of the
banking sector and the capital markets was initiated, and divestment of public
enterprises and tax reforms were announced (Acharya 2004).
A decade after the start of internationalisation, the number of workers
involved in the international economic system had increased to 2.67 billion in
2000 (with 1.36 billion workers from the former Soviet Union, India and China)
(Table 4.1). The Heckscher-Ohlin model would predict that this doubling of world
labour—achieved by bringing in cheaper labour from the former Soviet Union,
India and China—would lower the relative price of labour-intensive goods and
hence reduce real wages in industrialised economies. 7
The fact that US capital could now move abroad to set up production facilities
in the economies of the former Soviet Union, India and China to service the
Table 4.1 The distribution of the global labour force, 1990 and 2000
(million persons)
Non-SIC a countries
sic countries
Total Industrialised Developing China India Soviet bloc
economies economies
1990 2,315 403 680 687 332 213
2000 2,672 438 851 764 405 214
a SIC— former Soviet Union, India and China.
Source: Freeman, R., 2004. Doubling the global work force: the challenge of integrating China,
India, and the former Soviet Bloc into the world economy, Harvard University, 8 November
(unpublished). Our figure for ‘total’ in 2002 is different from that in Freeman (2004).
49

China—Linking Markets for Growth
US market provided another channel (besides the cross-border movement of
goods) for globalisation to depress US wage rates. It is important to note that
the imposition of a very high US tariff would not only drastically curb imports
from the former Soviet Union, India and China, it would also radically reduce
this type of FDI flow from the United States to the former Soviet Union, India
and China.
The inconvenient fact is, however, that the US real wage has not fallen.
One possible explanation to reconcile the theoretical prediction with the
real outcome is the remarkably high US productivity growth since the late
1980s, perhaps enabled in large part by the information and communications
technology revolution. This productivity growth was high enough to prevent
the real wage from declining but not enough to keep it growing at the same
rate as GDP growth—and the economic impact of globalisation is manifested
in a diminished labour share of GDP.
While the Heckscher-Ohlin model does provide a coherent mechanism
for globalisation to lower the labour share of US income and to widen the
distribution of US wages, the inconvenient truth is that China cannot be blamed
as the most influential factor in these two wage outcomes, even though China
accounted for 764 million of the combined labour force of the former Soviet
Union, India and China of 1.38 billion in 2000. China is not the main culprit
because there have been three other, independent developments that have
had important consequences for US wages.
First, there have been technological innovations that have substituted capital
for labour—for example, fewer secretaries are needed because answering
machines can now convert messages into voice files and email them to the
travelling professionals. Technological innovations have also transformed
many of what were traditionally non-tradable services into tradable services,
allowing jobs to be outsourced to foreign service providers. For example, the
information and communications technology revolution has allowed offshore
call centres to handle questions from US customers, offshore accountants to
process US-based transactions and offshore medical technicians to read the
X-rays of US patients. 8
Second, there have been institutional changes that attenuated the labour
share of income. Union membership has declined, reducing the bargaining
power of labour. There has also been an upward shift in the compensation
norms for high-level executives, often using vehicles such as stock options,
which in effect make them co-owners of the company. This could reflect a
combination of a shift in social attitudinal norms and more collusion between
managers and their boards. 9
50

Facing protectionism generated by trade disputes
Third, there was increased immigration into the United States (before 2001),
especially a disproportionate inward immigration of low-skilled labour. 10
Based on a partial review of the literature, our assessment is that the
pressure that is preventing US wages (especially of unskilled labour) from
rising in line with GDP growth can be roughly decomposed among the various
factors as follows
• 70–80 per cent of the downward wage pressure is from labour-substituting
technological innovations, and wage-weakening institutional changes
• 5–10 per cent of the downward wage pressure is from inward
immigration
• 15–20 per cent of the downward pressure is from import competition
and the relocation of manufacturing activities abroad.
In short, the popular outcry in the United States and the European Union
against China’s trade surpluses is misplaced. Even if China’s trade balance were
zero, the pains of structural adjustment and income redistribution caused by
technological innovations, institutional changes, globalisation and immigration
would still be there. The additional pain from the incremental structural
adjustment caused by the widening trade deficit is minor in comparison.
What are the problems revealed by the appearance of trade
imbalances?
Before discussing the economic problems in China and the United States that
generated the trade imbalances, we should mention a troubling basic data
issue: there is strong disagreement about the size of the US–China trade deficit.
Figure 4.1 shows that the Chinese figure for the bilateral deficit in 2006 (US$145
billion) was only 57.7 per cent of the US figure (US$251 billion). 11 The huge gap
between these two estimates in 2006 was a huge improvement in accuracy
from the past in two ways. First, the gap was usually much larger in previous
years: for example, the 1993 Chinese estimate of the trade deficit was only 25.6
per cent of the US estimate. Second, the recent period is one in which the two
countries could agree whether the bilateral balance was in surplus or in deficit!
Throughout the 1983–92 period, the Chinese data showed China to be running
a deficit in its trade with the US but the US data showed a surplus.
Given these wildly different measures of the size of the bilateral trade
imbalance, it is only to be expected that each side would regard the bilateral
trade imbalance with a different degree of concern. The primary reason for the
discrepancy between the Chinese and US estimates is the different national
treatment of US–China trade that goes through Hong Kong. 12 Drawing on the
51

China—Linking Markets for Growth
work of Feenstra et al. (1999) for the analysis in this chapter, we will measure
the US–China trade balance as the simple average between the US estimate
and the Chinese estimate, as reported in the IMF’s Direction of Trade Statistics
database. 13
Figure 4.2 displays three items: China’s overall trade balance, the China–US
trade balance and the China–EU trade balance. China has been running a
surplus on its US trade since 1986, a surplus on its EU trade since 1997 and a
surplus on its overall trade since 1994. Since 1986—except for the four years
associated with an economic downturn in China (1990, 1991, 1997 and 1998)—the
bilateral surplus with the United States exceeded China’s overall trade surplus,
meaning that China was running massive deficits in its trade with some of its
other trading partners.
The changing configuration of China’s bilateral trade balances reflects
mainly the steady expansion of production networks into China. In this new
geographical division of the production of components and of the production
stages in manufacturing, China usually makes the cheaper components
and assembles the final products by combining the domestically produced
components with imported components. The fast transfer of manufacturing and
assembly operations to China from Japan, Taiwan and South Korea translates
directly into high growth in the China–US trade surplus because this transfer
reduces the Japan–US trade surplus and the South Korean–US trade surplus
correspondingly. In short, the China–US trade deficit could be reduced by
transferring the assembly operations of Korean, Taiwanese, Japanese and
European production networks to Vietnam, but the Vietnam–US trade deficit
would then increase, leaving the overall US trade balance unchanged.
China’s chronic and growing overall trade surplus reveals a deep-seated
problem in its economy: its dysfunctional financial system. This problem is
revealed by the aggregate-level accounting identity that the overall current
account balance (of which, in China, the overall trade account is the biggest
part) is determined by the fiscal position of the government, and by the savingsinvestment
decisions of the state-controlled enterprise (SCE) sector and the
private sector. 14 Specifically,
CA = (T – G) + (S SCE – I SCE ) + (S private – I private ) (1)
where CA is the current account in the balance of payments.
CA = (X – M) + R (2)
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Facing protectionism generated by trade disputes
Figure 4.1
US–China trade deficit: discrepancy between US and
Chinese data, 1980–2006 (US$ million)
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
-10,000.0
-60,000.0
US$ million
-110,000.0
-160,000.0
-210,000.0
-260,000.0
Official US estimate
Official Chinese estimate
Source: International Monetary Fund (IMF), 2007. Direction of Trade Statistics, 9 May, Statistics
Department, International Monetary Fund, Washington, DC.
Figure 4.2
China trade account balance, 1980–2006 (US$ million)
180,000
Overall trade surplus China-EU surplus China-US surplus
130,000
US$ million
80,000
30,000
-20,000
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
Source: International Monetary Fund (IMF), 2007. Direction of Trade Statistics, 9 May, Statistics
Department, International Monetary Fund, Washington, DC.
53

China—Linking Markets for Growth
where X is the export of goods and non-factor services, M is the import of
goods and non-factor services, R is the net factor earnings from abroad (that is,
export of factor services), T is state revenue, G is state expenditure (including
state investment), S SCE are the savings of the SCEs, I SCE is investment of
the SCEs, S private is savings of the private sector and I private is private-sector
investment.
The Chinese fiscal position (T–G) has for the past decade been a small deficit,
so it was not the cause for the swelling current account surpluses in the 2000s.
The current account surplus exists because the sum of savings by SCEs and the
private sector exceeds the sum of their investment expenditures. The current
account surplus has expanded steadily because the non-government savings
rate has been rising steadily. We will argue later that there is a link between the
existence of the current account surplus and the growth of the surplus.
Why has China’s financial system failed to translate the savings into
investments? Such an outcome was not always the case. Before 1994, the
voracious absorption of bank loans by SCEs to invest recklessly kept the current
account mostly negative and the creation of non-performing loans high. When
the government implemented stricter controls on the state-owned banks from
1994 onwards (for example, by removing top bank officials whenever their bank
lent more than its credit quota or allowed the non-performing loan ratio to
increase too rapidly), the state-owned banks slowed the growth of loans to SCEs.
This cut-back created an excess of savings because the state-owned bankdominated
financial sector did not then channel the released savings (which
were also increasing) to finance the investment of the private sector. This failure
in financial intermediation by the state-owned banks is quite understandable.
Firstly, the legal status of private enterprises was, until recently, lower than that
of state-owned enterprises; and, secondly, there was no reliable way to assess
the balance sheets of the private enterprises, which were naturally eager to
escape taxation. The upshot was that the residual excess savings leaked abroad
in the form of the current account surplus. Inadequate financial intermediation
has made developing China a capital-exporting country!
This perverse current account outcome is not new. Taiwan had exactly this
problem until the mid 1980s when all Taiwanese banks were state owned and
were operated according to the civil service regulation that the loan officer had
to repay any bad loan that he had approved. The result was a massive failure
in financial intermediation, which caused Taiwan’s current account surplus to
be 21 per cent of GDP in 1986. The reason why China has not been producing
the gargantuan current account surpluses seen in Taiwan in the mid 1980s is
because of the large amount of SCE investments.
54

Facing protectionism generated by trade disputes
Why is the savings rate of the non-government sector rising? The combined
savings of the state-owned enterprise and non-state-owned enterprise sector
rose from 20 per cent in 1978 to 30 per cent in 1987, and then went above 45 per
cent after 2004. In discussions on the rise of the savings rate, a common view
is that the rise reflects the uncertainty about the future that many state-owned
enterprise workers feel in the face of widespread privatisation of loss-making
state-owned enterprises. We find this explanation incomplete because it seems
that there has also been a rise in the rural savings rate even though rural
residents have little to fear about the loss of jobs in the state-owned enterprise
sector because none of them are employed there. 15
We see two general changes that have caused urban and rural savings rates
to rise significantly. The first is increased worries about the future. The steady
decline in state subsidies to medical care, housing, loss-making enterprises
and education, and mismanagement of pension funds by the state, have led
people to save more to insure against future bad luck (for example, sickness,
job loss), to buy their own lodging, build up nest eggs for retirement and invest
in their children.
The second change is the secular improvement in the official Chinese
attitude towards market capitalism. Given the high rate of return to capital, this
increasingly business-friendly attitude of the Communist Party of China has
no doubt encouraged rural and urban residents to save for investment: that is,
greater optimism about the future has spawned investment-motivated saving. 16
Our investment-motivated savings hypothesis is not new. According to Jeffrey
Williamson (1988), the historical record of Western Europe and North America
shows that ‘investment demand seems to have been the driving force behind
private saving and accumulation, past and present’.
In our explanations for the existence and the growth of the current account
surpluses, there is a common element: China’s financial system. The fact is that
savings behaviour is not independent of the sophistication of the financial system.
An advanced financial system will have a variety of financial institutions that
enable pooling of risks by providing medical insurance, pension insurance and
unemployment insurance; and transform savings into education loans, housing
loans and other types of investment loans to the private sector. Ceteris paribus, the
more sophisticated a financial system, the lower the savings rate—a proposition
that finds formal statistical support in Liu and Woo (1994) and Woo and Liu (1995).
China generates the current account surplus because of inadequate financial
intermediation, and the surplus grows over time because the dysfunctional
financial system fails to pool risks to reduce uncertainty-induced savings and
fails to provide loans to reduce investment-motivated saving (Figure 4.2).
55

China—Linking Markets for Growth
The overall US trade balance has been in deficit at least since 1980, and it
has always been much bigger than the US–China trade balance (Figure 4.3).
This pattern of imbalances suggests three conclusions. First, the US–China
trade deficit is only 22.4 per cent of the overall US trade deficit, so even if the
bilateral trade balance were brought to zero by tariffs aimed at China, the overall
trade deficit would still be large. Second, the bilateral trade deficit surplus is
created by the same factors that are causing the overall trade deficit: the large
annual budget deficit created by the tax cuts enacted by the Bush administration
in 2001 and the post 2001 growth in defence expenditure. Third, the highly
sophisticated US financial system (which pioneered the sub-prime mortgage
market and corporate junk bonds to enable consumption and investment) has
lowered the US private savings rate.
Clearly, the sustained nature of the overall US trade deficit was possible only
because foreign lenders had faith in the growth prospects of the US economy,
and because the East Asian central banks were willing to hold an increasing
amount of US financial instruments. The paradox is why the US Congress is
so concerned about trade deficits when foreigners have such confidence in the
economic future of the United States. Both groups cannot be right.
Figure 4.3
US trade imbalance, 1980–2006 (US$ million)
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
0
-150,000
US$ million
-300,000
-450,000
-600,000
-750,000
-900,000
Overall trade balance
US-China trade balance
Source: International Monetary Fund (IMF), 2007. Direction of Trade Statistics, 9 May, Statistics
Department, International Monetary Fund, Washington, DC.
56

Facing protectionism generated by trade disputes
Is a large yuan appreciation the cure for trade friction?
China has been under foreign pressure at least since 2002 to appreciate the yuan
significantly. In December 2002, Haruhiko Kuroda and Masahiro Kawai (2002)
from Japan’s Ministry of Finance called for a yuan appreciation in order to stop
China exporting its price deflation to the rest of the world. In September 2003,
US Treasury Secretary, John Snow, declared that China should appreciate the
yuan as part of its international responsibility to eliminate imbalances in the
global balance of payments. 17 In September 2003, Morris Goldstein and Nicholas
Lardy (2003) of the Institute for International Economics in Washington, DC,
claimed that an immediate yuan appreciation of 15–25 per cent would benefit
China because it would remove ‘the incentive for further speculative capital
inflow and reserve accumulation. No longer would the foreign component of
the money supply be working at cross-purposes with the needs of domestic
stabilization.’
In March 2007, Goldstein (2007) offered the opinion to the US Congress
that the
…renminbi (RMB) is now grossly undervalued—on the order of 30 percent
or more against an average of China’s trading partners and 40 percent or
more against the US dollar…[The] US Treasury has refused to label China
as a ‘currency manipulator’ despite overwhelming evidence to the contrary
and the managing director of the International Monetary Fund continues to
reject the role of global umpire for exchange rate policies that was laid out for
the Fund in its charter. China should deliver right away a meaningful ‘down
payment’ of a 10–15 per cent appreciation of the RMB from its current level.
Failure by China to drastically reduce its large-scale, one-way intervention in
the exchange market should result in a finding of ‘currency manipulation’ in
the Treasury’s May 2007 report to the US Congress…Finally, the IMF should
return to its roots by taking up in earnest the role that its founders set out for
it as the global umpire for exchange rate policies.
We will use the format of question and answer to analyse the question posed
in the title of this part of the paper and to assess the validity of the above
assertions.
Did China export deflation, as Kuroda and Kawai (2003) claimed?
The fundamental problem with Kuroda and Kawai’s claim is that it is impossible
to blame Japan’s deflation on China’s deflation because the timing is wrong.
Japan’s deflation started with the bursting of the stock market cum real estate
bubble in 1992, which was well before China’s trade account surpluses started to
soar in the 2000s. If anything, trade with China since 2003 has been an important
57

China—Linking Markets for Growth
stimulus to Japanese economic recovery. Sustained high Chinese investment
spending has sucked in large amounts of intermediate inputs, machinery and
capital equipment from Japan.
Would a yuan appreciation reduce global imbalances, as Bergsten
(2007) claimed?
There is little doubt that a large appreciation of the yuan against the US
dollar—say, 40 per cent, as suggested by Goldstein (2007)—could eliminate the
US–China trade deficit as well as China’s overall trade surplus. But this move
would only hurt China and would not ‘save’ the world. Ceteris paribus, in the
aftermath of a 40 per cent yuan appreciation, foreign companies producing in
China for the G7 markets would move their operations to other Asian economies
(such as Vietnam and Thailand) and export from there, and G7 importers would
start importing the same goods from other Asian countries instead. In the
absence of a collective appreciation of all Asian currencies, a yuan appreciation
would only reconfigure the geographical distribution of the global imbalances,
not eliminate them.
How could a collective regional appreciation against the US dollar be
achieved?
It would be naive to assume that Asian currencies tend to move closely together
when one of them moves a large amount, such as 40 per cent. The last time
the Asian currencies moved together by a large amount was during the Asian
financial crisis of 1997–98, and China did not join in despite many predictions to
the contrary. Should the US government now expand its currency appreciation
campaign serially to other East Asian countries and undertake a ‘surge’ in
exchange rate activism on any country that pushes back? For many reasons,
this would not be a desirable international economic strategy for the United
States. 18
Would a large, simultaneous collective appreciation of the Asian
currencies be an unambiguous gain for the United States?
We are not sure. Immediate cessation of the foreign financing of the US savings
gap would translate into an immediate zero current account balance, and
this would require an immediate increase in US exports and/or an immediate
decrease in US imports. Exports would increase quickly only if there were
substantial excess production capacity or if there were a substantial drop in
domestic demand that freed up the domestic goods for sale abroad. Imports
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Facing protectionism generated by trade disputes
would decrease quickly only if there were excess production capacity (to
enable replacement of imports) or if there were a substantial drop in domestic
demand that reduced the use of consumer goods and inputs. Since there is no
substantial excess production capacity in the US economy today, the immediate
elimination of the current account deficit would require a huge drop in domestic
demand, which would have its origin in a large negative wealth shock, possibly
in the form of a stock market collapse or an inflationary spike. 19
Would the absence of a yuan appreciation cause high inflation in
China, as Goldstein and Lardy (2003) claimed?
The growth of Chinese money supply has not slowed drastically despite the
heightening of anti-inflation rhetoric by the Chinese government in response
to the continued high growth of investment expenditure. Has the Chinese
government lost control of its money supply, as a number of analysts have
warned? Not at all. The speculative inflows and growth in foreign exchange
reserves cannot expand the money supply without the agreement of the People’s
Bank of China (PBC). As well as sterilisation through open-market operations,
China has the use of credit quotas on bank lending. The fact is that all Chinese
banks are state controlled, and their high-ranking executives are appointed by
the state. Given the choice between maximising bank profits or heeding orders
from the prime minister’s office, the bank chiefs can always be counted on to
choose the latter. There is no question about the Communist Party of China
losing control of the money supply since 2002.
Money supply growth in 2005–07 did not slow markedly because China chose
not to enforce the credit quotas stringently. First, the inflation rate, although
rising, is still low. Second, it is good politics to have a booming economy in the
period leading up to the important seventeenth Party Congress in November
2007, which will ratify important personnel appointments for the next five
years.
What is the correct level for the exchange rate?
The Economist magazine constructs a purchasing power parity (PPP) exchange
rate based on the prices of Big Mac hamburgers sold in different countries.
In 2006, it cost 10.4 yuan to buy a Big Mac in China and US$3.15 in the United
States, so the PPP exchange rate was 3.3 yuan per US dollar in 2006, compared
with the actual (nominal) exchange rate of 8 yuan per US dollar. Is it, therefore,
meaningful to say that the Chinese exchange rate was undervalued by almost
60 per cent in 2006? The answer is no, because the prices of the hamburgers
59

China—Linking Markets for Growth
included non-tradable inputs, and the prices of non-tradables were lower in
China than in the United States. In general, the prices of non-tradables are lower
in developing economies than in industrialised economies because labour costs
are lower in the former. With economic development, the prices of non-tradables
in the developing economies will rise to bring the price ratio of non-tradables
to tradables closer to the price ratio in the industrialised economy.
To see that the gap between the usual PPP exchange rate and the actual
exchange rate reflects the development gap between the two countries, we
first make the following definitions
a) Defining the consumer price index in China and the United States
CPI of China, CPI C = (1-a) P C T + a PC N
CPI of the United States, CPI U = (1-a) P U T + a PU N
(3)
where CPI is the consumer price index, C is China, U is the United States,
P i is the price of the tradable good in country ‘i’, T Pi is the price of the
N
non-tradable good in country ‘i’, and ‘a’ is the weight of non-tradable
goods in the price index.
b) Defining the PPP exchange rate
e PPP = CPI C / CPI U (4)
We next state the equilibrium conditions.
a) Goods arbitrage
P C T = eactual P U T (5)
where e actual is the actual (nominal) exchange rate expressed as the
number of yuan per US dollar.
b) Relationship between prices of tradables and non-tradables within each
country
for developing China, P C T = d PC N
for industrialised United States, P U T = f PU N (6)
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Facing protectionism generated by trade disputes
c) The difference between the industrialised and the developing economy
is that the relative price of non-tradables is higher in the former.
d > f > 0 (7)
We can now derive the following relationship between the PPP exchange rate
and the actual exchange rate
e PPP = CPI C / CPI U
e PPP = [(1-a+af)/(1-a+ad)] e actual
e PPP < e actual (8)
The above exercise shows that it is conceptually difficult to determine the
‘correctness’ of a country’s exchange rate on the basis of PPP exchange rates.
The actual (nominal) exchange rate of a developing economy will always be
undervalued in relation to the PPP exchange rate, and it is ludicrous to demand
that the government of the developing economy set its exchange rate equal to
the PPP exchange rate (because this is not a sustainable policy).
One meaningful definition of the ‘correct exchange rate’ is that it is the
‘market-clearing exchange rate’: the exchange rate that is generated by the
foreign exchange markets in the absence of intervention by any central bank.
The fact that the People’s Bank of China has been accumulating foreign
reserves during every period means that the yuan is undervalued according to
this definition. What would happen, however, if China were to go further in its
marketisation of foreign exchange transactions by removing its capital controls?
Diversification of asset portfolios by private Chinese agents would surely result
in a great outflow of funds, possibly causing the yuan to depreciate. In such a
case, the present exchange rate of 8 yuan per US dollar would be overvalued
compared with the ‘complete free-market exchange rate’. Of course, no one
knows whether the complete free-market exchange rate would be higher or
lower than 8 yuan per US dollar.
Suppose the value of the complete free-market exchange rate was 6.5 yuan
per US dollar and the market-clearing exchange rate with controls on capital
outflows was 4.5 yuan per US dollar—and suppose the government stops
intervention immediately and then removes capital controls a few years later,
after it has strengthened the supervision, management and technical capability
61

China—Linking Markets for Growth
of the domestic financial institutions. One plausible result of this particular twostep
market liberalisation (which we call Option A) would be appreciation to 4.5
yuan per dollar on cessation of foreign exchange market intervention followed
by depreciation to 6.5 yuan per dollar on removal of the capital controls.
Suppose China adopts another form of two-step liberalisation (Option
B), incremental appreciation of the yuan and removal of the capital controls
after a few years. Option B is better than Option A because the exchange
rate overshooting in Option A creates an unnecessary to-and-fro movement
in resources. As mentioned, the removal of capital controls could very well
cause the yuan to depreciate past 8 yuan per dollar, say, to 9.5 yuan per dollar,
meaning that Option A would result in very severe exchange rate overshooting
compared to Option B.
In effect, the Chinese government has been implementing a form of Option
B since July 2005. In our opinion, the Chinese government has chosen a speed
of exchange rate adjustment that is too slow, causing the yuan to depreciate
significantly against the euro. We recommend that the Chinese government
increases the speed of the yuan appreciation, but not in the form of an immediate
discrete 10–15 per cent appreciation as advocated by Goldstein (2007). 20
In our opinion, the instinctive calls by some economists for the use of the
exchange-rate mechanism to solve China’s external imbalance is only partially
correct. Given China’s capital controls, a freely floating currency regime could
mean a value for the yuan that would be greatly over-appreciated compared
with what its value would be under free capital flows, and could therefore
reduce economic growth significantly. 21 Freeing capital flows is not, however,
an option at this time. Given the weakness of the balance sheets of China’s
state-owned banks and the considerable embezzlement of state assets that
has occurred—and the experience of the East Asian financial crisis—we advise
against allowing the free movement of capital in the short term.
The correct way to think about exchange-rate management is to analyse
the issue within the context of overall macroeconomic management and not
just in regard to its impact on the balance of payments. It is likely that there are
alternative combinations of macroeconomic policies that would produce results
superior to the one generated by appreciating the yuan alone. The general point
is that because the balance of payments is only one of the main outcomes of
concern 22 and the exchange rate is only one of the ways to affect the balance
of payments, 23 it is seldom the optimum to concentrate exclusively on one
policy target (which does not dominate the other policy targets in importance)
and then to employ only one policy tool (which is chosen idiosyncratically) to
achieve that target.
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Facing protectionism generated by trade disputes
What is to be done?
The real source of the anxieties that have given rise to the present US obsession
with yuan appreciation is not the large trade imbalances but the large amount
of structural adjustment necessitated by the acceleration of globalisation and
of labour-saving technological progress. Dollar depreciation and trade barriers
will slow the process of structural adjustment but will not stop it because
the main driver of structural adjustment in the United States is technological
progress. The optimal solution is a policy package that emphasises multilateral
action to achieve several important objectives. It is bad economics and bad
politics to dwell on just one region (China alone must change), to dwell on just
one instrument (yuan appreciation alone) and to dwell entirely on one target
(external imbalance).
We start by stating what should be done in the United States. Congress
should quicken the reduction in fiscal imbalance, and expand trade adjustment
programs, especially those that upgrade the skills of younger workers. The
Trade Adjustment Assistance (TAA) program still functions inadequately after
its overhaul in 2002. Lael Brainard (2007) reported that
[p]articipation has remained surprisingly low, thanks in part to confusing
Department of Labor interpretations and practices that ultimately deny
benefits to roughly three-quarters of workers who are certified as eligible
for them. TAA has helped fewer than 75,000 new workers per year, while
denying more than 40 per cent of all employers’ petitions. And remarkably,
the Department of Labor has interpreted the TAA statute as excluding the
growing number of services workers displaced by trade. Between 2001 and
2004, an average of only 64 per cent of participants found jobs while they
participated in TAA. And earnings on the new job were more than 20 per cent
below those prior to displacement.
The TAA program is in clear need of further improvement. Brainard’s (2007)
proposal for the establishment of wage insurance is an excellent way to bring
the US social safety net more in line with the type of structural adjustments
driven by globalisation and technological changes.
What is to be done in China? The obvious short-term policy package has
three components. First, the steady process of yuan appreciation begun in July
2005 should be quickened—and should be used more aggressively as an antiinflation
instrument. Second, import liberalisation should be accelerated (for
example, commitments made in negotiations for WTO membership, such as
intellectual property rights protection, should be implemented) and expanded
beyond WTO specifications.
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China—Linking Markets for Growth
The third component of the short-term policy package is to have an
expansionary fiscal policy (such as rural infrastructure investments) to soak up
excess savings, with an emphasis on import-intensive investments (for example,
buying aeroplanes and sending students abroad). There must be time limits put
on the expanded public works and SCE investments because, in the long term,
increased public investments could follow an increasingly rent-seeking path
that is wasteful (for example, building a second big bridge to a low-populated
island to benefit a politically connected construction company, as happened
in Japan), and the increased SCE investments could convert themselves into
non-performing loans at the state-owned banks.
It is now common to hear calls for China to rebalance its growth path
by reducing savings to increase consumption. This advice on increasing
consumption cannot be wrong, however, consumption in China today is largely
under the control of individual families and firms. They have probably already
tried their best to optimise their consumption given all the constraints they
face, and are unlikely to welcome the government telling them how to spend
their money.
Since the health insurance and social security networks in China are in
their infancy, many Chinese people are choosing to save a great deal of money
as a hedge against severe illness. In the absence of student-loan programs,
families are also choosing to save a great deal for their children’s education.
Many middle-class Chinese families have bought property in anticipation of
capital gains but have refrained from moving into the new property because
roads, subways and schools for many newly developed residential communities
are underdeveloped. These are their best choices given the structural and
economic constraints on Chinese society. As a result, the consumption of
Chinese households remains low and savings rates remain high. All of these
factors beg the question, ‘how can China increase domestic consumption?’.
In the context of the above examples, the answers are quite straightforward:
build an integrated health insurance system; create student-loan and scholarship
programs; and build more roads, subways and schools. 24 The optimal solution
to the problem of excess saving is not, however, for the government to absorb
it by increasing its budget deficit but to establish an improved mechanism
for coordinating private savings and private investments. Establishment of a
modern financial system will not only achieve this objective, it will enhance
welfare and lower the savings rate by pooling risks through vehicles such as
medical and pension insurance. In a nutshell, China’s main challenge today
is to develop smoothly functioning financial, planning and regulatory systems
that can employ the remaining rural surplus labour (as indicated by an average
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Facing protectionism generated by trade disputes
wage of about US$120 per month for 480 million rural and migrant workers)
and surplus capital, which now shows up in China’s sustained current account
surplus and rising foreign exchange reserves.
The most important priority for financial-sector development is the appearance
and growth of competitive domestic private banks. As China is required by its
WTO accession agreement to allow foreign banks to compete against its stateowned
banks on an equal basis by 2007, it would be akin to self-loathing not to
allow the formation of truly private banks of domestic origin. There is no reason to
favour foreign private banks over domestic private banks, and there is no reason
why China should not allow its best financial minds to compete with—and achieve
the same glorious success as—the best foreign financial minds.
We therefore recommend that after the recapitalisation of the big four state
banks, at least two of them should be broken into several regional banks, and
the majority of these regional banks should be privatised. At the same time,
laws on the establishment of new banks should be loosened, and interest rates
deregulated. It is crucial, however, that financial-sector liberalisation proceeds
no faster than the development of the financial regulatory ability of the state.
Even then, the danger of substituting a financial crash for financial repression
is real. A modern financial system requires a modern system of supervision
and prudential regulation for its proper functioning.
It would be a good idea to sell a few of the regional state banks to foreign
banks. This would facilitate the transfer of modern banking technology to
Chinese banks. The more local staff the foreign bankers train, the larger is the
pool of future managers for Chinese-owned banks. An accelerated process
of promoting the growth of sound domestic private financial institutions and
allowing the entry of foreign financial institutions would shorten the time
needed for Shanghai to assume its rightful place among the major international
financial centres, and to contribute to more efficient intermediation of the
world’s savings.
An important part of financial reform should be promotion of the development
of sound rural financial institutions. The government can usefully draw on the
wealth of international experience with various schemes in developing economies
to direct investment credit to rural areas. In particular, we wish to draw attention
to the successful Indonesian experience of establishing a self-sustaining and
profitable banking system (the ‘Unit Desa’ system) in the countryside to provide
a starting point for discussing how to accelerate financial development in rural
China. 25 China should allow the appearance of new small-scale rural financial
institutions that will mobilise local savings to finance local investments as quickly
as adequate prudential supervision can be put into place.
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China—Linking Markets for Growth
The widespread international attention on the value of the yuan is possibly
the first time in international monetary history that the value of the currency
of a developing economy has so greatly exercised the finance ministries and
central banks of the largest industrialised economies for such a sustained
period. This anomalous situation reveals two noteworthy points about China’s
return to the international stage: it shows the significant economic impact
that China is already having on the world; and it portends that the anticipated
continued fast growth of China in the next two decades will not only force
more structural adjustments in other countries, it will require China to assume
a broader ‘global system’ perspective in resolving disputes caused by crossborder
spillovers from its policies. The most important and obvious area for
collaboration between China and industrialised economies at this point is
working together to further liberalise the multilateral free-trade system, and,
at the minimum, to prevent it being eroded.
As China continues to grow rapidly, there is the unfortunate possibility that
the range of international disputes could expand—possibly in the medium
term—to include international concerns about China’s public health readiness
and environmental protection. Hopefully, the world will be more multilateral in
its approach to the solution of these issues rather than insisting on a unilateral
solution by China, as in the present case of the yuan.
Notes
1 At the end of May, the National Development and Reform Commission predicted that ‘China’s
trade surplus will swell to between US$250 billion to US$300 billion this year, driven by price
competitiveness and strong external demand. The surplus for the first four months of this year
totaled US$63.3 billion, up 88% from the same period of last year’ (Wall Street Journal 2007a).
In mid June, it was revealed that China’s overall trade surplus had widened to US$22.45 billion
in May 2007, which was a 33 per cent gain on April’s figure (Standard 2007).
2 Details of these three WTO cases are found in USTR 2007a, 2007b and 2007c.
3 Neither the date nor the sample of newspapers was selected randomly. These were the
newspapers that were on the Singapore Airlines flight from Singapore to San Francisco (via
Hong Kong) on the day of our travel.
4 The article also reported that Peter Mandelson ‘wants greater access for European companies
to China and a crackdown on piracy—threatening extra tariffs or import quotas if not. He also
wants the renminbi pegged to a basket of currencies.’
5 The US civilian labour force in 2006 was 151.4 million (United States President 2007:Table
B-35).
6 For details and analysis of the economic transition in the former Soviet bloc and China, see
the papers in Woo et al. 1997.
7 More accurately, the wage of the formerly isolated worker in the former Soviet Union, India and
China would rise while the wage for the worker in the industrialised economy would fall.
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Facing protectionism generated by trade disputes
8 There is a large empirical literature on the relative impact of technological changes and
globalisation on the US wage rate; notable contributions include Sachs and Shatz (1994) and
Feenstra and Hanson (1996 and 1998).
9 Akerlof (2007) is a recent discussion on ‘norms’ and their economic consequences.
10 Borjas (1994) and Ottaviano and Peri (2005) are good discussions of this topic.
11 The data are from the Direction of Trade Statistics database maintained by the International
Monetary Fund (IMF 2007).
12 See Feenstra et al. 1999 for the details of the different national treatments. This study reestimated
the export and import data of China–US trade, and reduced the gap between the
two estimates: for example, the US$29 billion gap between the two official figures in 1996
was reduced to US$5 billion after revision of the data.
13 The simple average of the Direction of Trade Statistics data was closer than the simple average
of the official data to the simple average of the revised data of Feenstra et al. (1999); the latter
two are reported in Feenstra et al. (1999:Table 1).
14 The SCE category covers companies that are classified as state-owned companies and joint
ventures and joint-stock companies that are controlled by third parties (for example, legal
persons), who are answerable to the state.
15 The Economist Intelligence Unit (2004:23) reported that ‘farmers’ propensity to save seems
to have increased’.
16 Liu and Woo (1994) and Woo and Liu (1995) contain formal modelling and econometric support
for the investment-motivated saving hypothesis.
17 See, for example, Financial Times (2003).
18 For one thing, serial exchange-rate activism and the surge of it are unlikely to be more
successful than the expansion of the war from Afghanistan to Iraq and the surge of US military
effort in Iraq in 2007.
19 Considerations like this might be the reason why Goldstein and Lardy (2003) and Goldstein
(2007) advocated a two-step strategy of yuan appreciation: a modest appreciation followed
by incremental appreciation.
20 Our analysis therefore leads us to agree with the three recent policy positions of the US
Treasury: that China must increase the pace of reform in financial services market (Paulson
2007), that China has not engaged in currency manipulation, and that China should increase
the rate of yuan appreciation.
21 In Robert Mundell’s opinion, ‘China’s growth rate could fall by half and foreign direct investment
(FDI) could slow to a crawl if the country were to abandon its long-standing support of pegging
the currency’ (quoted in South China Morning Post 2003).
22 The inflation rate and unemployment would be among the other key concerns.
23 Other ways include monetary and fiscal policies.
24 Xiao (forthcoming) discusses this issue more fully and emphasises the problem of
distinguishing productive investments from non-productive investments.
25 Indonesia is similar to China in key economic and institutional features: a geographically
vast and heavily populated economy, and a rural financial system dominated by branches of
a state bank (Bank Rakyat Indonesia and Agricultural Bank of China respectively). See Woo
(2005).
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China—Linking Markets for Growth
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Economic Papers.
70

8
Global Capital Flows and the
Position of China: Structural and
Institutional Factors and their
Implications
Young Rok Cheong and Geng Xiao
Global capital flows into developing economies have been driven
by two fundamental factors: profit opportunities in the
emerging economic frontiers and the physical and institutional
barriers to international capital mobility. Advancement in transportation
and communication technology has greatly reduced the
physical costs of cross-border mobility of capital and goods while
the spread of global development knowledge has also led to new
profit opportunities in less developed economies, such as China.
Since the early 1980s, China has emerged as a major global
development frontier, following its open-door policies and economic
reforms initiated by Deng Xiaoping. Since that time, the barriers to
foreign trade and investment in China have declined steadily,
leading to China’s accession to the World Trade Organisation in late
2001 – after one-and-a-half decades of tough negotiations. By the
end of 2002, only a year after joining the WTO, China overtook the
US in FDI inflows, becoming the most attractive FDI destination in
the world, receiving $52.7 billion in FDI.
China’s recent dramatic achievement seems to suggest that
today’s global economy is unprecedented in terms of openness and
the amount of foreign capital flows into developing countries.
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Global Capital Flows and the Position of China
Unfortunately, this optimistic impression is not confirmed by facts.
Foreign capital flows into developing countries today are far below
historical record achieved before World War I. The gross value of
foreign capital stock in developing countries increased from 8.6% of
their GDP in 1870 to a peak of 32.4% in 1914. This ratio dropped
to 4.4% in 1950 due to the interruption to the global trade and
investment during the war and by 1973, recovered only to 10.9%
and 21.7% by 1998 (Maddison 2001, p. 28). Hence, in spite of
technological advances during the last century, the world is actually
less open for capital flows to less developed countries than one
hundred years ago.
Capital flows among developed countries are much freer than
between developed and developing countries because of better
protection of property rights and less capital control in the
developed economies. High capital mobility among developed
economies has led to a dramatic change in the holding of net foreign
assets among developed countries during the last decade. For
example, from 1989 to 1998, Japan’s holding of net foreign assets
increased from $294 to $1.153 billion while the US obligation in net
foreign liabilities jumped from $49 to $1.537 billion (Maddison
2001, p. 137). Clearly, Japan has exported a substantial amount of
capital to the US in search of better risk-adjusted return and in
preparation for its aging population, even while the policy
environment in Japan, such as the volatility of the exchange rate and
the secular appreciation of the yen, is unfavourable to Japanese
investment in foreign assets.
In the last decade, foreign direct investment in China increased
from about $3 billion in 1990 to $52.7 billion in 2002. As impressive
as this is, on a per capita basis, China’s FDI inflow in 2001 was still
below the average of FDI inflows to the rest of developing
countries. Per capita FDI inflows in 2001 was only $37 for China,
compared to an average of $120 for the world and $42 for all the
rest of developing countries.
Foreign invested enterprises in China have contributed to more
than half of China’s exports. China has been generating current
account surpluses for the last nine years. Since current account
surplus simply means net savings or net export of capital, China is
taking in FDI on the one hand and exporting capital to capital-rich
economies like the United States on the other hand. How can we
reconcile these seemingly inconsistent patterns of capital flows?
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Is China attracting too much FDI? What happened to China’s
investment in US bonds? What is the impact of foreign portfolio
investment on the stability of the Chinese financial markets and
other Asian regional markets? Is China generating global deflation?
How serious is China’s impact on its competitors? Is China saving
too much? Should China revaluate its currency? Is China becoming
a growth engine for the world? These are questions we examine in
this chapter.
The next section presents the basic facts on the patterns of global
capital flows and the position of China. Section 2 explains the
uniqueness of China’s economic conditions in attracting capital
inflows. Section 3 assesses the impact of China’s rapid integration
into the global economy on the rest of the world. Throughout our
analysis, we emphasise structural and institutional factors such as the
gaps in development, population structure, and financial and legal
institutions and their effects on the patterns of global capital flows
and global economic development. Section 4 concludes.
1 Global Capital Flows and the Position of China
In this section, we first summarise the pattern of global trade and
foreign direct investment based on the extensive information from
the WTO and the World Investment Report of UNCTAD. Then
we review global portfolio investment using detailed IMF and US
Treasury surveys. Our purpose here is to provide a concise and
comparative background to determine China’s position in the global
capital market.
US Trade Deficits with China and the Asian Region
Global merchandise trade increased from $124 billion in 1948 to
12.7 trillion in 2000, an increase of more than 100 times over a
period of half-century. Western Europe and North America have
maintained about 40% and 20% of the global trade respectively
throughout this period. Asia’s share has risen from about 14% to
about 24% at the costs of Latin America, Africa, and other regions.
During the last two decades from 1982 to 2001, the growth rate
for global merchandise trade varied from -5.8% in 1982 to 19.5% in
1995, averaging about 6.1% a year. The global trade in commercial
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Global Capital Flows and the Position of China
services was relatively stable at a level of about 23% of the
merchandise trade (see Table 1.1 1 ).
In 2000, Asia’s share of global exports (at 26.7%) is 3.9% higher
than its share of imports (at 22.8%) while North America’s share of
exports (at 17.1%) is 6.1% lower than its share of imports (at 23.2%)
due to exceptional export performance in Japan, Asia’s newly
industrialising trading economies and China. From 1948 to 2000,
Japan increased its share of global export from 0.4% to 7.7% and six
Asian traders (see Table 1.2) increased their share from 3% to
10.5%. In the last quarter of the 20th century, China increased its
share of global exports from 1.2% in 1983 to 4.3% in 2001, with a
strong momentum for further gains of market share in the future
(see Table 1.2).
In 2001, the US current account deficit (net capital import)
reached $393.4 billion. On the other side, current account surplus
(net capital export) was $87.8 billion for Japan, $57.1 billion for the
six Asian traders, $17.4 billion for China, and $39.6 for transition
economies (see Table 4.7). Except for Japan, many countries with a
current account surplus (net capital exporters) are not capital-rich
economies. In 2000, according to the IMF, the US absorbed 64% of
global net capital exports (i.e. the sum of the current account
surpluses of the rest of the world).
Who is financing the net capital import to the United States?
Table 4.10 shows the exports, imports and balance of goods account
for the US in 2002. The US goods deficit, which is the major part of
its current account deficit, is as high as $484 billion. The US goods
account deficit is financed by and distributed among the rest of the
world: 18% by North America, 18% by Western Europe, 14.5% by
Japan, and 21.3% by China. The importance of China in US trade
deficits is at the centre of the globalisation debate. Is China taking
away jobs from American workers or financing American
consumers? Is China generating global deflation? Is China saving
too much? Should China revaluate its currency? We discuss these
questions later.
Due to rapid regional integration of production through the socalled
supply chain management, China’s strong export performance
is intimately related to the export activities of its neighbours.
This modern management model, pioneered by Hong Kong
1
All tables and graphs are at the end of this chapter.
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Young Rok Cheong and Geng Xiao
117
entrepreneurs, separates the whole value-added chain into different
parts and searches for the best deals in distribution and production
among global providers of production and services. This innovation
makes our traditional concept of “made-in-China” or “made-in-
Japan” much less relevant as many parts of final goods and services
are produced or provided by countries other than the one where
final goods are exported.
Table 4.9 and Graph 5.2 show the rising US current account
deficits with the greater China, including Hong Kong and Taiwan.
It is clear that the part of trade deficits attributable to Hong Kong
and Taiwan are either declining or stabilising while the part due to
China is rising rapidly. This is largely because the production of
final goods has been rapidly relocated to China from Hong Kong,
Taiwan and other Asian economies over the last decade. But the key
components or high value-added parts of the supply chain are still
kept in the more developed Asian economies. If this part of the
contribution to the production of final goods is excluded, China’s
own value added in exports to the US would be very small. This
point needs to be remembered as we attempt to assess China’s
impact on the world. About two-thirds of China’s FDI is coming
from its neighbours such as Hong Kong, Macao, Taiwan, Japan,
Singapore and Korea, in part for the purpose of assembling final
products to be exported to North America and Europe.
Steady FDI Flows into China
Foreign direct investment is much more volatile than foreign trade,
but it is becoming increasingly important in recent decades for both
developed and developing countries. The growth rate for global
FDI fluctuated widely from 56.7% in 1999 to -50.7% in 2001,
averaging about 16.3% in the last two decades. As a result of rapid
FDI growth, global FDI flows as a percentage of global merchandise
trade increased from about 1.5% in the early 1980s to between 6%
and 12% in the last five years. But the scale of global FDI flows is
still much smaller than the global service trade, which is about 23%
of merchandise trade. At its peak in 2000, global FDI reached $1.5
trillion, or about 15% of the United States’ GDP (Table 1.1).
Most of global FDI, especially FDI among developed countries,
is through mergers and acquisitions (M&A) rather than green-field
investment. In 2001, M&A amounted to as much as 80% of global
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Global Capital Flows and the Position of China
FDI. Among all the M&A in 2001, 83.5% was conducted in the
developed countries, 31.1% in the US alone, and only 5.8% in Asia
and the Pacific region.
Developed countries are key hosts of FDI with their share of
global FDI at levels ranging from 60% to 80%. At the regional
level, North America has been expanding its market share at the
costs of European countries although the latter have been picking
up in the late 1990.
Graph 5.1 shows the trend since 1979 of FDI inflows to US,
China, Asia and the Pacific region, and all developing countries
excluding China. The US has been dominating the global FDI
inflows with its share ranging from 11.2% or $19 billion in 1992 to
26% or $283 billion in 1999. Asia and the Pacific region have
increased their market share from 15.2% in 1991 to 24.3% in 1996,
but the Asian financial crisis depressed their share to only 9% in
2000.
China’s share of global FDI increased from a low base of 1.7% in
1990 to a peak of 13% in 1994. After 1994, China’s share of global
FDI declined steadily to only 2.7% in 2000 largely due to massive
M&A activities in the developed economies during the tech bubble.
After the burst of the tech bubble, global FDI dropped 50% in 2001
but China’s FDI was growing steadily, contributing to a recovery of
China’s share in global FDI to 6.4%, which is consistent with its
trade expansion to 4.3% of the global export by 2001.
FDI into China has exceeded $40 billion since 1996 and has been
growing steadily every year since 1990. This puts pressure on other
developing countries, especially its Asian neighbours. As shown in
Table 1.3, the Asia-7, including India, Indonesia, Malaysia,
Philippines, Republic of Korea, Singapore, and Thailand, with more
population than China, only had $33 billion FDI inflows at their
peak year of 1997. After the Asian financial crisis in 1997-1998, the
Asia-7’s FDI inflows declined dramatically to only $18 billion by
2001. The Asian financial crisis however did not slow FDI flows into
the developing economies as a whole. FDI into developing economies
excluding China recorded a steady growth from $34 billion in
1990 to $147 billion in 1997, and peaked at $197 billion in 2000,
and then fell to $158 billion in 2001.
In 2001, per capita FDI inflows are $120 for the world, $420 for
the developed economies, $42 for the developing economies
excluding China, $37 for China, and only $12 for the Asia-7.
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Apparently China is winning the competition for FDI inflows and
its neighbours are very much concerned about this trend.
Table 1.6 shows inward FDI stocks for selected regions and
countries over the period from 1980 to 2001. Global FDI stock
increased from $636 billion in 1980 to $6258 billion in 2000, an
increase of almost ten times. During the same period, the world
trade volume only increased about three-folds from $4 trillion in
1980 to $12.5 trillion in 2000. This clearly shows the increasing
importance of FDI in the world economy and the expanding scope
and depth of globalisation.
However, the access to foreign capital is unequal with 5 billion
out of a 6.1 billion world population in the developing countries
receiving only $2.1 trillion out of $6.8 trillion in the FDI stock by
2001. In 2001, per capita FDI stock is $1,118 for the world, $3,763
for the developed economies, $478 for all developing economies
excluding China, $309 for China, and only $220 for the Asia-7.
The developed economies provided most of the global FDI stock
but its share is declining from 95.8% in 1980 to 87.8% in 2001. In
the last decade, Hong Kong emerged as a major financial centre for
facilitating capital flows into China. Hong Kong’s outward FDI
stock increased from $2.3 billion in 1985 to $375 billion in 2001,
exceeding Japan’s $300 billion. In 2001, Hong Kong captured 5.7%
of global FDI outward stock, compared with only 4.6% for Japan. A
significant part of Hong Kong’s outward FDI into China is “roundtripping”
Chinese capital, perhaps as much as one-quarter (World
Bank, 2002, p. 41).
The pattern of global FDI flows raises a few core questions. Is
China attracting too much FDI? Is China hurting its Asian
neighbours and competitors? These questions can only be discussed
meaningfully after examining many special development conditions
in China.
Two-Way Flows in Cross-Border Portfolio Investment
Based on the recent Global Portfolio Investment Survey by the IMF
(Table 2.1), the derived portfolio investment liabilities for the world
in 2001 are $12.5 trillion, about twice the amount of the global FDI
stock and almost equal to the sum of global merchandise exports and
imports. The IMF survey is so far the best estimate on the stock of
global portfolio investment. Compared to IMF’s last survey for
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Global Capital Flows and the Position of China
1997, the global portfolio investment stock doubled in only four
years. The top three targets for portfolio investment stock are very
stable, including the US, UK and Germany, sharing 24.5%, 10%,
and 9.2% of the global total respectively. Japan fell from the fourth
place in 1997 to the sixth in 2001, now behind France and the
Netherlands. Japan’s share dropped from 6.5% in 1997 to 4.2% in
2001, reflecting its weakening economy (see Table 2.1).
China made little progress in attracting foreign portfolio
investment during 1997 to 2001. The derived amount of foreign
portfolio investment in China increased slightly from $19.3 to
$20.1, reflecting its stagnant “B shares” market, which is a tiny
experimental stock market designed for foreign investors with share
prices quoted and traded in foreign exchange.
In March 2001, China opened its “B share” market to domestic
residents with foreign exchange savings. This opening caused a brief
surge in prices and many foreign investors took profits and dumped
many shares to domestic residents. At the end of 2002, China
announced its plan to allow the Qualified Foreign Institutional
Investors (QFII) to invest in its “A share” market designed for
domestic investors with RMB savings. The Chinese authorities are
also studying actively the mechanism of Qualified Domestic
Institutional Investors (QDII), which would allow Chinese residents to
invest in overseas securities markets, including Hong Kong markets,
where many Chinese companies are listed but their shares cannot be
sold to Chinese residents through legal channels. Compared to
China’s inward FDI stock of $395 billion, its foreign portfolio
investment stock of about $20 billion is insignificant. However, the
potential for foreign investment in China’s securities market is bright
as its stock market capitalisation is almost the same as that of Hong
Kong at $463 billion at the end of 2002, compared to $2 trillion in
Japan and $11 trillion in the US. China’s financial sector is still
underdeveloped and is the major bottleneck for China’s sustainable
growth and development as will be discussed further in the next
section. But with China’s commitment to WTO and its recent efforts
on modernising its financial regulation and development, it is just a
matter of time, perhaps as long as another decade, for China’s foreign
portfolio investment to catch up with its FDI and foreign trade.
To understand the potential foreign portfolio investment in
China, it is useful to take a look at the experiences of China’s more
developed neighbours. This is possible by examining the bilateral
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long-term securities investment data collected and maintained by
the US Treasury. Since the US is the largest player as assets and
liabilities holder in cross-border portfolio investment, the picture we
get from this data set should be illustrative. Some of the findings,
such as China’s huge investment in US bonds, are not only
surprising as new development but also have important implications
for building global capital market order.
Graph 6.1 shows the cross-border gross purchases and sales of
stocks and bonds between the US and the rest of the world. Clearly
the rest of the world traded much more US stocks and bonds than
the US traded the rest of the world’s stocks and bonds. In the most
recent period, the monthly gross purchases of US bonds by the rest
of the world are in the range of $600 to $800 billion. The monthly
gross purchases of US stocks by the rest of the world are in the
range of $200 to $400 billion. The monthly gross purchases of
foreign bonds or stocks by US residents, on the other hand, have
never exceeded $200 billion. A similar pattern can be seen in Graph
6.3 for the cross-border trading of stocks and bonds between the US
and Asia. Asia’s love with US bonds went back to the 1980s. Asian
countries have accumulated large amounts of net holdings of US
bonds, led by Japan and followed now by China.
Table 2.2 to 2.5 show the summary trends on cross-border
trading of long-term securities between the US and major Asian
economies. The transaction data reported monthly are added up to
get the annual numbers. The net purchases are derived by
subtracting the gross sales from gross purchases. During the ten
years from 1988 to 1997, Asia’s net purchases of US bonds reached
$415 billion, compared to $1.447 billion by the rest of the world. In
2001, Asia’s net purchases of US bonds were as high as $147 billion,
compared to $405 billion by the rest of the world. China’s net
purchases of US bonds in 2001 were as much as Japan’s at about
$52 billion. Both Japan and China have increased their net
purchases of US bonds after the Asian financial crisis. During the
ten years from 1988 to 1997, China’s net purchases of US bonds
were only 11.5% of the Asia total. But it increased to 23% in 1999,
19% in 2000, and 35.2% in 2001. Given China’s $280 billion official
reserves and about $260 non-official reserves foreign exchange
credit in the banking system, China’s increased net purchases of US
bonds are inevitable. But it is still surprising to know that China’s
share is as much as 35.2% of the Asia total.
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Global Capital Flows and the Position of China
Table 4.8 also shows a summary account of China’s balance of
payments since 1982. Two items are related to China’s capital
outflows. One is the current account surplus and the other is the
errors and omissions. China’s accumulated current account surplus
since 1982 reached $135 billion while the accumulated errors and
omissions since 1982 were even higher at $140 billion, both at about
12% of GDP. Table 4.8 also shows China’s external debt at the end
of 2001 was only about $170 billion or 14.7% of GDP. Clearly
China is putting a lot of official and private savings in US dollars.
Why? A simple explanation is property rights! Like other foreign
investors in US assets, the Chinese government and the Chinese
people certainly believe that the property rights of their US
investment are well protected. On the other hand, China also
provides better protection for property rights in FDI in China than
on domestic assets. Hence, on the whole, both sides are happy and
better protection of property rights enhances value and productivity
of capital.
It is interesting to note that the private foreign bank lending to
China is not as important as FDI. This can be seen from the
changes in cross-border banking capital flows between Hong Kong
and Mainland China during the last decade. As shown in Graph 5.3
and Table 4.11, Hong Kong used to be an important centre in Asia
for making syndicated loans to China and other Asian economies.
From 1994 to 1999, Hong Kong was a net lender of banking capital
to Mainland China. After 2000, however, Hong Kong turned into a
net borrower of banking capital from Mainland China. Since 1997,
there has been a steady decline in Mainland’s gross banking
liabilities to Hong Kong from more than $50 billion in 1997 to less
than 20 billion after 2001. This was triggered by the bankruptcy of
the GITIC (Guangdong International Trust and Investment
Corporation), which borrowed from foreign banks in Hong Kong
with the implicit understanding that the Chinese government would
guarantee the loans. The Chinese government, however, decided
not to use its money to save this regional state-owned holding
company in order to avoid moral hazard problem in similar cases for
other companies and in the future. After the GITIC bankruptcy,
foreign banks became very cautious in extending syndicated loans to
China.
During the Asian financial crisis in 1997, Hong Kong suffered a
huge withdrawal of foreign banking capital. Hong Kong’s foreign
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banking funds fell from $630 billion in June 1997 to $250 billion
by April 2002, a drop of 60%. Among the total withdrawal of
$380 billion, $251 is by Japan (see Table 4.11). In spite of fluctuations
in capital flows, Hong Kong’s banks have been extremely resilient
during and after the crisis with NPLs staying no more than 5%.
During the Asian financial crisis, short-term capital flows were
blamed as a driver for financial market instability. Hence, there have
been calls for caution on liberalisation of capital accounts and
portfolio investment. The role of foreign investors in the stability of
local markets becomes an interesting topic. Graphs 6.3 to 6.8
examine this issue using data after the Asian financial crisis and show
a strong negative correlation between the size of trading by foreign
investors and the level of the local stock market turnover. What it
means is that, at least, during the non-crisis period, the participation
of foreign investors in the Asian local stock markets enhances the
local market stability: the lower the local turnover, the higher the
share of trading by the US investors. This pattern appears in Japan,
Hong Kong, Singapore, Taiwan, Korea, and even the tiny “B share”
market of Mainland China. It appears that the US investment,
probably helped by their institutional investors, is more rational
than that of the local investors.
2 China’s Structural and Institutional Conditions for FDI
In spite of the large volume of literature on China’s foreign trade
and investment by scholars (Lardy, 2002), investment bank
economists (Lehman Brothers, 2002 and Goldman Sachs, 2003),
and international organisations (OECD, 2002), in our view, the
implications of recent development in China relating to its foreign
trade and investment are not appreciated properly in their scale,
scope and depth. This is partly due to China’s many unique
development conditions as well as an inclination to use the standard
equilibrium tools of economics to deal with intrinsically a
disequilibrium problem of development with unlimited supply of
cheap labour in China and other developing economies. This
section examines this Lewis type dual-sector development issue in
order to answer many of the questions raised in the previous
questions. The Lewis model of dual-sector development has many
new implications when the cross-border mobility of capital and
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Global Capital Flows and the Position of China
capitalist institutions become possible for a country as large as onefifth
of the world in terms of population.
Development Gaps and Unlimited Supply of Labour
China is large with one-fifth of the world’s population. China’s
labour force is larger than the sum in all developed economies.
China’s total GDP at purchasing power parity prices is about $5
trillion, or roughly half of the United States’ GDP at current prices.
However, China’s GDP at current prices is much smaller, about
one-fourth of Japan’s and one-tenth of US’s. However, for some
manufacturing products, China’s market share can be more than
50% of the global total. The size of China allows it to enjoy
economies of scale and scope. China can afford to have all major
global auto producers set up joint-venture production bases inside
China. However, China’s size in monetary terms is limited by the
extremely low market prices its labour and products have to face
now and for the next decade or so, a fact of life due to its effectively
unlimited supply of labour.
As shown in Table 3.4, in global context, China’s population is
mature, not too young and not too old, with 70% in working age of
15 to 65. China currently has only 7% population above age 65 and
23% under age 15.
China’s population compares favourably with both the aging
population in the developed economies and the less than mature
population in developing economies. The share of working age
population in China is among the highest at 70%, compared with
only 60% in other less developed countries and 67% in developed
countries.
The old age population in the developed countries reaches 15%,
or eight percent higher than in China. On the other hand, the
population under 15 in other less developed countries is as high as
36%, or 13 percent higher than in China.
Compared with both the developed and the other less developed
countries, China’s population structure in the past two decades and
next two decades is particularly favourable for rapid growth in
China, independent of other policy and institutional factors. China’s
advantage in population structure during these decades is further
enhanced by globalisation and the sustained prosperity in the
developed economies after World War II. Large amounts of
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retirement savings from the aging and rich economies accumulated
in the last half-century need to be invested in young, growing and
productive economies such as China.
China’s population structure today is almost the same as Japan’s
in 1975. Japan’s outstanding growth performance during the oneand-half
decades since 1975 could suggest that China should have at
least one more decade to enjoy the favourable population structure
for growth. However, Japan’s lost decade since 1990 also reminds
China of the challenges ahead. China has a window of opportunities
to reform its financial and legal system in the next decade to deal
with its future aging problem.
China is poor and has effectively unlimited supply of cheap,
mature and educated labour at least for the next one or two decades.
China’s per capita GDP at purchasing power parity prices of 2000 is
$3,920, slightly higher than the average for other less developed
countries at $3,470, but well below the level of $22,060 for the
developed countries. If using per capita GDP as a rough estimate for
average wage, China’s average wage at PPP would be about $1.86 an
hour ($3,920/[12mX22dX8h]). Since China’s GDP per capita at
current prices is only about $1,000, China’s average wage at current
prices would be only $0.47 an hour, compared to $10 an hour for
the developed economies under the same assumption.
At an average wage of less than half a dollar an hour, China has
added 150 million non-farm jobs over the last two decades and
reduced the number of people with income less than $1 a day by
150 million. This number, i.e. 150 million, is as large as the entire
population of Western Europe and its Western Offshoots (including
US, Canada, and Australia) in 1820 and is more than twice the
net migration to the Western Offshoots during the 129 years from
1870 to 1998 (Maddison 2001, p. 28). With this unprecedented
achievement in employment creation, China still needs to create at
least the same amount (150 million) of non-farm jobs perhaps over
the next one to two decades.
China’s case clearly fits well into W. Arthur Lewis’s dual-sector
economic development model of unlimited supply of labour except
that the Lewis model has never been applied seriously to an
economy as large and as open as the Chinese economy today. Also,
China has made great progress not only in providing primary
education for most of school age kids but also in higher education.
China produces more engineers in one year than Taiwan and Hong
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Global Capital Flows and the Position of China
Kong could do in ten to twenty years. Hence, China has not only
unlimited supply of cheap labour but also unlimited cheap talents.
This is confirmed by the fact that it is now more and more difficult
for China’s college graduates to find good jobs. China’s top
executive MBA programmes are as expensive as Hong Kong’s.
China’s overseas students have been putting pressures on their
classmates from other foreign countries.
Cross-Border Mobility of Capital and Capitalist Institutions
China’s economy is open, in many ways much more open than
today’s Japanese economy. China attracted much more FDI flows
and stocks than Japan. In 2001, Japan, with its half a century long
rapid economic growth and development, attracted only $49 per
capita in FDI flows and $395 per capita in FDI stock, compared to
the world average of $120 in flow and $1,118 in stock and China’s
$37 in flow and $309 in stock. At official exchange rates, China’s
foreign trade is more than 40% of GDP while Japan’s is about 20%.
China allows a large amount of processing trade, which requires a
large amount of imported components. Large scale processing trade
is only possible for very open economies with close to zero
transaction costs, including tariffs and other taxes. China has
committed itself to this close to zero transaction costs for processing
trade since early 1980s, drawing lessons from its successful
neighbours of newly industrialised Asian traders.
China’s experiences in opening up its economy have effectively
relaxed two crucial assumptions in international trade and development
theories: the mobility of capital and the replication of capitalist
institutions. Capital is mobile across the Chinese borders on a large
scale now as our review in the previous sections show. Traditional trade
theories based on factor immobility needs to be modified to take
capital mobility into account. For example, capital-intensive industries
such as auto and IC manufacturing can be profitable in China because
of the capital and technology brought in by FDI and MNCs. The
development of these capital-intensive industries is not constrained by
the lack of capital. Instead, it is determined by the total costs of
internationally linked supply chains and the global demand, including
the demand from China itself. Supply chain management theory and
global market equilibrium may be more important than the simple
application of traditional trade, investment, and macro theories.
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China’s imitation of capitalist economic institutions is also
unprecedented in scale, scope, depth, and speed, ranging from
central banks, modern public corporations, labour markets, stock
markets, and social security systems. The transfer of capitalist
institutions and practices is facilitated greatly by the existence of
mature market economies in the overseas Chinese communities in
Hong Kong and Taiwan as well as large amount of returning
overseas students and overseas Chinese business communities. In
this regard, the recent success and failure of Japan, Korea and other
Asian economies in development and modernisation also set useful
examples for China.
It is now possible for MNCs to combine unlimited supply of
Chinese cheap labour and cheap talents with advanced international
capital, technology and capitalist institutions by relocating some
major parts of their production and research in China. MNCs not
only benefit from access to China’s domestic markets but also gain
international competitiveness when they export some of their
products from their China bases. Since China allows MNCs to have
complete control on their China operations, they can get around
China’s underdeveloped financial and legal systems, at least for their
day-to-day operation. In other words, their risks of operation in
China are much lower than in other places in the region.
China’s rapid improvement in infrastructure over the last two
decades is also an important factor in attracting FDI. This is
especially relevant for a few key economic centres along the eastern
coast, including the Pearl River Delta region around Guangdong
and Hong Kong and the Yangtze River Delta region around
Shanghai. China now has more telephone lines than the US. Its
highway length is second only to that in the US and will form a
complete national network connecting all major cities across China
after the current five-year plan. Satellites are used not only for
television but also for clearing and settlements in banking and
securities transactions. Hong Kong has the world’s busiest seaport
and airport, handling 60% of China’s container shipments.
However, major port development planned in Shanghai and
Guangzhou are likely to increase their capacity to Hong Kong’s
current level in one or two decades. This rapid improvement in
infrastructure is coordinated by China’s forward-looking planning
authorities and led by innovative local leaders. China’s population
structure and its low level of development also allow fast catching up
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of investment in infrastructure. China’s obsession with infrastructure
investment is also encouraged by a generation of leaders
with engineering backgrounds who see investment in infrastructure
as much more valuable than investment in loss-making state-owned
enterprises. China’s government-directed infrastructure projects
may not make profits but will certainly facilitate the mobility of
labour, goods, and capital across China’s vast western, inland, and
coastal regions. They have laid a good physical foundation for
China’s further integration with the global market economy.
However, in the near future, China’s financial and legal systems
will come under great pressure to price the risks and returns for
millions of large and small projects, which would challenge even the
best bankers in the world. In spite of great achievements in
legislation, the legal system is still weak in the enforcement of
property rights and contracts. This weakness directly affects the
robustness and efficiency of China’s banking sector and capital
markets.
China’s financial system is efficient in generating savings but is
not effective in allocating them to productive investment. China’s
banking deposits increased from about 30% to 160% over the last
two decades. However, about 20% to 30% of these deposits have
difficulty finding productive investment outlets. A substantial part of
China’s surplus deposits ended up in government bonds. The local
governments are then forced to invest these funds in infrastructure
projects in order to keep the economy growing at 8% a year.
The flood of savings in China’s banking system is partly due to a
loose monetary policy during the early 1990s and after the Asian
financial crisis. China’s money supply (M2) increased ten times from
1990 to 2001 while its nominal GDP rose only five times during the
same period. Hence, China’s money supply is growing twice as fast
as its nominal GDP. China’s NPLs is in the range of 25% to 55% of
GDP by the official and private estimations. However, China’s
banking system is still stable for a number of reasons. First, the
government is still the owner of most banks in China and is
determined to reform its state-owned banks. So, the Chinese people
do not feel any risks to their bank deposits. Second, the Chinese
economy, although growing at 8% a year, still has ample surplus
labour and other unemployed resources, which are looking for
employment opportunities following two decades of a gradual but
steady loosening of migration policies and control of private
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enterprises. Third, China’s capital account is not open for its
domestic RMB deposit holders.
The traditional equilibrium model may not be useful for
understanding China’s macroeconomic conditions because of
China’s disequilibrium in the labour markets with unlimited supply
of labour. Unlike the situations in Japan and the newly industrialised
Asian economies, where the supply of labour quickly hit the limits
with wages shooting up, China’s market wages for the unskilled
labour in major manufacturing centres such as Guangdong have
been stagnant at a subsistence level of around $100 a month for
more than a decade.
China’s weak and inefficient financial system is creating a puzzle
of co-existence of surplus labour and capital. For 16 out of the 21
years since 1982, China ran current account surpluses, including the
last 9 years. The accumulated sum since 1982 of China’s current
account surpluses and the errors and omissions reached 23.8% of
GDP in 2001. As China reforms its financial system and opens up its
financial sector under the WTO commitment, the efficiency and
speed of China’s integration into the world economy will be
improved steadily. This implies that more and more of China’s
labour will work directly or indirectly for the global market
although their wages will be kept from rising due to ample surplus
labour. This trend of development in China is determined by the
interaction between China’s structural and institutional features and
prompts us to further examine the role of China as a world factory
and as a regional competitor in the next section.
3 Implications for the Rest of the World
To appreciate the impact of China’s development and integration
into the global economy, it is useful to review the history of global
capitalist development as articulated by Angus Maddison. For
thousands of years before 1000, the global economy was stagnant
but living standards as measured by GDP per capita were pretty
much equal across regions. During the first millennium, per capita
GDP of the world declined slightly from $444 to $435 (at the 1990
international prices for this and all other numbers cited from
Maddison, 2001) while world population increased only from 231 to
268 million.
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During the period from 1000 to 1820, global economic growth
picked up but slowly. Although the world population increased from
268 million to 1 billion, average per capita GDP for the world
increased only from $435 to $667. The world started to diverge in
development and income during this period. By 1820, the first
world, including Western Europe, Western Offshoots, and Japan,
increased their per capita GDP to $21,470 while the rest of the
world, or the third world, only had a per capita GDP level of $573.
From 1820 to 1998, a great divergence in development and
inequality in income emerged between the first and the third world.
The share of population in the first world declined from 16.8% to
14.2% but its share of GDP increased from 28.5% to 53.4%. By
1998, world population reached 5.9 billion with 5.1 billion in the
third world, including 1.2 billion in China.
The above are the global conditions under which W. Arthur
Lewis developed his dual-sector theory on economic development
under unlimited supply of labour (Lewis, 1954). Lewis pointed out
that the non-capitalist traditional sector in the rural area provides a
reservoir for unlimited supply of labour at a fixed urban wage
slightly higher than the subsistence rural wage. The urban wage is
checked not only by the surplus labour in the rural area but also by
rising unemployment in the urban area. This is exactly the condition
we see in China now. China’s leaders have been working hard to
raise the income for peasants. But that is a mission impossible with
the Lewis type development reality.
Lewis also points out that the capitalist modern sector is able to
generate profits and net savings for investment in capital that is
critical for sustained growth. He cites the evidences from Britain
where net savings increased from 5% before 1780 to 7% in early
1800s, and 12% around 1870. Similar rises of net savings are also
observed in the US between 1840s and 1890s, and in Asia after
World War II. Consistent with the Lewis dual-sector model,
Britain’s Manchester, US’s New England, New York, and Chicago,
Japan’s Tokyo and Osaka, and cities in Asia’s newly industrialised
economies have become the world factories one by one over time.
Now, the centre of global manufacturing is once again on the move
towards low costs economies. This time it goes to China’s
Guangdong and Shanghai, where access to unlimited supply of
labour is facilitated by low transportation and declining transaction
costs.
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China as a World Factory: Changes in Global Relative Prices
There is little disagreement on the trend that China will become a
world factory. Instead, the debates are on the impact of that trend on
the rest of the world. In our view, the single most important impact
of China’s outstanding development performance is on changes in
global relative prices. There is no doubt that new labour supply to
the global market will lead to a secular fall in the prices of labourintensive
manufacturing products.
Before China’s opening up, the world economy was largely a
capitalist open market economy dominated by the developed
economies. The majority of the third world population, including
those in China, were not very relevant to this global market. Let’s use
the population of age 15 to 65 in Table 3.4 to estimate the impact of
China’s opening on the labour supply in the world market. The
world’s working population at age 15 to 65 is 896 million in China,
2,242 million in other less developed countries, and 802 million in
more developed countries. Let’s assume for simplicity that about onequarter
of the labour force in China (224 million) and other less
developed countries (560 million) are working for the world market
now while the rest are effectively isolated from the world market.
Then, the total labour force working for the world market today
would be 1,586 million (224m+560m+802m). Since China’s labour
force was entirely outside of the global market twenty years ago,
China’s opening has added 224 million to the 1,363 million
(560m+802m) labour force that have already been integrated into the
global market. That is a net addition of about 16.4% over two
decades. If China’s past success in integrating its labour into the global
market can be continued and replicated in other developing countries,
the world market would certainly have no shortage of labour.
It is clear that the additional supply of China’s labour force to the
global market has concentrated in the manufacturing export sector.
This means the global prices for manufacturing products have to
fall dramatically. For example, the prices of televisions in the US
have been dropping by 8% a year since 1988. The deflation in
manufacturing products has started from the traditional labourintensive
products such as toys, plastics, clothing but has been
spreading to less labour-intensive products such as electronics and
machinery as China advances in its production and technology
capability.
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As the Say’s law predicts, supply creates demand, if there is a
perfect market. China’s opening leads to growth in income and
demand for final products. But it is clearly impossible for China to
consume all of its manufacturing products such as televisions,
DVDs, motorcycles, and bicycles. Because of China’s extremely low
level of per capita wealth, the Chinese people’s savings rate has been
as high as 40.3%, compared to 16.5% in the US, 20.3% in the
European Union, 26% in developing countries, and 27.3% in Japan.
China’s high savings depress its domestic current demand. Hence,
export is the most convenient way out and China’s export
significantly depresses global prices on some specific products such
as toys, televisions, and bicycles.
China’s impact on deflation in the manufacturing products,
however, is not going to cause a global deflation because the weight
of manufacturing products made in China is too small in the total
expenditure basket of the developed economies. China’s exports,
which usually incorporate a high proportion of imported
components, are only about 4.3% of the world total in 2001. There
is a long way to go before China has a direct impact on global
deflation.
This is partly due to terms-of-trade effect. The more China
exports, the lower the product prices, and the lower the share of
China’s exports in the total expenditure of the developed economies,
other things given.
Anderson and Hu (2003) highlighted that China’s net export of
manufacturing goods is negligible for causing global deflation in
manufacturing prices. This is true but the large deflation effects on
specific products are hidden within the net manufacturing exports.
The export value is likely to be depressed because of falling prices
on China’s export while the import value is likely to be high, partly
due to stronger demand from China for key components which
China can not produce.
In monetary terms, China’s impact on the rest of the world is
small. But in terms of specific product prices and welfare, or the socalled
consumer surplus, China’s contribution to the increase of the
standards of livings in both developed and developing countries is
huge but invisible in statistics. Today’s lucky kids around the world
can testify to this with their made-in-China toys. Without China’s
production, most toys may cost five to ten times more.
As we have emphasised, China’s impact is on changes in global
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relative prices. The deflation in manufacturing sector is accompanied
by inflation in commodity and skills, which are needed to
support the rapid increase in the volume of manufacturing goods
and the rising living standards in China and elsewhere. China has
turned from a net exporter of oil to a net importer and its imports of
oil have increased steadily in the last decade to about 60 million tons
a year by 2001. China’s net commodity imports since 1990s have
tripled. China’s tuition for top rank executive MBA programmes is
as high as in Hong Kong or even in the US.
Changes in global relative prices are followed by structural
changes in the global economy. The most important change is the
shift of manufacturing to China. However, China is only becoming
a platform for global manufacturing in order to take advantage
of China’s favourable labour supply and domestic markets. It is
clear that this competition is not between China and the foreign
manufacturers. Instead, it is a competition among foreign manufacturers
themselves with China only participating as a supply of
labour and domestic markets. Foreign invested firms produce half of
China’s exports with only a small part of the value-added going to
China’s labour and with a high proportion of imported components.
FDI in China concentrated mainly in a few clusters of manufacturing
bases in the coastal region (see Table 4.5). The unskilled
labour for the export industry is, however, largely coming from poor
and remote western and inland regions of China.
China’s development and integration with the capitalist world
economy is not a miracle if we compare it with the industrialisation
in the UK, the US, Japan, and the newly industrialised Asian
economies. But the size and structure of China’s population and the
mobility of capital and capitalist institutions – made possible by
today’s advances in technology and development knowledge – make
China’s case special, especially for many of its neighbours.
China as a Regional Competitor: Benefits Versus Costs
For many Asians, it is amazing that China weathered through the
Asian financial crisis with few changes in its high growth rate of
around 8%. Many are wondering whether China’s growth is at the
costs of others by siphoning off market shares in foreign trade,
investment and domestic jobs. There is no doubt that China has
become a major competitor in the world market, especially for its
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Global Capital Flows and the Position of China
Asian neighbours. The competitive pressure from China can best be
seen from Table 1.6 on the share of global inward FDI stock. China
increased its share from only 1% in 1980 and 1985 to 5.8% in 2001
while the Asia-7, which has more population than China, did not
gain much from 4.2% in 1980 to 4.8% in 2001. China’s per capita
inward FDI stock reached $309 by 2001, moving towards Japan’s
$395, and well above Asia-7’s $220. However, China’s per capita
FDI stock is still less than the average for all developing countries,
which is at $478. Table 1.3 shows per capita inward FDI flows and
gives similar pattern.
China’s competitiveness in labour-intensive manufactures is well
recognised and attracted 60% of China’s total FDI as shown in
Table 4.3. However, FDI is also significant in the non-labourintensive
real-estate sector that has 12% of China’s FDI. The
services sector also attracted substantial FDI.
What is particularly relevant for our discussion in this section is
the concentration of China’s FDI in a few clusters of coastal super
cities, which have critical mass for global scale production,
distribution and financing.
Table 4.5 ranks China’s 31 provincial level regions by their FDI
inflows in 2001 and provides a number of indicators for the
provincial economies. The provinces and cities are then divided into
three groups by their ranking in FDI inflows: the top-9, the middle-
12, and the bottom-10. The top-9 includes, in descending order of
the share of average FDI during 2000-2001, Guangdong (25.7%),
Jiangsu (14.9%), Shanghai (9.3%), Fujian (8.5%), Shandong (7.6%),
Liaoning (5.4%), Zhejiang (4.8%), Tianjin (4.6%), and Beijing
(3.8%). Many foreign visitors are impressed by the physical changes
in the cities such as Shanghai and Beijing but the real stars of
productive investment and manufacturing capacity in China are
Guangdong and Jiangsu, where land prices have not been driven up
to international levels as in Hong Kong, Shanghai and Beijing while
access to finance, research and other services provided by the big
cities is still convenient.
The concentration of economic activities in the top-9 is
impressive, if not surprising. This group has about one-third of
China’s population but produced half of China’s GDP, attracted
three-quarters of China’s FDI, and generated 90% of China’s
foreign trade.
The middle-12 includes mostly inland provinces while the
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bottom-10 consists of all western provinces, the poorest region of
China. The middle-12 has half of China’s population and one-third
of China’s GDP but only attracted one-seventh of China’s FDI and
8% of China’s foreign trade. The bottom-10 has 18% of China’s
population, 10% of GDP, 3% of foreign trade, and 1.8% of FDI.
Given the diversity of China’s regions, it is natural to ask which
parts of China we would like to compare with its neighbouring
countries. With China’s huge population, it is also important to
compare FDI per capita.
In 2001, China’s top-9 attracted $97 per capita in FDI, much
higher than the Asia-7 of $12. But the Asia-7 did much better than
China’s middle-12 at $10 per capita and bottom-10 at $4 per capita.
Both China’s inland and western regions face similar concerns as
the Asia-7 countries. They are working hard to improve their
investment environment as well as lobby for more support from
China’s central government. China’s central government is also
working very hard to help the less developed regions, particularly
through the “Go West” strategy. The central government has
invested heavily in highways, railroads, airports and other
infrastructural works in the western regions but their effects on
attracting FDI did not generate the intended results. Instead, the
poor people in the western and inland regions continue to rush to
the eastern coast for jobs, riding on the new roads built by the
government. These unintended results, however, may be better than
the plan, as the migrant labourers send remittances, knowledge, and
even skills they learnt in the big cities back to their hometowns.
For the Asia-7, labour mobility to China’s eastern coast is out of
question except for a few highly skilled professionals. But intraindustry
trade is expanding as can be seen from the rising trade
volume for the six Asian traders (Taiwan, Hong Kong, Korea,
Malaysia, Singapore, and Thailand, re-export excluded; see Table
1.2). While China’s share of global export increased from 2.5% in
1993 to 4.0% in 2000, the six Asian traders’ share increased from
9.7% to 10.5%. During the same period, Asia as a whole increased
slightly its share of global exports from 26.3% to 26.7% with a
significant decrease in Japan’s share from 10% to 7.7% and Australia
and New Zealand’s share from 1.5% to 1.2%.
There is no doubt that China’s export growth is much faster than
its neighbours’ as shown in Table 4.1. During 1990-2000, China’s
export growth was 14.9%, compared to 8.4% for the export growth
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Global Capital Flows and the Position of China
in Asia. But it is due to two factors. First, China started from a very
low share of only 2.5% of global trade in 1993. Even in 2001,
China’s share of global exports was only 4.3%. Second, as discussed
in the previous section, China’s exports include many components
imported from Asian and Western economies. The value-added
from China is small.
Table 4.2 compares the market share in global manufactures
exports in 1990 and 2000. This table should ease the concerns by
China’s competitors in Asia a bit as it shows clearly that they can
grow with China at the costs of more developed economies in terms
of market shares in manufacture export. From 1990 to 2000, the
developed economies lost 11 percentage points of market share in
global manufactures exports. Asia’s gain is as high as 7.3 percentage
points. China gained 2.3 percentage points while the six Asian
traders gained 3.1 percentage points, more than the gain by China.
The rest of Asia excluding China and the six Asian traders also
gained 1.3 percentage points.
Hence, China is not only a regional competitor but also an
important partner in terms of the integration of Asia’s global-scale
manufacturing. China not only has an unlimited supply of labour
and talents but also large markets for consumer products and
manufacturing equipments and parts, which are all opportunities for
its neighbours. Hong Kong and Taiwan are the first in seizing the
opportunities, followed by the US, Europe, and Japan.
The competitive pressures from China will not go away until
most of China’s surplus labour is absorbed by the expanding modern
sector. The key is how to best position oneself in the increasingly
competitive global economy. The pressure to force China to revalue
its currency would not affect China’s export competitiveness, simply
because the real wage in China is not set by the nominal exchange
rate. China’s wages are extremely flexible at the low end. The real
wage for unskilled labour is determined by the subsistence-level
income in China’s rural areas. The reliable and sustainable way for
China’s real wage to increase is to help China to develop its poor
regions in the western and inland provinces.
However, a revaluation in RMB is likely to put large deflation
pressure in the coastal regions’ real estate and services sectors as
these modern sectors are already substantially integrated with the
world economy. The price structure there, except for the wage of
unskilled migrant labour, are much more sensitive to changes in
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nominal exchange rates. In particular, large amount of assets and
liabilities concentrated in the more advanced regions of China are
denominated in foreign exchange. Any attempt to adjust the
currently fixed exchange rate of RMB would be equivalent to
redistribution of wealth among holders of foreign exchange assets
and liabilities, similar to redistribution among creditors and debtors
during inflation or deflation. Given China’s sustained surplus in
current account and rising official and private foreign exchange
reserves, it is entirely creditable for China to maintain the current
fixed exchange rate regime. Then, China can leave any adjustments
in real wages and other prices to domestic price adjustments. Given
China’s disequilibria in many markets, including the labour markets,
China’s fixed exchange rate provides an anchor and a reference for
gradually rationalising China’s price structure. Partly due to the
fixed exchange rate, China’s price structure today is largely consistent
with the requirement of a market economy.
As discussed in the previous section, China’s current account
surplus implies that China is exporting capital, which does not seem
consistent with China’s unlimited supply of labour. Would a
revaluation of RMB help to turn China’s current account surplus
into balance or deficit? Not really! China’s excessive savings are not
due to exchange rates but are a result of its underdeveloped financial
system, which is not able to identify good projects and enforce
lending contracts. Revaluation of RMB would depress the best parts
of the Chinese economy and lead to less lending and more surplus
savings, and hence more current account surplus, just like what
happened in Japan when the yen appreciated. So, for those who
would like to see a reduction in current account surplus in China or
Japan, they need to help China and Japan reform their financial
system, and not tamper with the exchange rates. After all, we all
have learnt from the Keynesian and Monetarist debates about the
neutrality of money and monetary policy in the long run. Exchange
rate policy is only part of the monetary policy. The role of China in
the region and in the global financial system is real, not just a
monetary phenomenon. The aging populations in Japan, Europe
and the US also need real returns from their savings, not nominal or
monetary illusions.
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Global Capital Flows and the Position of China
4 Conclusion
This paper reviews global capital flows and the position of China.
We have found that the rapid FDI inflows into China, following its
economic opening and reform, are essentially driven by two factors:
China’s unlimited supply of labour and talents and China’s declining
barriers for cross-border mobility of capital and capitalist institutions.
The combination of China’s unlimited supply of labour with
foreign capital under capitalist institutions is transforming China into
a world factory much like what happened before in Europe, America,
and Asia. The consequences of this are also similar to what we have
seen in the past: a decline of prices for labour-intensive manufacturing
products and a relative rise in the prices for raw materials and skills.
The catching up of China in economic development provides
competitive pressures as well as productive opportunities for the
world and especially for its neighbours. The aging populations in
the developed countries also need to rely on the much younger and
mature population in China and Asia to secure good returns on their
retirement savings.
However, due to the underdeveloped financial system in China
and other developing economies, global savings have refused to flow
into these developing economies with growth potential. Even China
is having a net export of savings as the Chinese government and
people are accumulating foreign assets, especially US bonds and
stocks. The global savings and capital flows, although driven by
structural factors such as the costs of labour, are hindered by
institutional factors, such as the quality of domestic banks and
capital markets in the less developed countries. This flight to quality
is partly responsible for the tech bubbles in the US and lies at the
heart of volatility in global capital flows.
The solution to these global mismatches in capital flows lies not
in manipulating exchange rates and other monetary tools, which
cannot change the real wages and potential competitiveness of
developing economies like China. Instead, developed economies
need to focus on real development problems in the developing
countries, which have more than 80% of the world’s population.
FDI is successful in China largely because foreign investments do
not rely on the domestic financial system and foreign investors have
complete control over the companies they establish.
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China has not yet become an engine of growth for the global
economy in cash terms. However, in terms of GDP measured by
PPP or the welfare of the global population or the global consumer
surplus, China is becoming an engine of growth for the world. This
is why we need to study China’s success and its problems seriously
since they have profound implications for all of us.
References
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Lardy, Nicholas R. (2002), Integrating China into the Global Economy,
Brookings Institute Press, Washington D.C.
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Possibilities, Present Realities, Lehman Brothers, New York.
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Challenges, OECD, Paris.
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Sheet, Washington D.C.
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York/Geneva.
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Global Capital Flows and the Position of China
Table 1.1. Global Trade and Investment, 1982-2001
(in billions of dollars and percentages)
1982 1983 1984 1985 1986 1987 1988 1989 1990 1991
Level
FDI 59 51 60 58 86 140 164 193 203 160
M&A 116 140 156 81
Service Trade 805 775 800 783 902 1,069 1,218 1,336 1,601 1,673
Merchandise Trade 3,780 3,684 3,889 3,931 4,326 5,050 5,737 6,156 6,982 6,982
Growth
FDI -13.2 17.0 -4.3 50.1 61.8 17.1 17.6 17.6 5.3 -21.0
M&A
Service Trade -2.4 -3.7 3.2 -2.2 15.3 18.5 13.9 9.7 19.8 4.5
Merchandise Trade -5.8 -2.5 5.6 1.1 10.1 16.7 13.6 7.3 13.4 0.0
As percentage of Merchandise Trade
FDI 1.6 1.4 1.5 1.5 2.0 2.8 2.9 3.1 2.9 2.3
M&A 2.0 2.3 2.2 1.2
Service Trade 21.3 21.0 20.6 19.9 20.9 21.2 21.2 21.7 22.9 24.0
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Table 1.1. (continued)
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Average
1982-
2001
Level
FDI 171 228 260 331 386 478 694 1,088 1,492 735 351.9
M&A 79 83 127 187 227 305 532 766 1,144 594 206.2
Service Trade 1,863 1,897 2,077 2,387 2,536 2,627 2,662 2,713 2,872 2,870 1,773.4
Merchandise Trade 7,484 7,464 8,485 10,142 10,585 10,950 10,797 11,204 12,538 12,601 7,638.3
Growth
FDI 6.9 32.9 14.1 27.3 16.8 23.8 45.3 56.7 37.1 -50.7 16.3
M&A -1.8 4.8 53.0 46.8 21.7 34.3 74.4 44.1 49.3 -48.1 27.8
Service Trade 11.4 1.8 9.5 14.9 6.3 3.6 1.3 1.9 5.9 -0.1 6.7
Merchandise Trade 7.2 -0.3 13.7 19.5 4.4 3.5 -1.4 3.8 11.9 0.5 6.1
As percentage of Merchandise Trade
FDI 2.3 3.0 3.1 3.3 3.6 4.4 6.4 9.7 11.9 5.8 3.8
M&A 1.2 1.1 1.5 1.8 2.1 2.8 4.9 6.8 9.1 4.7 1.9
Service Trade 24.0 25.4 24.5 23.5 24.0 24.0 24.7 24.2 22.9 22.8 22.8
Source: UNCTAD, World Investment Report 2002, website.
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Table 1.2 World Merchandise Trade by Region, 1948-2000
(in billions of dollars and percentages)
1948 1953 1963 1973 1983 1993 2000
World export in value 58.0 84.0 157.0 579.0 1835.0 3641.0 6186.0
Export Share
World 100.0 100.0 100.0 100.0 100.0 100.0 100.0
North America 27.3 24.2 19.3 16.9 15.4 16.8 17.1
Latin America 12.3 10.5 7.0 4.7 5.8 4.4 5.8
Western Europe 31.5 34.9 41.4 45.4 38.9 43.7 39.5
C./E. Europe/Baltic
States/CIS 6.0 8.1 11.0 9.1 9.5 2.9 4.4
Africa 7.3 6.5 5.7 4.8 4.4 2.5 2.3
Middle East 2.0 2.7 3.2 4.1 6.8 3.4 4.2
Asia 13.6 13.1 12.4 14.9 19.1 26.3 26.7
Japan 0.4 1.5 3.5 6.4 8.0 10.0 7.7
China 0.9 1.2 1.3 1.0 1.2 2.5 4.0
India 2.2 1.3 1.0 0.5 0.5 0.6 0.7
Australia and
New Zealand 3.7 3.2 2.4 2.1 1.4 1.5 1.2
Six East Asian traders* 3.0 2.7 2.4 3.4 5.8 9.7 10.5
World import in value 66.0 84.0 163.0 589.0 1881.0 3752.0 6490.0
Import Share
World 100.0 100.0 100.0 100.0 100.0 100.0 100.0
North America 19.8 19.7 15.5 16.7 17.8 19.8 23.2
Latin America 10.6 9.3 6.8 5.1 4.5 5.2 6.0
Western Europe 40.4 39.4 45.4 47.4 40.0 42.9 39.6
C./E. Europe/Baltic
States/CIS 5.8 7.6 10.3 8.9 8.4 2.9 3.7
Africa 7.6 7.0 5.5 4.0 4.6 2.6 2.1
Middle East 1.7 2.0 2.3 2.8 6.3 3.2 2.6
Asia 14.2 15.1 14.2 15.1 18.5 23.4 22.8
Japan 1.0 2.9 4.1 6.5 6.7 6.4 5.8
China 1.1 1.7 0.9 0.9 1.1 2.8 3.5
India 3.1 1.4 1.5 0.5 0.7 0.6 0.8
Australia and
New Zealand 2.6 2.4 2.3 1.6 1.4 1.5 1.3
Six East Asian traders* 3.0 3.4 3.1 3.7 6.1 9.9 9.5
Note:
* Asia six: Taiwan, Hong Kong, Korea, Malaysia, Singapore, and Thailand;
Significant re-exports excluded.
Source: WTO.
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Table 1.3 FDI Inflows in Selected Regions, 1990-2001
(in billions of dollars)
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Popu- 2001 FDI
lation Inflows
(million) per capita
Total World 203 160 171 228 260 331 386 478 694 1,088 1,492 735 6,125 120
Developed countries 165 113 107 137 145 203 220 268 484 838 1,227 503 1,197 420
United States 48 23 19 51 45 59 84 103 174 283 301 124 287 433
Japan 2 1 3 0 1 0 0 3 3 13 8 6 127 49
Asia and the Pacific 25 24 33 59 69 76 94 106 96 103 134 102
China 3 4 11 28 34 36 40 44 44 40 41 47 1,281 37
Hong Kong, China 3 1 4 7 8 6 10 11 15 25 62 23 7 3358
Taiwan Province of China 1 1 1 1 1 2 2 2 0 3 5 4 23 183
Greater China sub-total 8 7 16 35 43 44 53 58 59 68 108 74 1,310 56
India 0 0 0 1 1 2 3 4 3 2 2 3 1,050 3
Indonesia 1 1 2 2 2 4 6 5 0 -3 -5 -3 217 -15
Malaysia 3 4 5 6 5 6 7 6 3 4 4 1 24 23
Philippines 1 1 1 1 2 1 2 1 2 1 1 2 80 22
Republic of Korea 1 1 1 1 1 2 2 3 5 9 9 3 48 66
Singapore 6 5 2 5 9 9 9 11 6 12 5 9 4 2050
Thailand 3 2 2 2 1 2 2 4 5 4 3 4 63 60
Asia-7 sub-total 13 14 13 17 20 26 31 33 24 29 20 18 1,486 12
Developing countries 38 44 59 83 109 113 153 191 188 225 238 205 5,018 41
All developing countries
minus China 34 40 48 56 75 77 113 147 144 185 197 158 3,737 42
Source: UNCTAD, World Investment Report 2002, website.
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Table 1.4 Share of Global FDI Inflows by Selected Regions, 1990-2001
(in percentages)
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Total World 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0
Developed countries 81.2 70.6 62.7 60.3 55.7 61.5 57.0 56.0 69.7 77.0 82.3 68.4
United States 23.9 14.2 11.2 22.3 17.4 17.8 21.9 21.6 25.1 26.0 20.2 16.9
Japan 0.9 0.9 1.6 0.0 0.3 0.0 0.1 0.7 0.5 1.2 0.6 0.8
Asia and the Pacific 12.2 15.2 19.4 26.0 26.5 23.0 24.3 22.2 13.9 9.5 9.0 13.9
China 1.7 2.7 6.5 12.1 13.0 10.8 10.4 9.3 6.3 3.7 2.7 6.4
Hong Kong, China 1.6 0.6 2.3 3.0 3.0 1.9 2.7 2.4 2.1 2.3 4.2 3.1
Taiwan Province of China 0.7 0.8 0.5 0.4 0.5 0.5 0.5 0.5 0.0 0.3 0.3 0.6
Greater China sub-total 4.0 4.2 9.3 15.5 16.6 13.2 13.6 12.1 8.5 6.2 7.2 10.0
Singapore 2.7 3.1 1.3 2.1 3.3 2.7 2.2 2.2 0.9 1.1 0.4 1.2
Republic of Korea 0.4 0.7 0.4 0.3 0.3 0.5 0.6 0.6 0.8 0.9 0.6 0.4
India 0.1 0.0 0.1 0.2 0.4 0.7 0.7 0.8 0.4 0.2 0.2 0.5
Indonesia 0.5 0.9 1.0 0.9 0.8 1.3 1.6 1.0 -0.1 -0.3 -0.3 -0.4
Malaysia 1.3 2.5 3.0 2.5 1.8 1.8 1.9 1.3 0.4 0.4 0.3 0.1
Philippines 0.3 0.3 0.5 0.5 0.6 0.4 0.4 0.3 0.3 0.1 0.1 0.2
Thailand 1.3 1.3 1.2 0.8 0.5 0.6 0.6 0.8 0.7 0.3 0.2 0.5
Asia-7 sub-total 6.6 8.9 7.6 7.3 7.7 8.0 8.0 6.9 3.4 2.6 1.4 2.5
Developing countries 18.5 27.7 34.6 36.6 41.9 34.0 39.5 40.0 27.0 20.7 15.9 27.9
All developing countries minus China 16.8 25.0 28.1 24.5 28.8 23.2 29.1 30.7 20.7 17.0 13.2 21.5
Source: UNCTAD, World Investment Report 2002, website.
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

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145
Table 1.5 Shares in M&A Sales by Selected Regions and Countries
(in percentages)
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Total World 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0
Developed countries 91.7 86.2 81.4 87.0 87.9 82.6 76.1 83.4 88.7 92.3 83.5
United States 35.0 20.0 24.1 35.2 28.5 30.0 26.8 39.4 32.9 28.4 31.1
Japan 0.2 0.3 0.1 0.6 0.3 0.8 1.0 0.8 2.1 1.4 2.6
Asia and the Pacific 2.7 4.6 8.8 3.7 3.8 5.9 7.1 3.0 3.8 1.9 5.8
China 0.2 0.3 0.7 0.6 0.2 0.8 0.6 0.2 0.3 0.2 0.4
Hong Kong, China 0.7 2.1 6.4 1.3 0.9 1.4 2.4 0.2 0.5 0.4 1.7
Taiwan Province of China 0.2 0.0 0.2 0.1 0.4
Greater China sub-total 3.2 0.3 1.1 0.7 2.6
Singapore 0.1 0.3 0.1 0.1 0.5 0.1 0.1 0.1 0.2
Republic of Korea 0.2 0.3 0.2 0.2 0.4 0.2 0.1 0.1 0.2 0.1 0.6
India 0.2 0.1 0.6 0.3 0.1 0.3 0.1 0.2 0.2 0.0 0.2
Indonesia 0.1 0.5 0.2 0.7 0.6 0.2 1.4 0.4 0.2 0.0 0.3
Malaysia 0.8 0.0 0.0 0.0 0.1 0.2 0.3 0.7 1.3 0.6 0.6
Philippines 0.3 0.3 0.4 0.3 0.7 0.3 0.1 0.1 0.4 0.1 0.8
Thailand 0.1 0.6 0.1 0.1 0.1 0.1 0.2 0.6 0.3 0.2 0.2
Asia-7 sub-total 1.6 1.8 2.1 1.5 2.7 2.2 2.6 1.2 3.0
Developing countries 7.2 10.3 17.2 11.8 8.8 15.7 22.0 15.5 9.7 6.2 14.4
Source: UNCTAD, World Investment Report 2002, website.
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

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Table1.6 FDI Inward Stock by Selected Regions and Countries, 1980-2001
(in millions of dollars and percentages)
1980 1985 1990 1995 2000 2001 1980 1985 1990 1995 2000 2001 Popu- Inward
lation FDI
(million) Stock
per capita
Total World 635,534 913,182 1,871,594 2,911,725 6,258,263 6,845,723 100.0 100.0 100.0 100.0 100.0 100.0 6,125 1,118
Developed countries 389,715 568,670 1,382,978 2,021,303 4,124,261 4,504,122 61.3 62.3 73.9 69.4 65.9 65.8 1,197 3,763
United States 83,046 184,615 394,911 535,553 1,214,254 1,321,063 13.1 20.2 21.1 18.4 19.4 19.3 287 4,597
Japan 3,270 4,740 9,850 33,508 50,323 50,319 0.5 0.5 0.5 1.2 0.8 0.7 127 395
Asia and the Pacific 161,196 228,970 317,663 570,625 1,246,700 1,329,431 25.4 25.1 17.0 19.6 19.9 19.4
China 6,251 10,499 24,762 137,435 348,346 395,192 1.0 1.1 1.3 4.7 5.6 5.8 1,281 309
Hong Kong, China 124,286 129,750 148,183 174,063 429,036 451,870 19.6 14.2 7.9 6.0 6.9 6.6 7 66,451
Taiwan Province of China 2,405 2,930 9,735 15,736 27,924 32,033 0.4 0.3 0.5 0.5 0.4 0.5 23 1,424
Greater China sub-total 132,942 143,179 182,680 327,234 805,306 879,095 20.9 15.7 9.8 11.2 12.9 12.8 1,310 671
Singapore 1,177 1,075 1,668 5,652 18,916 22,319 0.2 0.1 0.1 0.2 0.3 0.3 1,050 21
Republic of Korea 10,274 24,971 38,883 50,601 60,638 57,361 1.6 2.7 2.1 1.7 1.0 0.8 217 264
India 5,169 7,388 10,318 28,732 52,748 53,302 0.8 0.8 0.6 1.0 0.8 0.8 24 2,185
Indonesia 1,281 2,601 3,268 6,086 12,440 14,232 0.2 0.3 0.2 0.2 0.2 0.2 80 178
Malaysia 1,327 2,160 5,864 9,991 62,786 47,228 0.2 0.2 0.3 0.3 1.0 0.7 48 976
Philippines 6,203 13,016 28,565 59,582 95,714 104,323 1.0 1.4 1.5 2.0 1.5 1.5 4 24,839
Thailand 981 1,999 8,209 17,452 24,468 28,227 0.2 0.2 0.4 0.6 0.4 0.4 63 451
Asia-7 sub-total 26,412 53,210 96,774 178,095 327,709 326,991 4.2 5.8 5.2 6.1 5.2 4.8 1,486 220
Developing countries 245,819 344,463 484,954 849,915 2,002,173 2,181,249 38.7 37.7 25.9 29.2 32.0 31.9 5,018 435
All developing countries
minus China 239,568 333,964 460,193 712,480 1,653,827 1,786,057 37.7 36.6 24.6 24.5 26.4 26.1 3,737 478
Source: UNCTAD, World Investment Report 2002, website.
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

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Table 1.7 FDI Outward Stock in Selected Regions and Countries, 1980-2001
(in millions of dollars and percentages)
1980 1985 1990 1995 2000 2001 1980 1985 1990 1995 2000 2001 Popu- Inward
lation FDI
(million) Stock
per capita
Total World 521,486 691,745 1,721,462 2,854,853 6,086,428 6,552,011 100.0 100.0 100.0 100.0 100.0 100.0 6,125 1,070
Developed countries 499,428 656,276 1,630,443 2,577,550 5,316,292 5,751,947 95.8 94.9 94.7 90.3 87.3 87.8 1,197 4,805
United States 215,375 238,369 430,521 699,015 1,293,431 1,381,674 41.3 34.5 25.0 24.5 21.3 21.1 287 4,807
Japan 19,610 43,970 201,440 238,452 278,445 300,115 3.8 6.4 11.7 8.4 4.6 4.6 127 2,356
Asia and the Pacific 6,206 11,699 47,813 185,931 583,524 603,290 1.2 1.7 2.8 6.5 9.6 9.2
China - 131 2,489 15,802 25,804 27,579 0.0 0.1 0.6 0.4 0.4 1,281 22
Hong Kong, China 148 2,344 11,920 78,833 365,803 374,780 0.0 0.3 0.7 2.8 6.0 5.7 7 55,115
Taiwan Province of China 97 204 12,888 25,144 49,187 54,667 0.0 0.0 0.7 0.9 0.8 0.8 23 2,430
Greater China sub-total 2,679 27,297 119,779 440,794 457,026 0.0 0.4 1.6 4.2 7.2 7.0 1,310 349
Singapore 235 250 281 495 1,311 2,068 0.0 0.0 0.0 0.0 0.0 0.0 1,050 2
Republic of Korea - 55 77 1,295 2,339 2,464 0.0 0.0 0.0 0.0 0.0 217 11
India 197 1,374 2,671 11,143 18,688 18,955 0.0 0.2 0.2 0.4 0.3 0.3 24 777
Indonesia 171 171 155 1,220 1,965 2,126 0.0 0.0 0.0 0.0 0.0 0.0 80 27
Malaysia 127 461 2,301 7,787 50,552 40,825 0.0 0.1 0.1 0.3 0.8 0.6 48 844
Philippines 3,718 4,387 7,808 35,050 53,009 63,225 0.7 0.6 0.5 1.2 0.9 1.0 4 15,054
Thailand 13 14 404 2,173 2,439 2,610 0.0 0.0 0.0 0.1 0.0 0.0 63 42
Asia-7 sub-total 6,712 13,698 59,163 130,304 132,274 0.9 1.0 0.8 2.1 2.1 2.0 1,486 89
Developing countries 22,058 35,469 90,404 270,925 751,632 776,065 4.2 5.1 5.3 9.5 12.3 11.8 5,018 155
All developing countries
minus China 22,058 35,338 87,915 255,123 725,828 748,486 4.2 5.1 5.1 8.9 11.9 11.4 3,737 200
Source: UNCTAD, World Investment Report 2002, website.
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

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Global Capital Flows and the Position of China
Table 2.1 Derived Portfolio Investment Liabilities in Selected Countries,
Year-End 1997 and 2001
(in millions of dollars and percentages)
Equity Securities Long-term Debt Securities Short-term Debt Securities TOTAL Share in TOTAL
Investment in: 1997 2001 1997 2001
United States 427,579 997,821 886,325 1,653,419 36,192 417,850 1,350,096 3,069,090 22.18 24.46
United Kingdom 313,962 705,331 232,378 395,148 7,099 153,795 553,439 1,254,346 9.09 10.00
Germany 143,058 271,367 446,255 798,524 2,437 81,488 591,750 1,151,378 9.72 9.18
France 163,195 388,422 105,150 332,358 2,222 55,209 270,567 775,990 4.44 6.19
Netherlands 164,443 285,897 116,817 368,280 1,938 37,417 283,199 691,594 4.65 5.51
Japan 241,804 333,581 144,855 157,246 7,382 36,553 394,041 527,380 6.47 4.20
Hong Kong SAR of China 62,952 79,056 9,884 8,829 1,188 505 74,024 88,390 1.22 0.70
Korea, Republic of 6,085 51,666 31,259 22,650 706 2,018 38,050 76,334 0.62 0.61
Singapore 19,316 35,850 4,918 7,330 129 1,236 24,363 44,417 0.40 0.35
Taiwan Province of China 9,302 38,808 2,545 2,004 21 65 11,868 40,877 0.19 0.33
Russian Federation 10,937 10,753 17,530 14,831 1,687 318 30,154 25,902 0.50 0.21
Malaysia 14,645 11,508 10,541 9,526 417 293 25,603 21,327 0.42 0.17
China, P.R. 4,618 13,210 14,112 5,504 610 1,457 19,340 20,103 0.32 0.16
India 10,396 13,252 4,404 1,793 203 214 15,003 15,260 0.25 0.12
Philippines 4,658 3,452 7,206 8,823 98 332 11,962 12,607 0.20 0.10
Thailand 4,526 7,684 8,108 3,837 276 349 12,909 11,870 0.21 0.09
Indonesia 4,258 3,800 5,226 1,607 870 79 10,354 5,486 0.17 0.04
Total value of investment 2,567,784 5,134,498 3,421,999 6,373,367 98,430 1,038,297 6,088,217 12,546,226 100.00 100.00
Source: IMF, Global Portforlio Investment Survey, 2003.
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

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Table 2.2 Net Purchases of Foreign Stocks by US Residents
(in millions of dollars and percentages)
All-ex-US Asia Japan Hong Singa- Taiwan Korea China
Kong pore
Amount
1988-1997 349,729 127,033 80,211 19,773 4,625 202 8,737 1,400
1998 -6,212 8,594 3,694 1,385 929 487 1,907 8
1999 -15,640 46,873 46,134 -2,777 -149 1,767 1,965 222
2000 13,088 -11,198 -16,461 3,254 -3,038 767 2,057 251
2001 50,113 27,523 19,938 4,823 -2,487 2,949 2,006 -40
As percengate of Asia Total
1988-1997 275.3 100.0 63.1 15.6 3.6 0.2 6.9 1.1
1998 -72.3 100.0 43.0 16.1 10.8 5.7 22.2 0.1
1999 -33.4 100.0 98.4 -5.9 -0.3 3.8 4.2 0.5
2000 116.9 -100.0 -147.0 29.1 -27.1 6.8 18.4 2.2
2001 182.1 100.0 72.4 17.5 -9.0 10.7 7.3 -0.1
Source: US Treasury website.
Table 2.3 Net Purchases of Foreign Bonds by US Residents
(in millions of dollars and percentages)
All-ex-US Asia Japan Hong Singa- Taiwan Korea China
Kong pore
Amount
1988-1997 302,824 15,001 -865 -10,045 -2,532 -7,619 9,627 -825
1998 17,349 -4,602 -1,952 -2,452 -2,445 -815 3,161 -1,716
1999 5,676 -3,912 -2,497 -1,458 -334 -2,173 -719 -336
2000 4,054 -13,290 -4,509 -984 -893 -2,762 -1,365 -1,808
2001 -30,393 -15,654 178 -3,298 -293 -3,792 -1,856 -4,033
As percengate of Asia Total
1988-1997 2018.7 100.0 -5.8 -67.0 -16.9 -50.8 64.2 -5.5
1998 377.0 -100.0 -42.4 -53.3 -53.1 -17.7 68.7 -37.3
1999 145.1 -100.0 -63.8 -37.3 -8.5 -55.5 -18.4 -8.6
2000 30.5 -100.0 -33.9 -7.4 -6.7 -20.8 -10.3 -13.6
2001 -194.2 -100.0 1.1 -21.1 -1.9 -24.2 -11.9 -25.8
Source: US Treasury website.
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

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Table 2.4 Net Purchases of US Stocks by Foreign Residents
(in millions of dollars and percentages)
All-ex-US Asia Japan Hong Singa- Taiwan Korea China
Kong pore
Amount
1988-1997 115,571 9,615 6,617 1,031 8,828 409 -29 28
1998 50,020 -13,781 -1,171 -2,223 -8,438 -69 -84 1
1999 107,522 3,379 5,723 -156 -852 37 -78 204
2000 174,890 21,683 2,070 215 10,788 -147 -160 -103
2001 116,386 22,516 6,788 675 13,078 261 -76 3
As percengate of Asia Total
1988-1997 1202.0 100.0 68.8 10.7 91.8 4.3 -0.3 0.3
1998 363.0 -100.0 -8.5 -16.1 -61.2 -0.5 -0.6 0.0
1999 3182.1 100.0 169.4 -4.6 -25.2 1.1 -2.3 6.0
2000 806.6 100.0 9.5 1.0 49.8 -0.7 -0.7 -0.5
2001 516.9 100.0 30.1 3.0 58.1 1.2 -0.3 0.0
Source: US Treasury website.
Table 2.5 Net Purchases of US Bonds by Foreign Residents
(in millions of dollars and percentages)
All-ex-US Asia Japan Hong Singa- Taiwan Korea China
Kong pore
Amount
1988-1997 1,447,448 415,223 202,793 52,694 36,900 22,701 2,900 47,890
1998 227,771 45,092 21,432 9,223 9,935 -2,996 15,812 3,519
1999 242,639 74,155 37,643 6,844 -7,417 -483 11,273 17,053
2000 282,938 82,474 49,936 10,181 -4,574 -5,240 5,839 15,656
2001 405,413 147,141 51,873 29,274 389 9,930 533 51,784
As percengate of Asia Total
1988-1997 348.6 100.0 48.8 12.7 8.9 5.5 0.7 11.5
1998 505.1 100.0 47.5 20.5 22.0 -6.6 35.1 7.8
1999 327.2 100.0 50.8 9.2 -10.0 -0.7 15.2 23.0
2000 343.1 100.0 60.5 12.3 -5.5 -6.4 7.1 19.0
2001 275.5 100.0 35.3 19.9 0.3 6.7 0.4 35.2
Source: US Treasury website.
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

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151
Table 3.1 Corporate tax comparison among Asian countries
(in percentages)
Regular
Preferential rate for foreign
investment
Korea 27
Singapore 22
Hong Kong 16
China 33 15
USA 35
Germany 25
Japan 30
Source: Joongang Daily, March 5, 2003, p. 3.
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

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Global Capital Flows and the Position of China
Table 3.2 Foreign Exchange Reserve to GDP Ratio
1990 1994 1995 1996 1997 1998 1999 2000 Average
Singapore 73.5 79.3 81.8 83.2 84.5 89.2 89.5 86.8 83.5
Hong Kong 33.8 37.7 39.8 41.4 54.3 55.1 60.9 66.2 48.7
Taiwan 44.5 37.2 33.6 31.0 28.5 33.6 36.6 34.0 34.9
Malaysia 21.8 32.6 26.2 26.1 27.6 33.0 37.6 31.8 29.6
Yemen 12.7 17.3 17.8 17.2 16.3 18.6 16.7
Venezuela 17.1 14.5 12.1 18.0 16.3 12.5 12.1 10.7 14.2
Norway 12.4 14.0 14.4 16.0 14.7 11.6 12.9 12.2 13.5
Swiss 12.8 12.3 11.0 13.5 14.5 13.9 14.1 12.5 13.1
China 7.4 9.3 10.5 12.8 15.5 15.0 15.6 15.3 12.7
Indonesia 6.9 6.8 6.8 8.0 11.9 18.8 16.8 21.0 12.1
Korea 5.7 6.1 6.6 6.7 7.4 14.1 17.4 23.4 10.9
Saudi Arabia 8.2 4.9 5.6 9.1 9.2 9.9 10.8 10.4 8.5
Spain 10.0 8.2 5.7 9.9 12.9 9.1 5.5 5.2 8.3
Austria 5.5 7.8 7.6 9.8 9.4 9.4 7.1 7.0 8.0
Denmark 7.8 5.3 5.6 7.5 11.1 7.5 12.7 0.9 7.3
group average 7.8 7.1 6.3 9.1 11.1 8.7 8.4 4.4 7.9
Sweden 7.6 10.5 8.9 7.1 4.2 5.3 5.8 6.3 7.0
Finland 6.8 9.1 7.2 4.9 6.4 6.3 5.6 6.0 6.5
Brazil 1.7 9.0 7.5 7.8 6.5 5.6 6.5 5.8 6.3
Mexico 3.8 2.3 6.3 6.0 7.2 8.1 6.4 6.2 5.8
India 0.4 6.0 5.2 5.2 6.3 6.5 7.1 5.3
Netherlands 5.7 8.9 7.5 6.1 6.0 4.3 1.7 1.9 5.2
Belgium 5.7 5.2 5.3 5.9 6.1 6.0 3.5 3.5 5.2
France 5.3 5.2 4.9 5.0 5.1 4.2 3.9 3.8 4.7
Japan 2.3 2.3 3.6 4.7 5.2 4.6 5.5 7.8 4.5
Australia 5.3 3.0 3.1 3.4 4.4 3.8 4.9 4.6 4.1
Italy 5.5 3.0 2.9 3.5 4.7 2.0 1.7 2.1 3.2
Canada 2.8 1.9 2.1 3.0 2.5 3.4 3.6 4.1 2.9
Great Britain 3.3 3.6 3.5 2.9 2.2 1.9 2.1 2.8 2.8
Germany 2.3 1.1 0.9 1.0 1.4 1.7 1.7 1.7 1.5
USA 0.9 0.6 0.7 0.5 0.4 0.0 0.3 0.3 0.5
Average 11.3 12.2 11.8 12.6 13.4 13.8 14.1 14.1 12.9
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

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153
Table 3.3 GDP by Country (at current price and official exchange rate)
1990 Rank 1999 Rank 1990 1999 2000 2001
USA 1 1 5,743.8 9,268.6 9,872.9 10,082.2
Japan 2 2 2,970.1 5,015.0 4,454.6 4,172.5
Germany 3 3 1,503.6 1,991.5 1,891.0 1,845.3
United Kingdom 6 4 983.6 1,448.3 1,397.6 1,423.7
France 4 5 1,195.4 1,355.7 1,308.9 1311
Italy 5 6 1,094.0 1,112.9 1,084.7
China 10 7 387.8 991.1 1,080.1 1,139.8
Canada 7 8 573.8 675.7 703.9 705.6
Spain 8 9 492.0 565.6 563.9
Brazil 9 10 442.9 538.8 555.9
Mexico 15 11 247.0 482.3 567.5
India 11 12 306.0 450.0 0.0
Korea 14 13 253.7 424.2 408.9 422.2
Australia 12 14 294.8 397.7 361.1 357.1
Netherlands 13 15 283.5 375.3 373.2
Taiwan 19 16 162.7 290.5 313.9 282.4
Switzerland 17 17 228.4 242.9 247.1
Belgium 18 18 193.8 237.1 230.8
Sweden 16 19 229.8 231.3 218.4
Austria 20 20 158.4 198.0 191.7
Denmark 22 21 129.1 166.2 163.6
Hong Kong 26 22 72.6 158.0 162.5
Indonesia 24 23 106.1 156.7 134.5
Norway 23 24 115.5 148.4 158.6
Poland 27 25 59.0 148.3 165.5
Saudi Arabia 25 26 104.7 142.9 173.3
Finland 21 27 134.8 121.0 122.5
Venezuala 28 28 48.6 96.5 117.8
Singapore 31 29 37.5 85.3 91.9 85.6
Malaysia 29 30 42.8 78.9 89.9
Nigeria 33 31 32.4 34.5 36.5
Kuwait 34 32 18.2 29.8 38.0
Romania 30 33 38.3 29.6 30.7
Yemen 32 34 33.6 0.0 0.0
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

154
Global Capital Flows and the Position of China
Table 3.4 Global Population by Region and Age
(in millions of habitants and percentages)
Habitants Share in Region Total
All Below 15 15 to 65 Above 65 Below 15 15 to 65 Above 65
China 1,281 295 896 90 23 70 7
Less developed countries
excluding China 3,737 1,345 2,242 149 36 60 4
More developed countries 1,197 215 802 180 18 67 15
East Asia 1,512 333 1,058 121 22 70 8
U.S. 287 60
190 37 21 66 13
Western Europe 184 31 123 29 17 67 16
Japan 127
18 87 23 14 68 18
Source: Population Reference Bureau, World Population Data Sheet, 2002.
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

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Table 4.1 China in World Trade
(in percentages)
Merchandise Exports Merchandise Imports
World Total Growth World Total Growth
in 2000 1990-2000 in 2000 1990-2000
World 100.0 6.0 100.0 6.0
Asia 26.7 8.4 22.8 7.6
Japan 7.7 5.2 5.9 4.9
China 4.0 14.9 3.5 15.5
Hong Kong 3.3 n.a. 3.3 n.a.
Commercial Service Commercial Service
Exports
Imports
World Total Growth World Total Growth
in 2000 1990-2000 in 2000 1990-2000
World 100.0 6.0 100.0 6.0
Asia 21.1 9.0 25.4 7.0
Japan 4.7 5.0 8.1 3.0
China 2.1 18.0 2.5 24.0
Hong Kong 2.9 0.09 1.8 0.09
Source: WTO.
Table 4.2 Share in World Exports of Manufactures, 1990 and 2000
(in percentages)
1990 2000 Gain/Loss
World 100.0 100.0
Developed countries 80.4 69.4 -11.0
Developing countries 17.5 27.4 9.9
Asia 12.6 19.9 7.3
China 1.9 4.7 2.8
Asia-Six* 9.1 12.2 3.1
Other Asia 1.6 2.9 1.3
Note:
* Asia Six: Taiwan, Hong Kong, Korea, Malaysia, Singapore and Thailand;
Significant re-exports excluded.
Source: WTO.
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

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Table 4.3 Foreign Direct Investment in China by Sector
(in millions of dollars and percentages)
Value
Share
Sector 1999 2000 2001 1999 2000 2001
Manufacturing 22,603 25,844 30,907 56.1 63.5 65.9
Electric Power, Gas and
Water Production and Supply 3,703 2,242 2,273 9.2 5.5 4.8
Wholesale & Retail Trade
and Catering Services 965 858 1,169 2.4 2.1 2.5
Transport, Storage, Post and
Telecommunication services 1,551 1,012 909 3.8 2.5 1.9
Farming, Forestry, Animal
Husbandry and Fishery 710 676 899 1.8 1.7 1.9
Mining and Quarrying 557 583 811 1.4 1.4 1.7
Construction 917 905 807 2.3 2.2 1.7
Scientific Research and
Polytechnical Services 110 57 120 0.3 0.1 0.3
Health Care, Sports and
Social Welfare 148 106 119 0.4 0.3 0.3
Education, Culture and Arts,
Radio, Film and Television 61 54 36 0.2 0.1 0.1
Banking and Insurance 98 76 35 0.2 0.2 0.1
Geological Prospecting and
Water Conservancy 5 5 10 0.0 0.0 0.0
Other Sectors 753 1,453 1,051 1.9 3.6 2.2
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

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Table 4.4 China’s FDI Inflows by Source Country, 1995-2001
(in billions of dollars and percentages)
1995 1996 1997 1998 1999 2000 2001
Level
Hong Kong and Macao 20.5 21.3 21.0 18.9 16.7 15.9 17.0
Japan 3.1 3.7 4.3 3.4 3.0 2.9 4.4
Taiwan 3.2 3.5 3.3 2.9 2.6 2.3 3.0
Singapore 1.9 2.2 2.6 3.4 2.6 2.2 2.1
Korea 1.0 1.4 2.1 1.8 1.3 1.5 2.2
Neighboring Countries 29.7 32.0 33.4 30.5 26.2 24.7 28.7
USA 3.1 3.4 3.2 3.9 4.2 4.4 4.4
Virgin Island 0.3 0.5 1.7 4.0 2.7 3.8 5.0
Great Britain 0.9 1.3 1.9 1.2 1.0 1.2 1.1
Germany 0.4 0.5 1.0 0.7 1.4 1.0 1.2
Others 3.2 3.9 4.1 5.2 4.9 5.6 6.5
Total 37.5 41.7 45.3 45.5 40.3 40.7 46.9
Share of total
Hong Kong and Macao 54.7 51.0 46.5 41.6 41.4 38.9 36.3
Japan 8.3 8.8 9.6 7.5 7.4 7.2 9.3
Taiwan 8.4 8.3 7.3 6.4 6.5 5.6 6.4
Singapore 4.9 5.4 5.8 7.5 6.5 5.3 4.6
Korea 2.8 3.3 4.7 4.0 3.2 3.7 4.6
Neighboring Countries 79.1 76.7 73.8 67.0 64.9 60.7 61.1
USA 8.2 8.2 7.2 8.6 10.5 10.8 9.4
Virgin Island 0.8 1.3 3.8 8.9 6.6 9.4 10.7
Great Britain 2.4 3.1 4.1 2.6 2.6 2.8 2.2
Germany 1.0 1.2 2.2 1.6 3.4 2.6 2.6
Others 8.5 9.4 9.0 11.4 12.1 13.7 13.9
Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0
Source: National Bureau of Statistics, Statistical Yearbook of China, 2002.
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

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Table 4.5 FDI and Trade Patterns by Province and Ranked by Provincial FDI Amount in 2001
(in millions of dollars and percentages)
Province Population GDP (2001, FDI Population GDP share FDI share Trade share Trade FDI as share FDI GDP
(2001, million) current (2001) share (2001) (2001) (2000-2001 (2000-2001 contribution of Fixed per capita per capita
price) average) average) by FIEs Capital (2001) (2001,
(2000-2001 Formation current
average) (2001) price)
National Total 1,276 1,286 46,367 100.0 100.0 100.0 100.0 50.4 23.7 36 1,008
Guangdong 78 128 11,932 6.1 10.0 25.7 36.1 53.6 75.0 153 1,648
Jiangsu 74 115 6,915 5.8 8.9 14.9 10.5 62.1 49.6 94 1,558
Shanghai 16 60 4,292 1.3 4.6 9.3 11.7 60.8 49.7 266 3,696
Fujian 34 51 3,918 2.7 4.0 8.5 4.8 61.4 80.9 114 1,490
Shandong 90 114 3,521 7.1 8.8 7.6 6.2 49.8 27.5 39 1,258
Liaoning 42 61 2,516 3.3 4.7 5.4 4.2 59.6 32.0 60 1,446
Zhejiang 46 81 2,212 3.6 6.3 4.8 7.0 31.0 16.7 48 1,762
Tianjin 10 22 2,133 0.8 1.7 4.6 3.6 79.2 51.3 212 2,208
Beijing 14 34 1,768 1.1 2.7 3.8 5.3 31.7 26.8 128 2,479
Top 9 by FDI 404 666 39,207 31.7 51.8 84.6 89.4 54.0 43.3 97 1,647
Hubei 60 56 1,189 4.7 4.4 2.6 0.8 29.3 14.3 20 940
Hunan 66 48 810 5.2 3.7 1.7 0.6 17.5 15.9 12 728
Hebei 67 67 670 5.2 5.2 1.4 1.1 29.9 6.6 10 1,003
Sichuan 86 53 582 6.8 4.1 1.3 0.6 21.0 7.1 7 617
Hainan 8 7 467 0.6 0.5 1.0 0.3 45.8 35.1 59 826
Henan 96 68 457 7.5 5.3 1.0 0.7 18.0 5.7 5 711
Jiangxi 42 26 396 3.3 2.0 0.9 0.4 15.5 14.5 9 626
Guangxi 48 27 384 3.8 2.1 0.8 0.4 23.2 11.6 8 561
Shaanxi 37 22 352 2.9 1.7 0.8 0.5 14.3 6.1 10 607
Heilongjiang 38 43 341 3.0 3.3 0.7 0.8 11.4 4.3 9 1,126
Jilin 27 24 338 2.1 1.9 0.7 0.7 40.1 8.5 13 910
Anhui 63 40 337 5.0 3.1 0.7 0.7 26.4 7.0 5 626
Middle 12 by FDI 637 482 6,322 49.9 37.4 13.6 7.7 24.4 11.4 10 756
Chongqing 31 21 256 2.4 1.6 0.6 0.4 16.1 8.3 8 681
Shanxi 33 21 234 2.6 1.7 0.5 0.6 11.5 5.9 7 655
Inner Mongolia 24 19 107 1.9 1.4 0.2 0.5 7.9 3.6 5 784
Gansu 26 13 74 2.0 1.0 0.2 0.2 9.0 2.1 3 502
Yunnan 43 25 65 3.4 1.9 0.1 0.4 10.1 1.3 2 583
Qinghai 5 4 36 0.4 0.3 0.1 0.0 6.6 2.6 7 693
Guizhou 38 13 28 3.0 1.0 0.1 0.2 7.0 0.9 1 344
Xinjiang 19 18 20 1.5 1.4 0.0 0.5 4.3 0.4 1 954
Ningxia 6 4 17 0.4 0.3 0.0 0.1 11.6 1.5 3 639
Tibet 3 2 - 0.2 0.1 - 0.0 3.2 0.0 - 636
Bottom 10 by FDI 226 139 838 17.7 10.8 1.8 2.9 8.7 2.7 4 614
Source: National Bureau of Statistics, Statistical Yearbook of China, 2002.
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

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Table 4.6 China’s External Borrowing in 2000
(in thousands of dollars and percentages)
Borrower / Foreign Interna- Foreign Buyer’s Borrowing Issuing Delayed Savings by Lease Portion of Trade Total Share in
Type of Loan Govern- tional Banks Credit by Bonds Payment Foreigners Hard Credit Total
ment financial exporters, (Usance?) Currency
institutions foreign Payment
companies related with
and Counterindividuals
trade
State Council, Ministries 1,655,869 2,679,027 43,935 603,039 4,981,869 29.3
Chinese Banks 712,225 593,240 1,130,712 5,919 336,999 176,839 49,764 117 3,005,815 17.7
Chinese Non-Banking
Financial Institutions 182,602 4,522 249,900 284 591 437,899 2.6
Foreign Invested Enterprises 1,668 77,601 800,517 157,978 2,314,315 76,998 59,498 31,262 154 3,519,989 20.7
Chinese Enterprises 596 89,457 9,432 25,054 13,709 976,296 10,328 1,124,871 6.6
Foreign Financial Institutions 1,581,144 20,036 103,375 1,704,556 10.0
Others 57,947 2,460 8,718 4,821 1,378 75,324 0.4
Trade Credit 2,370,358 2,756,627 3,348,841 1,305,105 2,354,006 1,266,935 274,903 153,424 1,009,643 10,482 2,161,000 17,011,323 100.0
Share in total 13.9 16.2 19.7 7.7 13.8 7.4 1.6 0.9 5.9 0.1 12.7 100.0
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

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Global Capital Flows and the Position of China
Table 4.7 Population, GDP, Savings and Current Account Surplus by Selected Regions and Countries, 2001
(percentages and billions of dollars)
Population GDP at PPP GDP (PPP) per Saving Investment Net Lending Current
(% of World) (% of World) capita as % of the (% of GDP) (% of GDP) (% of GDP) Account
World Average Balance
($ bn)
China 21.0 12.1 58 40.3 37.9 2.4 17.4
India 16.7 4.7 28 20.3 22.9 -2.6 -0.1
Developing Asia 52.2 22.2 43 32.3 30.3 2.0 39.4
Developing countries 78.0 37.6 48 26.8 26.2 0.6 39.6
Countries in transition 6.6 6.2 94 24.0 21.0 3.0 11.8
Newly industrialized Asian Countries 1.3 3.3 254 29.0 23.9 5.1 57.1
Japan 2.1 7.3 348 27.3 25.2 2.1 87.8
European Union 6.2 19.9 321 20.3 20.2 0.1 3.2
United States 4.6 21.4 465 16.5 19.1 -2.6 -393.4
Sources: IMF, World Economic Outlook, September 2002 and World Bank website.
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

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Table 4. 8 China’s Balance of Payments, 1982-2001
(in millions of dollars and percentages)
1982 1983 1984 1985 1986 1987 1988 1989 1990 1991
Current Account Balance 5,674 4,240 2,030 -11,417 -7,035 300 -3,803 -4,317 11,997 13,270
FDI into China 430 636 1,258 1,659 1,875 2,314 3,194 3,393 3,487 4,366
Net Errors & Omissions 279 117 -932 92 -863 -1,371 -1,011 90 -3,134 -6,748
Reserve Assets Change -6,291 -4,137 -95 2,353 1,954 -4,931 -2,318 503 -12,118 -14,554
GDP in dollars at average
exchange rate 304,423 294,247 321,277 400,000 448,913 389,259 406,443
Accumulated CA since 1982 527 -6,508 -6,208 -10,011 -14,328 -2,331 10,939
Accumulated FDI since 1982 3,983 5,858 8,172 11,366 14,759 18,246 22,612
Accumulated capital flight
(E&O) since 1982 444 1,307 2,678 3,689 3,599 6,733 13,481
Accumulated official foreign
exchange reserves 6,986 8,901 8,220 2,644 2,072 2,923 3,372 5,550 11,093 21,712
External debt 15,830 21,480 30,200 40,000 41,300 52,550 60,560
Accumulated CA since 1982
as % of GDP 0.2 -2.2 -1.9 -2.5 -3.2 -0.6 2.7
Accumulated FDI since 1982
as % of GDP 1.3 2.0 2.5 2.8 3.3 4.7 5.6
Accumulated capital flight
(E&O) since 1982 as % of GDP 0.1 0.4 0.8 0.9 0.8 1.7 3.3
Official reserves as % of GDP 0.9 0.7 0.9 0.8 1.2 2.8 5.3
External debt as % of GDP 5.20 7.30 9.40 10.00 9.20 13.50 14.90
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

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Global Capital Flows and the Position of China
Table 4. 8 (continued)
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Current Account Balance 6,401 -11,903 7,658 1,618 7,242 29,717 29,324 15,667 20,519 17,405
FDI into China 11,156 27,515 33,787 35,849 40,180 44,236 43,752 38,752 38,399 44,241
Net Errors & Omissions -8,252 -9,804 -9,775 -17,812 -15,566 -16,952 -16,576 -14,804 -11,893 -4,856
Reserve Assets Change 2,102 -1,767 -30,527 -22,481 -31,643 -35,724 -6,426 -8,505 -10,548 -47,325
GDP in dollars at average
exchange rate 481,389 601,223 542,749 701,250 818,873 903,241 960,789 992,353 1,079,481 1,157,211
Accumulated CA since 1982 17,340 5,437 13,095 14,713 21,955 51,672 80,996 96,663 117,182 134,588
Accumulated FDI since 1982 33,768 61,283 95,070 130,919 171,099 215,335 259,087 297,840 336,238 380,479
Accumulated capital flight
(E&O) since 1982 21,733 31,537 41,312 59,124 74,690 91,642 108,218 123,023 134,916 139,771
Accumulated official foreign
exchange reserves 19,443 21,199 51,620 73,597 105,029 139,890 144,959 154,675 165,574 212,165
External debt 69,320 83,570 92,810 106,590 116,280 130,970 146,040 151,830 145,730 170,110
Accumulated CA since 1982
as % of GDP 3.6 0.9 2.4 2.1 2.7 5.7 8.4 9.7 10.9 11.6
Accumulated FDI since 1982
as % of GDP 7.0 10.2 17.5 18.7 20.9 23.8 27.0 30.0 31.1 32.9
Accumulated capital flight
(E&O) since 1982 as % of GDP 4.5 5.2 7.6 8.4 9.1 10.1 11.3 12.4 12.5 12.1
Official reserves as % of GDP 4.0 3.5 9.5 10.5 12.8 15.5 15.1 15.6 15.3 18.3
External debt as % of GDP 14.40 13.90 17.10 15.20 14.20 14.50 15.20 15.30 13.50 14.70
Source: National Bureau of Statistics, Statistical Yearbook of China, 2002 and People’s Bank of China website.
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

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Table 4.9 US Current Account Deficits with Greater China
(in millions of dollars and percentages)
Amount Share of Greater China Total
China Taiwan Hong Kong Greater China Taiwan Hong Kong Greater
China China
1985 -6 -11,697 -5,610 -17,313 0 68 32 100
1986 -1,665 -14,267 -5,861 -21,792 8 65 27 100
1987 -2,796 -17,209 -5,871 -25,876 11 67 23 100
1988 -3,490 -12,585 -4,550 -20,625 17 61 22 100
1989 -6,235 -12,978 -3,431 -22,644 28 57 15 100
1990 -10,431 -11,175 -2,805 -24,411 43 46 11 100
1991 -12,691 -9,841 -1,141 -23,673 54 42 5 100
1992 -18,309 -9,346 -716 -28,371 65 33 3 100
1993 -22,777 -8,934 319 -31,391 73 28 -1 100
1994 -29,505 -9,597 1,745 -37,357 79 26 -5 100
1995 -33,790 -9,682 3,940 -39,532 85 24 -10 100
1996 -39,520 -11,447 4,102 -46,865 84 24 -9 100
1997 -49,695 -12,263 4,829 -57,129 87 21 -8 100
1998 -56,927 -14,960 2,387 -69,501 82 22 -3 100
1999 -68,677 -16,073 2,124 -82,626 83 19 -3 100
2000 -83,833 -16,097 3,133 -96,797 87 17 -3 100
2001 -83,096 -15,253 4,381 -93,968 88 16 -5 100
2002 -103,115 -13,805 3,283 -113,637 91 12 -3 100
Source: US Census Bureau website.
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

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Table 4.10 US Exports, Imports and Balance of Goods in 2002
(in millions of dollars and percentages)
Amount Share of the Total
Balance Exports Imports Balance Exports Imports
Total Balance of Payments Basis -484,353 682,586 1,166,939 100.0 100.0 100.0
North America -86,962 258,360 345,322 18.0 37.9 29.6
Western Europe -89,218 157,080 246,298 18.4 23.0 21.1
Eastern Europe/FSR -8,283 6,599 14,883 1.7 1.0 1.3
Pacific Rim Countries -215,005 178,561 393,567 44.4 26.2 33.7
Australia 6,606 13,084 6,478 -1.4 1.9 0.6
China
Japan
-103,115 22,053 -70,055 125,168 21.3 3.2 10.7
51,440 121,494 14.5 7.5 10.4
Newly Industrialized Countries(NICS) -22,073 69,823 91,896 4.6 10.2 7.9
Hong Kong 3,283 12,612 9,328 -0.7 1.8 0.8
Korea -12,979 22,596 35,575 2.7 3.3 3.0
Singapore 1,429 16,221 14,793 -0.3 2.4 1.3
Taiwan -13,805 18,394 32,199 2.9 2.7 2.8
Other Pacific Rim(3) -26,369 22,162 48,531 5.4 3.2 4.2
South/Central America -17,902 51,643 69,544 3.7 7.6 6.0
OPEC -34,482 18,852 53,334 7.1 2.8 4.6
Other Countries -36,397 28,956 65,353 7.5 4.2 5.6
Source: US Census Bureau website.
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

Young Rok Cheong and Geng Xiao
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Table 4.11 Cross-Border Banking Capital Flows in Hong Kong, 1997-2002
(in millions of dollars and percentages)
Period
Outside Banking Outside Banking Net Outside
Claims on HK Liabilities to HK Banking
(HK Gross (HK Gross Liabilities to HK
Borrowing) Lending) (Net HK Lending)
1997-06 629,554 640,490 10,936
All Outside 2002-04 249,541 389,987 140,446
Hong Kong Change -380,013 -250,504 129,509
Change in % -60.4 -39.1 1184.2
Japan
Singapore
UK
US
1997-06 309,067 361,423 52,357
2002-04 57,942 81,484 23,542
Change -251,125 -279,939 -28,814
Change in % -81.3 -77.5 -55.0
1997-06 48,863 37,597 -11,266
2002-04 24,214 39,700 15,486
Change -24,649 2,103 26,753
Change in % -50.4 5.6 -237.5
1997-06 50,679 28,231 -22,448
2002-04 18,753 60,207 41,454
Change -31,926 31,976 63,902
Change in % -63.0 113.3 -284.7
1997-06 24,974 23,606 -1,368
2002-04 12,491 31,806 19,315
Change -12,482 8,201 20,683
Change in % -50.0 34.7 -1511.7
1997-06 40,087 50,105 10,018
Mainland 2002-04 39,312 16,651 -22,661
China Change -776 -33,454 -32,679
Change in % -1.9 -66.8 -326.2
Source: Hong Kong Monetary Authority website.
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

166
Global Capital Flows and the Position of China
Figure 5.1 FDI Inflows, 1979-2001
(in billions of dollars)
350
300
250
200
150
100
50
0
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
United States Asia and the Pacific China All developing countries minus China
Figure 5.2 US Current Account Deficits with Greater China
(in billions of dollars)
-140
-120
-100
-80
-60
-40
-20
0
20
1985
1986
1987
1988
1989
1990
China Taiwan Hong Kong
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

Young Rok Cheong and Geng Xiao
167
Figure 5.3 Banking Capital Flows between Hong Kong and Mainland
China
(in billions of dollars)
60
50
40
30
20
10
0
-10
-20
-30
1994-03
1994-09
1995-03
1995-09
1996-03
1996-09
1997-03
1997-09
1998-03
1998-09
1999-03
1999-09
2000-03
2000-09
2001-03
2001-09
2002-03
Mainland China Banking Claims on HK (HK Gross Borrowing from Mainland China)
Mainland China Banking Liabilities on HK (HK Gross Lending to Mainland China)
Net Mainland China Banking Liabilities to HK (Net HK Lending to Mainland China)
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

1995
1996
1997
1998
1999
2000
2001
2002
1995
1996
1997
1998
1999
2000
2001
2002
168
Global Capital Flows and the Position of China
Figure 6.1 Cross-Border Trading between US and the Rest of the World
(in billions of dollars)
Foreign Stocks by US Residents
Foreign Bonds by US Residents
800
700
600
500
400
300
200
100
0
-100
Gross Sales
Gross Purchases
Net Purchases
800
700
600
500
400
300
200
100
0
-100
Gross Sales
Gross Purchases
Net Purchases
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
1988
1989
1990
1991
1992
1993
1994
US Stocks by Foreign Residents
US Bonds by Foreign Residents
800
700
600
500
400
300
200
100
0
-100
Gross Sales
Gross Purchases
Net Purchases
800
700
600
500
400
300
200
100
0
-100
Gross Sales
Gross Purchases
Net Purchases
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
1988
1989
1990
1991
1992
1993
1994
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

1997
1998
1999
2000
2001
2002
1997
1998
1999
2000
2001
2002
Young Rok Cheong and Geng Xiao
169
Figure 6.2 Cross-Border Trading between US and Asia
(in billions of dollars)
Asia Stocks by US Residents
150
120
90
60
Gross Sales
Gross Purchases
Net Purchases
30
0
-30
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
US Stocks by Asia Residents
150
120
90
60
Gross Sales
Gross Purchases
Net Purchases
30
0
-30
Asia Bonds by US Residents
150
120
90
60
Gross Sales
Gross Purchases
Net Purchases
30
0
-30
1988
1989
1990
1991
1992
1993
1994
1995
1996
US Bonds by Asia Residents
150
120
90
Gross Sales
Gross Purchases
Net Purchases
60
30
0
-30
1988
1989
1990
1991
1992
1993
1994
1995
1996
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

170
Global Capital Flows and the Position of China
Figure 6.3 The Lower the Local Turnover, the Higher the Share of
Trading by US Residents, The Case of Japan
(in percentages and billions of dollars)
Ratio of Gross Purchases by US Residents over Market Turnover in Japan
Japan Stock Market Monthly Turnover
18.0%
350
16.0%
14.0%
12.0%
300
250
10.0%
8.0%
6.0%
4.0%
2.0%
200
150
100
50
billions of dollars
0.0%
0
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
18.0%
16.0%
Share of Gross Purchases of Japan Stocks
by US Residents
14.0%
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
Actual during Oct1988-Apr2002
Fitted using sample from Oct1998-Apr2002
0 50 100 150 200 250 300 350
Monthly Stock Market Turnover in Japan
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

Young Rok Cheong and Geng Xiao
171
Figure 6.4 The Lower the Local Turnover, the Higher the Share of
Trading by US Residents, The Case of Hong Kong
(in percentages and billions of dollars)
Ratio of Gross Purchases by US Residents over Market Turnover in Hong Kong
Hong Kong Stock Market Monthly Turnover
45.0%
90
40.0%
80
35.0%
70
30.0%
60
25.0%
20.0%
15.0%
10.0%
50
40
30
20
billions of dollars
5.0%
10
0.0%
0
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
40.0%
Share of Gross Purchases by US Residents
35.0%
Actual during 1997-April 2002
Fitted using sample from 1997-April 2002
30.0%
25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
0 10 20 30 40 50 60 70 80 90
Monthly Stock Market Turnover in Hong Kong
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

172
Global Capital Flows and the Position of China
Figure 6.5 The Lower the Local Turnover, the Higher the Share of
Trading by US Residents, The Case of Mainland China
(in percentages and billions of dollars)
Ratio of Gross Purchases by US Residents over Market Turnover in Mainland China
Mainland China Stock Market Monthly Turnover
200.0%
18
180.0%
160.0%
140.0%
120.0%
100.0%
80.0%
60.0%
40.0%
20.0%
16
14
12
10
8
6
4
2
billions of dollars
0.0%
0
1995-07
1996-01
1996-07
1997-01
1997-07
1998-01
1998-07
1999-01
1999-07
2000-01
2000-07
2001-01
2001-07
2002-01
Share of Gross Purchases by US Residents
7.0%
6.0%
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
Actual during Apr2000-April 2002
Fitted using sample from Apr2000-April 2002
-1.0%
0 2 4 6 8 10 12
Monthly Turnover in the B Shares Markets of Mainland China
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

Young Rok Cheong and Geng Xiao
173
Figure 6.6 The Lower the Local Turnover, the Higher the Share of
Trading by US Residents, The Case of Singapore
(in percentages and billions of dollars)
Ratio of Gross Purchases by US Residents over Market Turnover in Singapore
Singapore Stock Market Monthly Turnover
45.0%
25
40.0%
35.0%
20
30.0%
25.0%
20.0%
15.0%
15
10
billions of dollars
10.0%
5.0%
5
0.0%
0
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
Share of Gross Purchases by US
Residents
45.0%
40.0%
35.0%
30.0%
25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
Actual during Jan1998-Apr2002
Fitted using sample from Jap1998-Apr2002
0 5 10 15 20 25
Monthly Stock Market Turnover in Singapore
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

174
Global Capital Flows and the Position of China
Figure 6.7 The Lower the Local Turnover, the Higher the Share of
Trading by US Residents, The Case of Taiwan
(in percentages and billions of dollars)
Ratio of Gross Purchases by US Residents over Market Turnover in Taiwan
Taiwan Stock Market Monthly Turnover
4.5%
200
4.0%
180
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
160
140
120
100
80
60
40
20
billions of dollars
0.0%
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
0
Share of Gross Purchases by US Residents
4.50%
4.00%
3.50%
3.00%
2.50%
2.00%
1.50%
1.00%
0.50%
0.00%
Actual during Jan1998-Apr2002
Fitted using sample from Jan1998-Apr2002
-0.50%
- 20 40 60 80 100 120 140 160
Monthly Stock Market Turnover in Taiwan
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

Young Rok Cheong and Geng Xiao
175
Figure 6.8 The Lower the Local Turnover, the Higher the Share of
Trading by US Residents, The Case of Korea
(in percentages and billions of dollars)
Ratio of Gross Purchases by US Residents over Market Turnover in Korea
Korea Stock Market Monthly Turnover
12.0%
120
10.0%
100
8.0%
80
6.0%
4.0%
2.0%
60
40
20
billions of dollars
0.0%
0
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
6.0%
5.0%
Actual during Jan1999-Apr2002
Fitted using sample from Jan1999-Apr2002
Share of Gross Purchases by US
Residents
4.0%
3.0%
2.0%
1.0%
0.0%
0 20 40 60 80 100 120
Monthly Stock Market Turnover in Korea
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

9
Comment on Young Rok Cheong
and Geng Xiao
Li-Gang Liu*
T
his overview paper is very thought-provoking. It has raised
many important issues facing the Chinese and world
economies. The authors have painstakingly compiled a wealth of
data, as indicated in 38 tables and charts, to provide evidence for
their argument. The paper raises many interesting issues – each of
which would be sufficient for a paper itself; but it is also styled so
well that we can understand these complex issues with ease.
Let me give a quick review of key points of the paper. Essentially,
the authors raise nine questions.
The first one is how to reconcile the fact that China is exporting
capital and, at the same time, importing a large amount of capital.
The answer they provide is that China used its trade surplus to
finance its main customers, mainly the US customers.
The second question is whether China is attracting too much
FDI. The answer appears to be ‘yes’.
The third question is what happens to China’s investment in US
bonds. The authors’ figure indicates that China has become the
second largest bondholder of the US treasury. Indeed, by 2001,
China purchased the same amount of bonds as Japan.
* The discussant was formerly a senior research fellow at the Asian
Development Bank Institute in Tokyo. He now is an assistant professor of Public
Policy and Finance at the School of Public Policy of the George Mason
University in Arlington, Virginia, USA.
176
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Li-Gang Liu
177
The fourth question is: What is the impact of foreign portfolio
investment on the stability of the Chinese stock markets? At this
moment, the impact is negligible given that China’s capital account
is closed, but we may expect more impact in the near future as the
Qualified Foreign Institutional Investors (QFII) plan to allow
foreign institutional investors to set up joint-venture mutual funds
in the Chinese stock market.
Fifth, they ask if China is generating global deflation. The
answer is ‘yes’ in the labour-intensive manufacturing products but
‘no’ in overall manufactured products since China’s share in world
trade is still rather small, around 4 percent in 2000.
Sixth, they are interested in determining the seriousness of
China’s impact on its competitors. As Geng Xiao mentioned in his
presentation, there are both benefits and costs of China’s emergence
in the world economy. Perhaps the rational strategy is for other
countries to respond proactively and deal with the challenge of the
emergence of the Chinese economy.
Seventh, they raise the issue of whether China is saving too
much. Their answer is affirmative. Demographics and growth can
explain this phenomenon. However, Chinese savings are not well
utilised. The existing financial system is the root problem.
Eight, given large capital inflows and domestic savings, they ask
a hotly debated question: Should China revalue its currency? Their
qualified answer is, ‘No, but perhaps some domestic price adjustment
should be used.’
The last question they entertain is whether China has become a
growth engine for the world. From the paper the answer is not that
clear. Although China has become a major trading nation in the
world and its GDP size in PPP is the third largest in the world, it is
not obvious that China is an engine of global growth at this
moment.
Having recapped the key points of the paper, I would like to
make the following observations and comments.
The first one concerns the sustainability of the current trade-FDI
pattern in China. There is a big difference between ‘made in China’
and ‘made by China’. At present, more than 50 percent of Chinese
exports is conducted in the form of processed trade: China imports
intermediate components, mainly from Japan, South Korea, and
Taiwan, and then assembles them for exports. The assembled
products are then disproportionately exported to the US market.
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
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Comment on Young Rok Cheong and Geng Xiao
This pattern of triangular trade has allowed China’s powerful
exporting neighbours, South Korea, Taiwan, and to some extent,
Japan, to divert their previously US-bound exports to China,
thereby reducing their trade surplus with the US. If this triangular
feature of the China-US trade were to be taken into consideration,
the adjusted real trade balance between China and the US would be
far smaller than the current number since China’s value-added in
the processed trade has been rather minimal, mostly in the form of
low wages of the assembly workers. Indeed, this feature is evidenced
by the fact that although China has a large trade surplus with the
US, it runs a similarly large trade deficit with South Korea, Taiwan
and Japan. Therefore, China’s global trade surplus is small,
accounting for only 2 percent of its GDP per year. As the US-China
trade deficit balloons, it is not surprising that China has become a
new target of US trade policies, similar to Japan and other East
Asian economies in the 1980s. Thus, it is very doubtful whether the
current pattern is sustainable and whether China can continue to
export its trade surplus to the US. At this moment, China’s trade-to-
GDP ratio is close to 50 percent and the US current account deficit
is historically high, possibly reaching 7 percent of its GDP by the
end of this year. One would have to wonder whether this size of US
current account deficits could be maintained. There will have to be
some kind of adjustment on both sides.
Second, I am puzzled by the fact that the wage rates in the export
sector have been rather stagnant over the last ten years despite an
impressive improvement in the sophistication of Chinese exports.
The authors mention that FDI-funded firms are the main drivers of
China’s export growth contributing to 50 percent of China’s exports.
Indeed, China has become the largest FDI recipient in the world for
the first time this year. Then it is puzzling that the wage rates in the
exporting sector have not gone up much over the last ten years.
Empirical evidence indicates that, normally, a country with a large
amount of FDI like China would experience a rapid growth of wages
in the export sector. The authors mention that in Guangdong
province, over the last ten years, the average wage for manufacturing
workers is only 100 dollars per month. I suspect that this rather
stagnant wage pattern has a direct connection with the ongoing
restructuring in the state-owned enterprise sector and the unlimited
supply of labour from China’s vast rural area. Because of these two
factors, the wages in the export sector have not led to an overall
178
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

Li-Gang Liu
179
domestic wage growth, as is usually observed in a country with large
inflows of FDI. However, without wage growth, it will be difficult
for China to raise domestic demand. This is perhaps why China’s
growth is so dependent on export growth, as indicated by its tradeto-GDP
ratio.
If you look at the nominal GDP among China, the US and Japan
over the last 30 years, China’s GDP in nominal US dollars as a share
of United States’ GDP has not changed much; it stayed more or less
below 10 percent of United States’ nominal GDP. On the other
hand, if you look at Japan, its GDP as a share of United States’
GDP has converged to the size of the US GDP until the bubble
collapsed in the 1990s.
It is quite puzzling that although China has experienced quite
high growth, it has not grown much in terms of nominal value of
US dollars. This seems to indicate that the wealth from FDIgenerated
income is located overseas rather than within China. I
wonder whether this is because the net value added in China’s
exports has been minimal, mainly in the form of cheap labour
income.
The third issue I would like to comment on is whether there is an
FDI diversion from ASEAN to China. This is a controversial issue,
especially among Asian countries. However, I want to put this in
perspective by asking whether the current trend of high FDI in
China is a cyclical issue or a permanent phenomenon. If you look at
the overall FDI flows to less-developed countries, excluding China,
over the last several years, they have increased. Why have ASEAN
countries received less FDI from the rest of the world? I think
domestic factors play the major role. ASEAN countries were hit by
the financial crisis of 1997-98 and the recovery from the crisis was
further exacerbated by the September 11th terrorist attacks in the
US. In addition, Islamic countries such as Indonesia and Malaysia
may have suffered from a higher investment premium. Western
investors may view these countries as quite risky, so they prefer not
to move their assets to these countries for the time being.
If we look at the adjusted per capita flows and stock figures of
FDI, as the two authors mention, 25 percent of FDI from Hong
Kong to China is round-tripped FDI. That is, Chinese money or
investment is first taken to Hong Kong or other offshore facilities
and is then taken back to China in order to enjoy tax incentives,
favourable land use concessions, better property protections, and
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
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180
Comment on Young Rok Cheong and Geng Xiao
other types of subsidies. If these tax incentives are going to be
phased out with China’s WTO commitment, I feel that such capital
flight may not return. After the dust has settled in the ASEAN
economies, perhaps such capital from China will go to Malaysia or
Indonesia, rather than go back to China.
The fourth issue I would like to discuss is an interesting and
rather controversial one, that is, the prediction of the Lewis model
the authors used: If the Lewis model is applicable, China is going to
contribute to world deflation, or wage deflation at least. According
to the authors, currently 224 million of Chinese would be
participating in the world market, while two-thirds of the
population are still waiting in line. If we think those people are
waiting in line to get into the labour-intensive industry only, perhaps
that kind of prediction could materialise. However, if we qualify this
assumption by assuming that China will continue to grow with
industrialisation and urbanisation, the non-tradable service sector
will increase to a normal size as we have seen in most of the
industrialised countries, and, as a result, the immiserising impact of
Chinese export growth on the rest of the world will not take place.
Thus, the participation ratio of Chinese workers in the world
economy will be much lower than the authors’ prediction, and it is
likely that a majority of people in China will engage in the nontradable
service sector rather than compete internationally. Also, as I
mentioned, China cannot maintain a 50 percent trade-to-GDP ratio
forever. This ratio is obviously unsustainable for a continent-sized
country like China.
However, the issue is, as China’s nominal GDP ratio to Japan
and the US shows, that China’s terms of trade have been flat over
the years, despite the fact that it has been climbing the value-added
product ladder. Perhaps the average wage rigidity, due to a lack of
active bargaining power of the workers in the foreign-owned firms,
might be the reason why wages cannot go up. And perhaps because
of this problem, the income inequality in China in the 1990s has
become worse. The problem is that local governments have great
incentives to attract FDI, so in a sense, they tend to collude with
foreign investors and the interests of workers may have been
ignored here.
What is the policy implication then? Wing Thye Woo has
mentioned that one should try to increase the income of the rural
sector. I think we should go a bit further and also look at the wage
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

Li-Gang Liu
181
issue of FDI-funded firms. The question is whether the bargaining
power of workers can be increased so that their wages can be
increased through the bargaining process. In fact, this will be one of
the solutions if China wants to sustain its growth by creating
sustainable domestic demand in the future. Almost 90 years ago,
when Henry Ford offered his workers a wage of 5 dollars a day, a
much higher wage than usual, he had an economic insight not
apparent to most people at the time. If a majority of his workers
could not afford to buy his Model-T automobiles, who would
demand them after productivity and efficiency were improved so
immensely that the mass production of cars was no longer a fantasy?
His insight proved to be right.
Today, the world is facing a similar challenge: integrating large,
populous and poor developing countries into the world market. If
this succeeds, it will boost their manufacturing capacities because of
their large pool of semi-skilled industrial workers and, at the same
time, it will directly impact the welfare of industrial workers of the
developed world. To address this challenge, the wage rates and
income of those developing countries will have to go up so that their
own large internal markets can demand some of the goods
produced. Besides waiting for the labour market alone to adjust the
wage rates in developing countries, this process can also be
facilitated if governments in both developed and developing
countries collectively pay attention to and enforce their labour laws
so as to allow wage bargaining between workers and capitalists to
take place. On the other hand, the beneficiaries from the
globalisation process, mostly the transnational corporations, will
have to share some of their profits with the industrial workers in the
developing countries. Similar to the insight of Henry Ford, it may
be a difficult policy for some to accept at the moment. But for the
sake of global prosperity, such measures will prove to be beneficial
for everyone. Presumed as a champion for the welfare of workers
and peasants, the Chinese government can play a decisive role in
initiating a global movement that will benefit its own millions of
industrial workers and peasants at home.
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

10
Floor Discussion of “China’s Role
in the Region and in the Global
Financial System”
The Park and Wang Paper
Masaru Yoshitomi, former dean of the Asian Development Bank
Institute (ADBI), wondered whether China’s economic boom
would eventually end in a financial crisis and what could be done to
prevent such a crisis from occurring. “The main reason for the
Chiang Mai Initiative is that we want to prevent a crisis similar to
the capital account crises that struck Asia in 1997, and to better
manage such a crisis when it would occur. First of all, we have to
understand the real nature of the capital account crises of 1997. At
the ADBI we have just released a report 1 that develops a set of policy
recommendations for China on how to sequence its financial
liberalisation, given that the sequencing order of financial
liberalisation was clearly the missing link when the World Bank
published its Asian miracle report in 1993 and only four years later
the Asian crisis erupted.
The ADBI found that there was a huge gap between the new
risks arising from financial liberalisation and deregulation (changing
the incentives of borrowers and lenders), on the one hand, and the
pre-existing, old kind of institutions including prudential regulation
and supervision, on the other hand. The old regulatory frameworks
1
ADBI, “Policy Proposals for Sequencing the PRC’s Domestic and External
Financial Liberalization”, October 2002.
182
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Floor Discussion
183
and institutions were clearly not prepared for managing the new
risks under liberalisation because they had no idea about how to do
capital account liberalisation. That is quite natural because under
the old, regulated financial markets we did not need such concepts at
all.
The capital account crisis did, in fact, happen in the 1990s in
Asia, and it might happen in the future in China as well. I have come
to the conclusion that big financial crises usually occur after a real
economic boom with some technological improvements. In this
decade, the Chinese economy will continue to boom at least until we
have the Olympics in 2008, and probably until 2010 when we have
the World Expo, financed by the banks and so on. The WTO
accession will liberalise financial services transactions in China by
inviting all kinds of financial institutions. So at the end of this
decade, there is likely to be a risky combination of a continued
economic boom together with a real estate bubble financed by the
banks, not by the securities market like in Japan in the 1980s.
The de facto capital account liberalisation in China will probably
end up in a capital account crisis because such crises tend to take
place, not every year but every ten or fifteen years. In order to
prevent a crisis from occurring in China, besides implementing the
kind of policy recommendation on the sequencing order of financial
liberalisation that we at the ADBI have suggested, we may also need
the arrangements beyond the Chiang Mai Initiative that Yung Chul
Park and Yunjong Wang have suggested in their paper. In my later
panel presentation I will talk more about the kind of recommendations
we have made in our ADBI report.” (See Chapter 17 of this
volume.)
Xie Ping, of the central bank of China, thought that it was not
yet clear to the Chinese government how regional financial
cooperation beyond the Chiang Mai agreement should be
developed. “It is not clear because China receives too many different
suggestions. One day the ADB makes a suggestion, one day the
World Bank, one day the IMF, and another day the BIS. It has been
suggested, for example, that we create an Asian bond market, and
that such a market would be very useful for the Asian countries
including China. In the context of the Chiang Mai Initiative, last
year we agreed on currency swaps with Japan, Thailand, Korea and
some other countries, amounting to about 10 or 20 billion dollars.
Some people say that this amount is very small and that, if China
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184
China’s Role in the Region and in the Global Financial System
would face a financial crisis, it would be absolutely nothing. So
maybe this currency swap agreement is just symbolic. It may just
mean that China participates actively in efforts at East Asian
financial cooperation. Also, we have been discussing this Asian
Monetary Fund proposal for a very long time. Some people are
upset with it and are saying, ‘You cannot do this!’, while others are
saying, ‘This is a good idea’. There are so many people with
different opinions about the Asian Monetary Fund.
Last week Professor Mundell from Columbia University, was in
Beijing for a week. I met with him and he suggested to me that in
the next 10 years, Asia should be united with one currency, and that
this currency should be based on the Chinese yuan and the Japanese
yen. He also thought that the Chinese yuan should be fully
convertible before the 2008 Olympic Games. He gave us, the central
bank, a lot of suggestions.”
Wing Thye Woo, of the University of California, said that in
every regional or global arrangement there is always an issue of
economic power involved. “Look at Japan’s experience in the IMF.
For many years, the Japanese tried to enlarge the capital base of the
IMF to increase Japan’s voting power, but the Americans and the
others resisted it. So any kind of regional financial institution set up
now in Asia would mean locking in the present distribution of
economic power. The president of such an institution would
possibly be a Japanese, the executive vice-president a Chinese, the
deputy vice-president a Korean. But let us say that we wait 20 years
from now, perhaps the president and the next 5 executive vicepresidents
would be all Chinese. So what’s the incentive for China
to lock-in the present status-quo distribution of power?
Another question is why China should be in favour of a regional
bloc when its trade relationship is global in nature. It should be in
favour of an Asian bloc only if this would be a building block toward
multilateralism. Then the Chinese would be more enthusiastic about
it. If you look at China’s aspirations for the future, I think it would
see its interests better served by a multilateral world rather than a
regional bloc; and if it has to be a regional bloc, it should be seen as
a bargaining chip to push the multilateral agenda. That’s why I think
the Chiang Mai Initiative has no life beyond monetary cooperation.”
Geng Xiao, of the University of Hong Kong, agreed with Wing
Thye Woo on the economic power issue in the Chiang Mai
Initiative. “The difficulty of the Chiang Mai Initiative sort of effort
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
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Floor Discussion
185
is that, at present, there are no credible leaders. Japan has a problem
with its financial system, and nobody knows how to fix it. China is
basically free-riding on the US system, pegged with the US dollar
and trading with the US. So it is indeed very important to go back
to fundamentals, as Yoshitomi and the ADBI people have done, and
look at the so-called Asian miracle. If you look at Japan, Korea,
Singapore, Hong Kong and all of these countries, they are all special
cases of Asia in the sense that they are all small countries with a
limited amount of labour supply and when the growth starts, the
labour supply hits the limit and then wages go up. But in Asia, which
has 50 percent of the world’s population, the typical Asian situation
is the case of unlimited supply of labour, fitting into the traditional
Lewis model, the dual sector model. When China started growing,
we had a huge population at subsistence level wages and an
unlimited supply of labour, and that had an immediate effect on the
ten years of growth. If you look at the Asian countries, we have all
these successful economies of Japan, Korea, Taiwan, and now China,
and you always see these huge current account surpluses, which
mean that these countries are exporting capital, are having huge
savings. But at the same time we have a huge surplus of labour in
Asia. This means that we have a surplus labour economy exporting
capital to the capital-rich US economy instead of investing it in the
unlimited supply of labour economies in Asia. If capital and labour
combine in Asia, these two things will continue to drive Asian
growth. But the problem now is that the capital cannot go to Asia, it
can only go to the US, and from the US it goes back to Asia through
FDI. So we are actually free-riding on the US system, largely
because the US financial system is the most competitive system in
the world.
So in this sense, we have to go back to these fundamentals, to
assess whether the free-riding on the US system is the best solution
for Asia. Hong Kong is the typical case, it is just free-riding, and
there is no monetary policy. If Japan would resolve its banking
problem, the Japanese interest rate would rise, which would help to
better allocate resources because at a 0 percent interest rate, this
capital just does not know where to go, it just goes to the US.
We are all without choice just investing in the US, but at the
same time we have so many resources in terms of labour, in terms of
oil in Indonesia, all kind of resources. We have technology in Japan
and in Taiwan, and we have financial markets in Hong Kong, but we
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186
China’s Role in the Region and in the Global Financial System
are not using it. Last year, even Hong Kong had capital flight to the
US. In Asia there is no leader, we are still relying on the US. But we
have to ask ourselves whether that is the best solution.”
Yung Chul Park was not sure that China would face a financial
crisis in the next 10 to 15 years. “Whether China is going to be the
next epicentre of a financial crisis within the next ten years or so
depends upon a couple of assumptions. The first is, to what extent
China is going to borrow from abroad, from the global market. The
second is, to what extent China is going to borrow from other Asian
countries. In the next 10 to 15 years, I don’t think China is going to
borrow so much from outside. Since the savings rate is still very
high, China will continue to run a current account surplus for some
time. But the foreign debt of China will not go up to the level of
Korea or Thailand or Indonesia, so the foreign debt-to-GDP ratio
will remain very low.
I am more concerned about domestic financial turbulence in
China because of this non-performing loan problem and the
bankruptcy of the state-owned banks. And this domestic instability
may spill over to other East Asian countries and that might be
something to worry about even though I think the spillover would be
relatively small. So I am not as much worried about the possibility of
China getting into a serious financial crisis as Yoshitomi.”
Li-Gang Liu, of the ADBI, was puzzled about the leadership
issue in Asian financial cooperation that Park and Wang raised at the
end of their paper. “I am not sure that the analogy of Germany and
France, as leaders in European integration, necessary applies to
China and Japan as leaders of Asian integration. In terms of
economic size, China is just one-fifth of the Japanese economy. Also,
if the rest of the Asian countries are further advanced in terms of
financial services liberalisation, capital account liberalisation and
domestic financial liberalisation, why can’t they start some kind of a
financial cooperation framework? China can always join at a later
stage. The IMF system started without Russia, and the WTO did
not have China as a member for many years, so why should the
other countries, if they are willing to go ahead, wait for China?”
Zdeněk Drábek, of the WTO, thought however that Chinese
cooperation was of key importance. “Since the stability of the
exchange rate in the region is important, the Chinese role in that
context is important. It would be very useful for Korea, for Thailand,
for Indonesia to know whether the Chinese are going to devalue their
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currency or not. So in that sense monetary cooperation with the
Chinese is not premature but highly important.”
In his reply to the comments, Yunjong Wang stressed that the
basic aim of the Chiang Mai Initiative (CMI) and the Asian
Monetary Fund (AMF) is to prevent financial crisis and manage the
crisis better. “In terms of crisis prevention, we need two things: one
is the swap facility and the other is the monitoring and surveillance
system. Regarding the facility, the current CMI just links to the
IMF, so if we are really satisfied with the current Chiang Mai swap
scheme, we should probably be happy with the way in which the
IMF deals with crisis prevention and management as well. Then we
don’t need to go any further. But if we are dissatisfied with the role
of the IMF and the current scheme of the CMI, then we should
think about what kind of elements could be introduced to better
prevent the crisis. Regarding the monitoring and surveillance
system, the main task is to identify the emerging problems in East
Asia. The policy dialogue has already started, but that’s not enough,
we need a secretariat to detect and initiate a discussion about the
emerging issues.
Probably ASEAN+3 will just have to forget about exchange rate
coordination, because it is too early. Currency union and currency
unification is a delicate political issue. In terms of exchange stability,
European countries have a different past, they started with the fixed
exchange system, and they didn’t need to care too much about
exchange rate stability. The Bretton Woods system guaranteed
exchange rate stability through various ways, and for two decades
the European countries had quite stable exchange rates and also
capital controls.
In East Asia there are now different degrees of capital market
opening. Geng Xiao talked about China’s free riding, but I think
that China’s monetary policy is independent because China has a
restrictive capital market opening. Hong Kong has a currency board
system and its capital market is open, so it is very sensitive to US
monetary policy. But China can maintain an independent monetary
policy.
Talking about currency unification, there is indeed this fact of
status quo in economic power. It is a very important factor. If we
pursue monetary unification, political will is important. Political
scientists are trying to explain why the East Asian countries have no
particular political will. European leaders have a kind of new
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China’s Role in the Region and in the Global Financial System
functionalistic vision underpinning the European system. In Europe
there is a lot of interaction between the countries and the spillover
effects are large, so there is a natural need for policy coordination.
But in East Asia we still have a relatively low degree of intraregional
trade. It is increasing but it is still low. We also have
minimal financial integration among the countries, but that is a less
important factor. The most important factor is that countries have
different policy objectives. For China, economic development is a
more important issue than regional integration, and Japan may have
yet another policy objective. Different political instruments are
required for these different policy objectives. My conclusion is that
it is probably still too early to say much about a high level of
economic integration in East Asia.”
The Cheong and Xiao Paper
Robert McCauley, of the BIS, wondered whether the Lewis model,
in the modern monetary world, would be the right way of looking at
wages and employment in China. “The current world is quite
different from the employment model when potential growth was
reasonably well defined. For example, if the renmimbi were to
revalue, would that mean that the nominal wage would simply go
down more or less in proportion to the devaluation?”
Geng Xiao explained that in the Lewis model, the real wage is
determined by subsistence labour and the unemployment rate.
“There is a lot of unskilled labour in China, and labourers are
competing with each other to find a job. On the one hand, the wage
level has to be higher than their incomes in the countryside and, on
the other hand, they have to face the unemployment in the cities. So
these two conditions more or less determine the wage rate. Chinese
people have lived so many years of endurance and frustration in real
income that they can deal with low wages. An exchange rate
revaluation would probably have an effect on real wages, but not too
much. On the longer time horizon of 5, 10, 20 years, wages are hard
to change, largely because you have so many people coming out of
the countryside who are looking for a job. Wages will go up largely
when things become cheaper and the living standard increases. Food
has become cheaper for everybody in China, including the people in
the countryside, and that has increased their living standards.”
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
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Floor Discussion
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Masaru Yoshitomi wondered how one could reconcile the fact
that income in China has increased and, at the same time, a large
part of the population still lives at a subsistence level. “How does the
Lewis model apply to China? On the one hand, we are hearing that
the income of people in China has increased over the past 20 years
and that it will continue to increase in the next 20 years. But, on the
other hand, Geng Xiao insists that the Lewis model applies because
the wage level will continue to be based on wages at the subsistence
level. How do you reconcile these two sort of conflicting facts?”
Young Rok Cheong thought the explanation was quite simple.
“These facts go together because there is a large inequality in
income in different areas. Look at the per capita GDP in the cities,
and at the difference between the top rich 9 cities and the rest. The
gap is widening.”
Yoshitomi insisted: “But the question is: Have the wages of the
labourers who migrated to the coastal areas remained constant over
the past 20 or 30 years? And are the wages in the coastal areas still
determined by the subsistence level in the very remote areas in
China? That is what I’m asking.”
Cheong explained: “You will be surprised to know that wages for
the workers in Guangdong in assembling lines in foreign investment
enterprises are actually lower than probably in the whole nation
because the competition in the labour market is so perfect that
labourers are coming from all over China. If you want to find a job
you go to the coastal cities. The wages there are not higher than in
the interior cities.”
Yoshitomi continued: “What kind of immigrants are they? Are
they coming into the cities from relatively near or from remote
areas?”
Cheong: “Both, they are coming from the Western part of
China, and they are coming from within the province. Many of the
migrating workers are not seeking the job by themselves but are
being sent by provincial governments. They organise the provision
of cheap labour, as cheapest as possible, and export the labourers to
the coastal areas. I visited many companies and they have their own
dormitories and maintain a very low level of wages.”
Geng Xiao added that for skilled labour, wages are increasing
rapidly in China. “The wage income of the professors and the
technicians is going up very fast, every year. The gap between skilled
and unskilled labour is increasing rapidly. Wages for unskilled
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China’s Role in the Region and in the Global Financial System
labour, on the other hand, remain low because you have plenty of
supply. For example, when you advertise for a waitress, there are
hundreds of people applying. How can you then increase the wage?
Even in Hong Kong the wage for unskilled labour has not changed
much, it is still the same as 10 years ago.”
Charles Adams thought that at the time Lewis developed his
model, he did not make a distinction between product wages and
consumption wages and that the subsistence argument is about the
consumption wages. Second, he found it very odd to be talking
about China’s exporting deflation. “At best it is an issue of relative
prices. But in the case of the US, manufacture prices have been
rising less rapidly than service prices for a long time, and well before
China was potentially on the scene. So I suspect it has something to
do with differential productivity. And just to make a provocative
point: while it seems that one can make the case that the RMB does
not need to appreciate vis-à-vis the US dollar, one can also make the
case that the RMB should appreciate against the rest of Asia. What
would happen if the US dollar weakened against the other Asian
currencies and the RMB did not change?”
Geng Xiao said that his quick answer would be that most Asian
economies are pegged to the US dollar, “so when the US dollar
changes everyone just follows”.
Adams observed that there might be a de facto pegging, but on
paper, most countries were floating. “So if we see adjustments in
other Asian currencies, then there will be an issue about the crossrate
between those currencies and the RMB. So all I’m asking you is,
if you think on that margin, what would be your answer?”
Xiao: “According to economic theory it is very simple: you just
don’t mess with the exchange rate. The issue of prices and price
changes is confusing in China because the country is not an
equilibrium economy. The exchange rate is about inflation; it is
about the price. In China, there are many sectors and many regions,
all fragmented, and they are all trying to find equivalent prices. So
the exchange rate is used as an anchor.”
Adams: “I may be old-fashioned, but nominal exchange rate
changes have quite a profound effect on real exchange rates, for a
sustained period, in many countries.”
Xiao: “That is true, but exchange rate fluctuations in China
would also have a huge wealth impact in the sense that China’s
holding of foreign assets are huge. I did some rough calculations:
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once you change the exchange rate by, say, 10 to 20 percent, there is
going to be a redistribution of wealth in China of the range of 7 to 8
percent of GDP. That is why I doubt whether China should have
floating exchange rates. The monetary system in China relies so
heavily on the US dollar, 45 percent of China’s central bank assets
are in US dollars, and 24 percent of China’s GDP is in US dollars.
So if you mess with the exchange rate, you will stimulate huge
speculations of people who will be trying to make money out of the
exchange rate changes. That’s why the exchange rate in China
should remain fixed. By remaining fixed, the renmimbi remains
credible – at least, as long as China continues to have a surplus. And
a fixed rate substantially reduces the risks for traders, producers,
foreign investors and Chinese people. So, in my view, the current
monetary system is the best for China. I don’t believe in the
traditional IMF recipe because that is only right for an economy
based on an equilibrium model. It is better to give China an
exchange rate anchor, so that it can fully employ its labour force.
Once that is realised, we can talk about floating and all the other
traditional arguments coming into effect. But first China has to
address the basic question of development.”
Xiao stressed that China’s trade-to-GDP ratio of 45 percent was
rather meaningless because of the minimal value-added in China’s
exports, and that China would remain a very attractive country for
foreign investors. “As a percentage of GDP, the value-added is very
small and China’s GDP, in PPP terms, is highly undervalued. It is
the opposite in Japan. Japan’s exports are only 10 percent of GDP
because its GDP, in PPP terms, is overvalued. I don’t think that the
potential of FDI into China is going to decline, largely because once
every major multinational corporation has production facilities in
China, you generate an economy of scale and scope that is going to
have its own momentum. Look at what happened earlier in history
in Manchester, New York, Chicago, Tokyo, Osaka – they have all
become major manufacture centres of the world. The same is now
happening in Shanghai and in Guangdong.”
Yunjong Wang shared Xiao’s view that China would continue to
attract foreign investors, because of its own large population and
that of neighbouring India. “I cannot see a turning point in foreign
investment in the near future. India, with its large English speaking
population, is trying to establish special economic zones along its
coast. Just like China, India also has an unlimited supply of unskilled
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China’s Role in the Region and in the Global Financial System
labour. The two countries together may have 1 billion unskilled
labourers. That is going to attract a lot of capital. But we should be
careful. There are still many foreign investors who do not want to
invest in the western part of China. To attract foreign capital, you
need a good infrastructure and a good working discipline. Foreign
factories are mostly concentrated on the coastal line and this might
create growing inequality, undermining social cohesion and stability.
However, both India and China have an enormous potential for
foreign investments.”
Geng Xiao emphasised that the competitive pressure of China in
the world is just there, not only because of the Lewis model and the
unlimited supply of labour, but also because of the mobility of
institutions and of capital. “The successes of Shanghai and Hong
Kong are tremendously important. You cannot believe how many
people are focused on China, and how much advice is given to
China. Look at the whole world, look at the major US and
European corporations, or at the major international, US and
European institutions, they all have China experts who study China,
advise China, and think about China. All the high techs are in Hong
Kong. So this is real. If China continues its success, the implications
for the whole world are tremendous. It is so simple, I mean, 1000 or
500 years ago we spent most of our time on getting food and shelter,
but today one hour is for food and the other time is for
entertainment. In a way, this relative price adjustment is good news,
it means that now, in principle, it should be easy for everyone in the
world to have a decent basic life. We have the technology, the
knowledge and the institutions to realise that.”
Zdeněk Drábek wondered about the importance of FDI for
China’s growth. “How important is the foreign sector? What is really
driving the growth? I would think that most of the aggregate demand
is domestic and that most of the investment must be domestic
investment. So I don’t think that foreign investment is the engine of
economic growth in China. What is much more important is what the
government is doing. I think that the fiscal policy and the investments
by state enterprises are driving this big investment drive in China.”
Young Rok Cheong agreed. “The magic is not just FDI or the
unlimited supply of labour. The magic is to put everything together.
The Chinese government is a very stable government and very
open-minded to foreigners. And indeed, the infrastructure investments
are huge and unprecedented in China.”
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Floor Discussion
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Cheong ended the discussion with three policy suggestions. “The
first is that the Chinese government can and should allow the
market to work. The market is working at the global level and it
should also work at the national level. Second, once China fully
employs all its surplus labour, it can apply the traditional recipes
of economic equilibrium theory. China’s labour force provides
competitive pressure to other countries, but it also harbours
domestic risks, social risks. Third, the development of the domestic
financial system in China is of key importance for sustained growth.
Economic growth is facilitated by the protection of property rights,
and the protection of property rights in China is coming through in
the wrong way, through the foreign investment enterprises. Only
when the foreigners came in, the government started to secure
property rights and apply other standards of international practice
in, for instance, the hiring of workers. Property rights protection is
going to be the key for China to have success in the next stage. The
financial sector is a derivative of the real sector and anything that
goes wrong will be reflected in the financial sector. So by tracing the
road for the financial sector in China, we can trace the road for
maintaining growth and development.”
From: China’s Role in Asia and the World Economy - Fostering Stability and Growth,
FONDAD, December 2003, www.fondad.org

State-owned
enterprises in China
Reform dynamics and impacts9
Xiao Geng, Xiuke Yang and Anna Janus
Introduction
Large-scale SOE reform in China has been going on since 1978. In spite of
the Chinese Government’s efforts towards privatisation and its commitment
to market-oriented development, SOEs remain a dominant part of the
Chinese economy, especially among certain strategically important
sectors, such as infrastructure construction, telecommunications, financial
services, energy and raw materials. The question of how this apparent
paradox can be resolved—and what the explanation might imply for
our understanding of China—is the main focus for this chapter. Many
questions arise in this context: should the Chinese Government continue
its trend of privatising SOEs or should it continue to keep control of the
largest and most important SOEs? Is there a set of implicit objectives in
government policies that can explain China’s SOE reform dynamics in the
past and predict future trends?
SOE reform in China has been unique in many ways. Unlike the abrupt
approach to privatisation adopted in Russia, which was followed by a
collapse of the economies in all former Soviet Union partner countries in
the last decade of the twentieth century, the more gradual approach taken
in China has entailed a steady expansion of SOE assets and profits, as well
as an accumulation of power and influence among SOEs. Unlike in India,
which has to cope with high urban unemployment and poor industrial
infrastructure, in China, the privatisation of SOEs has coincided with
large-scale improvement of infrastructure and still relatively low urban
unemployment.
This chapter reviews the relative performance of large and mediumsized
enterprises during the reform period in a comprehensive and
systematic way in order to reveal possible underlying patterns and trends.
For this purpose, we have used three sets of data: sector-level annual
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China’s New Place in a World in Crisis
survey data for China’s large and medium-sized industrial enterprises
from 1995 to 2005, collected by the National Bureau of Statistics; firmlevel
survey data for China’s top-500 enterprises, published by the China
Enterprise Confederation; and the Fortune Global 500 data published
by Fortune Magazine. For our analysis, we have used the novel approach
of grouping SOEs by sector into two categories: the competitive and
the strategic markets. This distinction was made based on the specific
characteristics of the industry sectors. The competitive market contains
sectors that relate to the manufacturing of consumer products. Sectors in
this market have undergone intensive privatisation. The strategic market
contains sectors such as infrastructure construction, financial services,
energy and raw materials, where there are still government-imposed
market entry barriers. Many government documents and research papers
have cited such a distinction when discussing industrial policy, although
there has been no official classification of which industries belong to
competitive markets and which to strategic markets. The distinction we
make in this chapter helps us unveil an implicit objective function behind
the facts of SOE transformation in China. The analytical framework in this
chapter also highlights the impacts of reforms on enterprise performance
as well as on the Chinese economy and society. The results of this study
show a comprehensive picture of SOE transformation and provide a useful
foundation for consideration of future reforms.
We begin with a review of the advancement of SOE transformation
since the beginning of the reforms and an assessment of the current state
of SOEs in China. We then explore the characteristic dynamics of SOE
transformation in the main part of our chapter. Possible policy implications
are then outlined.
Progress of SOE reforms in China
Background of SOE reform
Under heavy influence from the Soviet Union, China gave birth to the
SOEs about 50 years ago after the establishment of the People’s Republic of
China and the socialist industrialisation that came soon after. In less than
10 years, China nationalised virtually all private industrial enterprises
during the 1950s. Before 1978—the year that marked the beginning
of market-oriented transformation—China operated its SOEs under a
centrally planned economy. Since 1978, Chinese authorities have initiated
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State-owned enterprises in China: reform dynamics and impacts
intensive reforms and privatisation of SOEs. At the macro level, the SOE
reforms can be seen as a strategic adjustment of the nationalised and
centralised economy towards a more market-oriented economy; at the
micro level, the reforms are intended to transform the Chinese SOEs into
modern corporations. Specifically, SOE reforms fall into three successive
phases.
The first phase, from 1978 to 1984, concentrated on increasing
managerial autonomy in order to motivate the Chinese SOEs to pursue
profit and growth. By loosening its hold on the planned economy, the
Chinese Government to some degree began to weaken the link between
the State and enterprises. Managers were essentially allowed to sell
surplus production at market prices for a profit, once the planned quotas
for production were met. The most important innovations during this
period were the delegation of managerial autonomy from government
bureaucracy to enterprise managers and the introduction of a dual-price
system (the existing planned price for within-the-quota output and the
new market price for above-the-quota output).
The second phase, from 1985 to 1993, focused on separating company
ownership and management by introducing a ‘contract responsibility’
system. Managers signed a contract with the relevant government agencies
and became the legal representatives of the SOE, consequently being held
responsible for the company’s profits and losses. The idea of reform during
this period was to transform SOEs into truly independent economic
entities that were responsible for their own profits and losses, as well
as to establish independent legal entities that shared certain rights and
obligations. The result was that the management teams tended to pursue
short-term interests rather than long-term profitable growth because they
had the rights only to operate SOEs but no clear property rights. The
main problem of the ‘responsibility system’ is that the managers can easily
share profits with the government and employees but are not practically
capable of assuming losses and liabilities that might follow from their
managerial decisions, since they do not own any significant amount of
assets or property.
The third phase, starting from 1993 and continuing into the present,
emphasised transforming SOEs into modern corporations. The main
elements of reform during this period include the policies of ‘grasping
the large and letting go the small’, severing the link between the State
and labour, as well as changing the State’s position towards shareholders
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China’s New Place in a World in Crisis
under mixed ownership (state and non-state ownership). During this
period, privatisation took place on a large scale, notably among small
SOEs. Some of the largest SOEs are even being listed on the young Chinese
stock markets and the Hong Kong Stock Exchange, usually with the State
still holding about two-thirds of the shares in the listed companies.
Current state of Chinese SOEs
Even after more than two decades of market-oriented reforms, SOEs
still play a prominent role in the Chinese economy. To examine the most
relevant trends, our focus here will be on SOEs among large and mediumsized
enterprises in China.
In 2005, there were 3999 SOEs among all large and medium-sized
industrial enterprises (25 per cent of the total), centralising assets of
RMB6.09 trillion (58 per cent of the total) and generating a total profit of
RMB268 billion (48 per cent of the total) (Table 9.1).
Table 9.1
Structure and performance of SOEs in large and mediumsized
industrial enterprises, 2005
Ownership No. SOEs Assets (RMB billion) Profit (RMB billion) ROA (%)
State 3999 6090 268 4.40
Collective 1331 343 23 6.62
Private 5584 1110 68 6.13
Foreign 5272 2880 203 7.05
Total 16 186 10 423 562 5.39
ROA = return on assets
Source: National Bureau of Statistics (NBS) 2005, China Statistical Yearbook 2005, China
Statistics Press, Beijing.
Table 9.2
Structure and performance of top-500 Chinese
enterprises in 2007, by ownership (per cent)
Ownership No. SOEs Assets Profit Employees Taxes ROA
State 69.8 93.6 87.9 89.3 92.7 1.4
Collective 5.8 4.2 2.2 2.4 1.7 0.8
Private 17.8 1.7 7.1 7.0 3.9 6.1
Foreign 6.6 0.5 2.8 1.3 1.7 8.5
ROA = return on assets
Source: A Report on the Development of China’s Enterprises 2007, Enterprise Management
Publishing House, Beijing, Chapter 12, p. 88.
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State-owned enterprises in China: reform dynamics and impacts
In 2007, of the top-500 Chinese enterprises, an astounding 69.8 per
cent were SOEs, accounting for 94 per cent of asset value and creating
88 per cent of the total profit (Table 9.2). SOEs are not only economically
dominant, they are still socially relevant too, employing 89.3 per cent of
the workforce and contributing 92.7 per cent of overall taxes.
In 2007, of the top-500 Chinese manufacturing enterprises, almost 50
per cent were SOEs, creating 61 per cent of the total profit (Table 9.3).
Table 9.3
Structure and performance of top-500 Chinese
manufacturing enterprises in 2007, by ownership (per cent)
Ownership No. SOEs Profit ROA
State 49.8 61.1 3.2
Collective 7.8 7.8 6.2
Private 29.4 21.4 6.4
Foreign 13.0 9.7 7.9
ROA = return on assets
Source: A Report on the Development of China’s Enterprises 2007, Enterprise Management
Publishing House, Beijing, Chapter 13, p. 126.
In 2007, of the top-500 Chinese service-sector enterprises, SOEs were
even more dominant, accounting for 94 per cent of assets, 92 per cent of
profit and 61 per cent of the number of firms (Table 9.4).
Table 9.4
Structure and performance of top-500 Chinese enterprises
in the service industry in 2007, by ownership (per cent)
Ownership No. SOEs Assets Profit ROA
State 61.4 93.6 92.4 0.8
Collective 11.4 5.4 1.1 0.2
Private 23.2 0.8 5.3 5.3
Foreign 4.0 0.1 1.2 8.3
ROA = return on assets
Source: A Report on the Development of China’s Enterprises 2007, Enterprise Management
Publishing House, Beijing, Chapter 14, p. 137.
Meanwhile, Chinese SOEs are also becoming a globally noticeable force.
In 2007, there were 22 Chinese SOEs listed in the Fortune Global 500 and
China ranked sixth in the number of firms by country. The contributions
of the 22 Chinese SOEs in the Fortune Global 500 include employment of
13 per cent of the workforce, 3.6 per cent of overall profit and 3.8 per cent
of total revenue (Table 9.5).
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China’s New Place in a World in Crisis
Table 9.5
Structure and performance of Fortune Global 500 in
2007, by country (per cent)
Country No. firms Assets Revenue Profit No. employees ROA
United States 32.4 25.5 35.1 38.5 34.1 2.7
Japan 13.4 9.4 11.5 7.0 9.4 1.3
France 7.6 10.9 8.7 7.4 9.7 1.2
Germany 7.4 9.5 8.8 5.7 8.9 1.1
Britain 6.6 12.1 7.4 8.3 6.1 1.2
China 4.4 4.7 3.8 3.5 13.0 1.4
ROA = return on assets
Source: ‘Fortune Global 500’, Fortune Magazine, 23 July 2007.
In addition, the Chinese SOEs accounted for three of the top-five
largest employers in the world in 2006 (Table 9.6) and three of the top-five
enterprises in Asia in terms of revenue (Table 9.7).
Table 9.6
Top-five enterprises in Asia in 2006, by revenue
Company Country Revenue ($million)
Toyota Motors Japan 204 746.4
Sinopec China 131 636
China National Petroleum China 110 520.2
State Grid China 107 185.5
Honda Motors Japan 94 790.5
Source: ‘Fortune Global 500’, Fortune Magazine, 23 July 2007.
Table 9.7 Top-five biggest employers in the world, 2006
Company Country No. employees
Wal-Mart Stores United States 1 900 000
State Grid China 1 504 000
China National Petroleum China 1 086 966
US Postal Service United States 796 199
Sinopec China 681 900
Source: ‘Fortune Global 500’, Fortune Magazine, 23 July 2007.
For the SOE reforms in the past 30 years, however, revenues and profits
have consistently run ahead of deeper enterprise transformation such
as improvement of operating efficiency and enhancement of industrial
productivity. The return on assets (ROA) of Chinese SOEs in the top-500
Chinese enterprises was only 1.4 per cent in 2007—lagging far behind
non-state enterprises (NSEs) in China, such as private-owned enterprises
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State-owned enterprises in China: reform dynamics and impacts
(6.08 per cent) and foreign-funded enterprises (8.48 per cent) (Table 9.2).
As for return on equity (ROE), it is only 10.07 per cent for the heavily
SOE-dominated top-500 Chinese enterprises—performing far worse than
the Fortune Global 500 average of 16.13 per cent (Table 9.8).
Table 9.8
Performance of top-500 Chinese and global companies
(per cent)
ROA
ROE
Top-500 Chinese enterprises 1.82 10.07
Fortune Global 500 companies 1.79 16.13
ROA = return on assets
ROE = return on equity
Sources: A Report on the Development of China’s Enterprises 2007, Enterprise Management
Publishing House, Beijing; ‘Fortune Global 500’, Fortune Magazine, 23 July 2007.
Clearly, apart from increasing revenues and profits, Chinese SOEs
still show major deficiencies in regard to efficiency and productivity. As
a major economic force in China, they are also quickly becoming more
relevant on a global scale. There appears therefore to be a continuing
need for reform and enhanced policies for SOEs in China. In order for
China’s economic transformation to be successful, we have to recognise
accurately what is happening in the Chinese SOEs. For this purpose, this
chapter attempts to shed some light on the underlying characteristics of
SOE reform in China.
The dynamics of SOE reform in China
Our analytical approach
In order to highlight the special characteristics of SOE reform in China,
this chapter uses sector-level annual survey data from China’s large and
medium-sized industrial enterprises during 1995–2005, which are collected
at the firm level and maintained at the National Bureau of Statistics
(NBS) in China. The sector-level data allow us to compare enterprise
performance across ownership, industry and time. The NBS survey covers
all of the large and medium-sized industrial enterprises in 38 sectors
(Appendix 9.1). In addition to differentiating firms by ownership and by
sector (as other studies have done), this chapter groups the 38 sectors into
two overall categories: the strategic market and the competitive market
(Appendices 9.2 and 9.3). The strategic market, including the sectors of
161

China’s New Place in a World in Crisis
infrastructure construction, energy and raw materials, has been providing
critical infrastructure support for the Chinese national economy, whereas
the competitive market, including sectors related to personal services and
the manufacturing of consumer products, is essential to improving the
living standards of the Chinese people. Such a distinction allows us to
systematically interpret reform processes and to derive considerations and
strategies for future SOE reform.
Special characteristics of SOE reform in China
The transformation of SOEs has been characterised on the one hand by a
rapid decline in the number of SOEs and on the other hand by a steady
accumulation and expansion of state-owned assets as well as profits in
large and medium-sized industrial enterprises.
The number of Chinese SOEs in large and medium-sized industrial
enterprises was 15 107 in 1995 and diminished to 3999 in 2005—a loss
of 73.5 per cent—and the number of all industrial SOEs fell from 118 000
in 1995 to 27 500 in 2005, a loss of 76.7 per cent (Table 9.9). The sharp
decrease in the number of SOEs shows how dramatically privatisation has
taken place in the course of reforms.
Table 9.9 The number of industrial SOEs in China, 1995–2005
Year
No. industrial SOEs
(all sizes)
No. industrial SOEs
(large and medium-sized)
1995 118 000 15 107
2000 53 500 9144
2005 27 500 3999
Sources: National Bureau of Statistics (NBS) 1995, China Statistical Yearbook 1995, China
Statistics Press, Beijing; National Bureau of Statistics (NBS) 2000, China Statistical Yearbook
2000, China Statistics Press, Beijing; National Bureau of Statistics (NBS) 2005, China Statistical
Yearbook 2005, China Statistics Press, Beijing.
162
The state-owned assets in large and medium-sized industrial
enterprises, however, steadily accumulated from RMB3.89 trillion in 1995
to RMB6.09 trillion in 2005 (Table 9.10), with a compound annual growth
rate of 4.6 per cent for 10 years. At the same time, the profit generated
from large and medium-sized state-owned industrial enterprises also
soared—from RMB70.8 billion in 1995 to RMB268 billion in 2005, with a
compound annual growth rate as high as 14.2 per cent—indicating that the
privatisation and transformation of SOEs during this period contributed
to a dramatic increase in state-owned profits and assets, which enhanced
the government’s financial, political and social net asset value.

State-owned enterprises in China: reform dynamics and impacts
Table 9.10 Assets and profits of SOEs in large and medium-sized
industrial enterprises
Year Assets (RMB billion) Profit (RMB billion) ROA (%)
1995 3890 70.8 1.82
2000 4640 87.4 1.88
2005 6090 268 4.40
ROA = return on assets
Sources: National Bureau of Statistics (NBS) 1995, China Statistical Yearbook 1995, China
Statistics Press, Beijing; National Bureau of Statistics (NBS) 2000, China Statistical Yearbook
2000, China Statistics Press, Beijing; National Bureau of Statistics (NBS) 2005, China Statistical
Yearbook 2005, China Statistics Press, Beijing.
Starting with these observations, we explore two key hypotheses about
SOE reform in China.
Hypothesis 1
SOEs are more likely to be privatised when they are losing profit in the
competitive market.
If we examine the competitive market and the strategic market
separately (Table 9.11), we can see that the number of SOEs in the
competitive market has diminished dramatically from 12 128 in 1995 to
1975 in 2005 (a loss of 83.7 per cent). However, the amount of state-owned
assets in the competitive market remained relatively stable (falling from
RMB1819 billion in 1995 to RMB1423 billion in 2005).
Table 9.11 The number and performance of SOEs in the competitive
market
Year No. SOEs Assets (RMB billion) Profit (RMB billion) ROA (%)
1995 12 128 1819 9 0.51
2000 6872 1902 7 0.38
2005 1975 1423 27 1.89
ROA = return on assets
Sources: National Bureau of Statistics (NBS) 1995, China Statistical Yearbook 1995, China
Statistics Press, Beijing; National Bureau of Statistics (NBS) 2000, China Statistical Yearbook
2000, China Statistics Press, Beijing; National Bureau of Statistics (NBS) 2005, China Statistical
Yearbook 2005, China Statistics Press, Beijing.
At the same time, the change in the number of SOEs in the strategic
market was less extreme—from 2979 in 1995 to 2024 in 1995 (a loss of only
32 per cent)—yet there was a remarkable increase in state-owned assets,
from RMB1.99 trillion to RMB4.66 trillion (Table 9.12).
163

China’s New Place in a World in Crisis
Table 9.12 The number and performance of SOEs in the strategic
market
Year No. SOEs Assets (RMB billion) Profit (RMB billion) ROA (%)
1995 2979 1985 62 3.10
2000 2272 2642 80 3.03
2005 2024 4664 241 5.17
ROA = return on assets
Sources: National Bureau of Statistics (NBS) 1995, China Statistical Yearbook 1995, China
Statistics Press, Beijing; National Bureau of Statistics (NBS) 2000, China Statistical Yearbook
2000, China Statistics Press, Beijing; National Bureau of Statistics (NBS) 2005, China Statistical
Yearbook 2005, China Statistics Press, Beijing.
Looking more closely at the competitive market (Table 9.11), it is
striking to see that the ROA of SOEs was as low as 0.5 per cent in 1995,
0.4 per cent in 2000 and 1.9 per cent in 2005—lagging far behind the ROA
achieved by SOEs in the strategic market, which was 3.1 per cent in 1995,
3.0 per cent in 2000 and 5.2 per cent in 2005 (Table 9.12). The ROA of
SOEs in the competitive market was also significantly lower than the ROA
of NSEs—4.6 per cent in 1995, 6.26 per cent in 2000 and 7.04 per cent
in 2005 (Table 9.14).
The above empirical evidence shows privatisation has been rather
instrumental in the abandonment of less-profitable and less-efficient SOEs
and thus reducing financial, social and political liabilities arising from
loss-making SOEs.
Hypothesis 2
When SOEs are profitable in the strategic market, their sector’s state
monopoly is more likely to be maintained.
Looking more closely at the strategic market, the number of SOEs has
remained relatively stable during the reform period, while the number
of assets accumulated in the strategic market has soared remarkably.
Moreover, the strategic market was also immensely profitable, with a rise
in total profit from RMB61.5 billion in 1995 to RMB241.2 billion in 2005
(Table 9.12). Enterprises in the strategic market had an average ROA of 5.17
per cent in 2005 compared with 1.89 per cent in the competitive market.
The government’s strong grip on the strategic market is obvious from the
proportion of state-owned assets to total assets in the respective sectors.
In the strategic market, state-owned assets accounted for 56 per cent of
total assets, while in the competitive market the number was only 15 per
164

State-owned enterprises in China: reform dynamics and impacts
cent in 2005 (Table 9.13). The strategic market comprises various sectors
in which SOEs still hold monopolies, such as infrastructure and energy,
and it becomes evident from our analysis that SOEs in this market have
been consistently maintained. From the view of the government, reforms
of SOEs in the strategic market have led to an increase in profit and asset
value and a strengthening of social and political assets.
Table 9.13 Total assets in the strategic and competitive markets
in 2005 (RMB billion)
State-owned assets Total assets State-owned assets (%)
Total 6086.7 17 632.5 34.5
The strategic market 4663.7 8338.9 55.9
The competitive market 1423 9293.6 15.3
Source: National Bureau of Statistics (NBS) 2005, China Statistical Yearbook 2005, China
Statistics Press, Beijing.
General implications
If we combine the preceding observations from the competitive market and
the strategic market, we can see how SOE reforms have left the government
fundamentally better off. In the competitive market, the number of lessefficient
and less-profitable SOEs was dramatically reduced, while in the
strategic market SOEs were guarded and profits soared. At the same time,
this course of reforms has significant wider implications.
Impact on NSEs: infrastructural support and
price controls
SOE reforms have successfully created room for non-state enterprises
(NSEs) to grow. Assets in NSEs have soared from RMB1264.6 billion in
1995 to RMB11 545.8 billion in 2005, with profit rising from RMB58.2
billion in 1995 to RMB812.6 billion in 2005 (Table 9.14).
The dominance of SOEs in China’s strategic market has contributed
to this success in two distinct ways. On the one hand, SOEs still hold
state monopolies over critical sectors such as infrastructure. By centrally
coordinating and pursuing its efforts in these regards, the Chinese
Government has managed to provide an extensive and ever-growing
infrastructure network as one of the pillars of overall economic growth.
165

China’s New Place in a World in Crisis
Table 9.14 Performance of NSEs in large and medium-sized industrial
enterprises
Year Assets (RMB billion) Profit (RMB billion) ROA (%)
1995 1264.6 58.2 4.60
2000 3584.2 224.4 6.26
2005 11 545.8 812.6 7.04
ROA = return on assets
Sources: National Bureau of Statistics (NBS) 1995, China Statistical Yearbook 1995, China
Statistics Press, Beijing; National Bureau of Statistics (NBS) 2000, China Statistical Yearbook
2000, China Statistics Press, Beijing; National Bureau of Statistics (NBS) 2005, China Statistical
Yearbook 2005, China Statistics Press, Beijing.
The growth in infrastructure is outstanding: in the area of transportation
routes, the length of railways in operation extended from 59 700 kilometres
in 1995 to 77 100km in 2006 (up 28 per cent). The length of highways
extended from 1.16 million km in 1995 to 3.46 million in 2006 (up 200 per
cent) and the length of civil aviation routes extended from 1.13 million km
in 1995 to about 2.11 million km in 2006 (up 87 per cent). Postal delivery
routes, which were about 1.9 million km in length in 1995, extended to 3.4
million km at the end of 2006 (up 79 per cent). As for telecommunications,
the capacity of mobile telephone exchanges extended from 8 million
subscribers in 1995 to 610 million subscribers in 2006 (up 7525 per cent),
and broadband subscriber ports extended from 18 million ports in 2003 to
65 million ports in 2006 (up 260 per cent) (see Appendices 9.4–7 for details
on infrastructure growth).
Another channel through which the dominant position of SOEs in the
strategic market has contributed to NSE growth is by upholding price controls.
Since SOEs still hold monopolies in these strategically relevant sectors, the
prices of energy, water and resources are kept artificially low. On the one
hand, this serves Chinese consumers. On the other, private and other nonstate
enterprises also benefit notably from this favourable price environment.
The implicit subsidisation of the private sector, however—including
many foreign-invested enterprises—through lower than market prices in
key inputs implies that China is subsidising global consumers of madein-China
products. It has also attracted many energy-intensive and
environmentally harmful industrial activities to China. On the whole, the
price controls that followed from the tight control by the government of
SOEs in the strategic market have led to significant hidden social costs. It
will be interesting to see how long China can sustain the price control and
the implicit subsidies to domestic and international firms and consumers.
166

Distorted distribution of wealth
State-owned enterprises in China: reform dynamics and impacts
SOE transformation has so far increased state-owned assets and profits.
The resulting wealth distribution seems unbalanced, as state-owned assets
are centralised within the strategic market. While about 51 per cent of all
SOEs are included in the strategic market, the assets accumulated here
amount to RMB4664 billion, or 77 per cent of total state-owned assets in
large and medium-sized industrial enterprises. At the same time, profit
generated from SOEs in the strategic market amounts to RMB241 billion,
which equals 90 per cent of the total profit generated from large and
medium-sized SOEs (Table 9.15).
Table 9.15 Structure and performance of SOEs in strategic and
competitive markets, 2005 (per cent)
Total Strategic market Competitive market
No. SOEs 100 51.61 49.39
Assets 100 76.62 23.38
Profit 100 89.97 10.03
Source: National Bureau of Statistics (NBS) 2005, China Statistical Yearbook 2005, China
Statistics Press, Beijing.
The centralisation of assets and profits in the strategic market and the
strengthened monopoly position of SOEs in the most profitable sectors of
the Chinese economy, as well as the low efficiency and low productivity
of SOEs, all indicate a distorted allocation of wealth. This is prone to
hinder innovation and entrepreneurship in China’s largest companies and
most important sectors, as well as encumbering enterprise efficiency and
industrial productivity.
Impact on China’s consumption and savings
Retaining profitable SOEs in the strategic market also has major implications
for China’s macroeconomic balance. Since SOE dividends are not paid out
to shareholders, a major source of wealth and income is held back. As
a result, household consumption is about only 37 per cent of GDP and
household income is about 45 per cent of national income (Table 9.16).
High savings held by SOEs and the government (through high taxation)
are among the key reasons for China’s low consumption rate and large
current account surplus.
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China’s New Place in a World in Crisis
Table 9.16 China’s household income and consumption, 2007
(RMB billion) Percentage of GDP (%)
Household income 11 198 45
Household consumption 9332 37
Note: Household income is estimated using data on per capita income of rural and urban
households multiplied by the respective population estimates.
Source: National Bureau of Statistics (NBS) 2008, China Statistical Yearbook 2008, China
Statistics Press, Beijing.
Concentration of SOEs among top-500 Chinese
companies
After several stages of reform, Chinese SOEs still dominate among large
enterprises in China to a remarkable degree. SOEs account for 70 per cent
of the Chinese top-500 enterprises, 94 per cent of assets and 88 per cent of
profits. The Chinese SOEs also contribute 93 per cent of the taxes generated
from, and employ 89 per cent of the total workforce in the Chinese top-
500 enterprises (Table 9.2). Although the Chinese SOEs perform worse
than non-state enterprises such as collective-owned enterprises, privateowned
enterprises and foreign-funded enterprises, they still dominate
among large manufacturing enterprises. In the manufacturing sector, SOEs
account for about 50 per cent of firms, contributing 61 per cent of the
total profit generated from the top-500 Chinese manufacturing enterprises
(Table 9.3). In the service sector, SOEs account for 61 per cent of firms, 93
per cent of assets and 92 per cent of profits among the top-500 Chinese
enterprises in the service industry (Table 9.4).
Even globally, Chinese SOEs are becoming more and more significant.
The number of Chinese enterprises in the Fortune Global 500 increased
from 15 in 2005 to 22 in 2007 and China ranked sixth in 2007 in the
number of firms by country (Table 9.17).
Table 9.17 The number of Chinese enterprises in the Fortune
Global 500
Year
No. of Chinese enterprises
2005 15
2006 19
2007 22
Note: All of the Chinese enterprises in the Fortune Global 500 are SOEs.
Source: ‘Fortune Global 500’, Fortune Magazine, 23 July 2007.
168

Some policy implications
State-owned enterprises in China: reform dynamics and impacts
To address the apparent shortcomings of past SOE reforms, we propose
full privatisation as part of a large-scale reform of China’s financial sector. 1
Reforms should focus on limiting the role of the State and increasing
the global competitiveness of Chinese enterprises. We present several
recommendations for such a scenario:
• all large SOEs under central or local-government control should be
listed within a short period—that is, five to 10 years
• for SOEs that are already listed, state ownership should be reduced to
a minority shareholder level—for example, below 30 per cent—within
three to five years
• state-owned shares should be limited to less than 50 per cent for all
new initial public offerings (IPOs)
• listed SOEs should be required to have a plan to further reduce state
ownership—for example, to below 30 per cent—within three to five
years after their IPO.
Majority state ownership is neither necessary to represent the interests
of the State nor advantageous in improving the competitiveness of the
listed company. The interest of the State can still be maintained through
one golden share that gives the State veto power against any decisions by
the board that are potentially harmful to the national interest or national
security.
Summary and conclusion
By using various statistical data, this chapter examines the transformation
of SOEs during the reform period from 1995 to 2005, which has been
characterised on the one hand by a sharp decline in the number of firms
and on the other hand by a steady accumulation of state-owned assets.
The results of this study show that it is the competitive market where
there is a sharp decline in the number of SOEs and the strategic market
where there is a steady accumulation of state-owned assets. We have shown
how Chinese SOEs are more likely to be privatised when they are losing
profit. When they are more profitable, their sector’s monopoly position is
more likely to be strengthened, which leads us to the conclusion that the
privatisation of SOEs in China has been driven by an implicit objective
of the government to maximise financial, social and political assets and
minimise financial, social and political liabilities.
169

China’s New Place in a World in Crisis
Moreover, we point out that this specific course of reform has affected
China’s macroeconomic environment in a number of ways. NSEs have
benefited from the continuing monopoly position of SOEs in the strategic
market in the sense that they can take advantage of a vast system of
basic infrastructure, as well as of lasting price controls on energy and
resources. The over-concentration of SOEs in the strategic market seems
to have served specific government purposes to bolster the nation’s
economic growth. Low efficiency and productivity in these sectors still
hinder innovation and entrepreneurship in China’s largest companies and
in China’s most important sectors. Apart from this domestic problem of a
distorted distribution of wealth, the global impacts of the ever-growing
Chinese SOEs will not be ignored abroad. Therefore, there will be a further
demand for transformation of the Chinese SOEs with pressure coming from
domestic consumers and politics, as well as from international competition
and international politics.
References
A Report on the Development of China’s Enterprises 2007, Enterprise
Management Publishing House, Beijing.
‘Fortune Global 500’, Fortune Magazine, 23 July 2007.
National Bureau of Statistics (NBS) 1995, China Statistical Yearbook 1995,
China Statistics Press, Beijing.
—— 2000, China Statistical Yearbook 2000, China Statistics Press, Beijing.
—— 2005, China Statistical Yearbook 2005, China Statistics Press, Beijing.
—— 2008, China Statistical Yearbook 2008, China Statistics Press, Beijing.
Ten policy recommendations to build Shanghai into a top international
financial center within a decade, Brookings-Tsinghua Center Working
Paper, Brookings-Tsinghua Center, Beijing.
Endnotes
1. See Ten policy recommendations to build Shanghai into a top international financial center
within a decade, Brookings-Tsinghua Center Working Paper, Brookings-Tsinghua Center,
Beijing.
170

State-owned enterprises in China: reform dynamics and impacts
Appendix 9.1 List of industry codes and the full
industry name
06 Coal mining and dressing (CMD)
07 Petroleum and natural gas extraction (PNGE)
08 Ferrous metals mining and dressing (FMMD)
09 Non-ferrous metals mining and dressing (NFMMD)
10 Non-metal minerals mining and dressing (NMMD)
13 Food processing (FPc)
14 Food production (FPd)
15 Beverage production (BP)
16 Tobacco processing (TP)
17 Textile industry (TI)
18 Garments and other fibre products (GOFP)
19 Leather, furs, down and related products (LFDRP)
20 Timber, bamboo, cane, palm fibre and straw (TBCPFS)
21 Furniture manufacturing (FM)
22 Papermaking and paper products (PPP)
23 Printing and recording medium reproduction (PRMR)
24 Cultural, educational and sporting goods (CESG)
25 Petroleum processing and coking (PPC)
26 Raw chemical materials and chemicals (RCMC)
27 Medical and pharmaceutical products (MPP)
28 Chemical fibre (CF)
29 Rubber products (RP)
30 Plastic products (PP)
31 Non-metal mineral products (NMP)
32 Smelting and pressing of ferrous metals (SPFM)
33 Smelting and pressing of non-ferrous metals (SPNFM)
171

China’s New Place in a World in Crisis
34 Metal products (MP)
35 Ordinary machinery manufacturing (OMM)
36 Special purposes equipment manufacturing (SPEM)
37 Transport equipment manufacturing (TEM)
39 Electric equipment and machinery (EEM)
40 Electronic and telecommunications equipment (ETE)
41 Apparatus and instruments (AI)
42 Cultural, office machinery and other manufacturing (COMOM)
43 Recycling industry (RI)
44 Electric power, steam and hot water (EPSHW)
45 Gas production and supply (GPS)
46 Tap water production and supply (TWPS)
172

State-owned enterprises in China: reform dynamics and impacts
Appendix 9.2 List of sectors in the strategic market
06 Coal mining and dressing (CMD)
07 Petroleum and natural gas extraction (PNGE)
08 Ferrous metals mining and dressing (FMMD)
09 Non-ferrous metals mining and dressing (NFMMD)
10 Non-metal minerals mining and dressing (NMMD)
16 Tobacco processing (TP)
25 Petroleum processing and coking (PPC)
27 Medical and pharmaceutical products (MPP)
32 Smelting and pressing of ferrous metals (SPFM)
33 Smelting and pressing of non-ferrous metals (SPNFM)
44 Electric power, steam and hot water (EPSHW)
45 Gas production and supply (GPS)
46 Tap water production and supply (TWPS)
173

China’s New Place in a World in Crisis
Appendix 9.3 List of sectors in the competitive market
13 Food processing (FPc)
14 Food production (FPd)
15 Beverage production (BP)
17 Textile industry (TI)
18 Garments and other fibre products (GOFP)
19 Leather, furs, down and related products (LFDRP)
20 Timber, bamboo, cane, palm fibre and straw (TBCPFS)
21 Furniture manufacturing (FM)
22 Papermaking and paper products (PPP)
23 Printing and recording medium reproduction (PRMR)
24 Cultural, educational and sporting goods (CESG)
26 Raw chemical materials and chemicals (RCMC)
28 Chemical fibre (CF)
29 Rubber products (RP)
30 Plastic products (PP)
31 Non-metal mineral products (NMP)
34 Metal products (MP)
35 Ordinary machinery manufacturing (OMM)
36 Special purposes equipment manufacturing (SPEM)
37 Transport equipment manufacturing (TEM)
39 Electric equipment and machinery (EEM)
40 Electronic and telecommunications equipment (ETE)
41 Apparatus and instruments (AI)
42 Cultural, office machinery and other manufacturing (COMOM)
43 Recycling industry (RI)
174

State-owned enterprises in China: reform dynamics and impacts
Appendix 9.4 Length of transportation routes (10 000km)
Year Length of
railways in
operation
Length of
national
electrified
railways
Length of
highways
Length of
expressways
Length of
navigable
inland
waterways
Length of
civil aviation
routes
Length of
international
aviation routes
Length of
petroleum and
gas pipelines
1995 5.97 0.97 115.70 0.21 11.06 112.90 34.82 1.72
1996 6.49 1.01 118.58 0.34 11.08 116.65 38.63 1.93
1997 6.60 1.20 122.64 0.48 10.98 142.50 50.44 2.04
1998 6.64 1.30 127.85 0.87 11.03 150.58 50.44 2.31
1999 6.74 1.40 135.17 1.16 11.65 152.22 52.33 2.49
2000 6.87 1.49 140.27 1.63 11.93 150.29 50.84 2.47
2001 7.01 1.69 169.80 1.94 12.15 155.36 51.69 2.76
2002 7.19 1.74 176.52 2.51 12.16 163.77 57.45 2.98
2003 7.30 1.81 180.98 2.97 12.40 174.95 71.53 3.26
2004 7.44 1.86 187.07 3.43 12.33 204.94 89.42 3.82
2005 7.54 1.94 334.52 4.10 12.33 199.85 85.59 4.40
2006 7.71 2.34 345.70 4.53 12.34 211.35 96.62 4.82
175

China’s New Place in a World in Crisis
Appendix 9.5 Number of berths in major coastal ports
Year Total For productive use For non-productive use
Length of
quay line (km)
No. berths
(unit)
10 000-tonne
class
Length of
quay line (km)
No. berths
(unit)
10 000-tonne
class
Length of
quay line (m)
No. berths
(unit)
2003 281 2562 650 257 2238 650 24 008 324
2005 379 3641 769 341 3110 769 37 951 531
2006 418 3804 883 382 3291 883 35 257 513
176

Appendix 9.6 Postal delivery routes
State-owned enterprises in China: reform dynamics and impacts
(‘000 km) Length of postal routes Highway routes Railway routes
Year
1995 1 886 819 183
1996 2 119 917 184
1997 2 363 874 186
1998 2 854 931 190
1999 2 979 989 190
2000 3 073 1 070 185
2001 3 103 1 074 180
2002 3 081 1 113 178
2003 3 270 1 137 191
2004 3 336 1 195 196
2005 3 406 1 230 200
2006 3 369 1 231 205
177

China’s New Place in a World in Crisis
Appendix 9.7 Main communication capacity of telecommunications
Year Capacity of longdistance
telephone
exchanges (circuit,
thousands)
Capacity of local-office
telephone exchanges
(10 000 lines)
Capacity of mobile
telephone exchanges
Length of long-distance
optical cable lines
(‘000 km)
Broadband subscribers
port of Internet (10 000
ports)
1995 3 519 7204 797 107 -
1996 4 162 9291 1536 130 -
1997 4 368 11 269 2586 151 -
1998 4 492 13 824 4707 194 -
1999 5 032 15 346 8136 240 -
2000 5 635 17 826 13 986 287 -
2001 7 036 25 566 21 926 399 -
2002 7 730 28 657 27 400 488 -
2003 8 694 35 083 33 698 594 1802
2004 12 630 42 347 39 684 695 3578
2005 13 716 47 196 48 242 723 4875
2006 14 423 50 280 61 032 722 6486
- zero
178

Preliminary draft: 8 October 2004
Not for publication or quotation
without written permission from authors
Stanford Center for International Development (SCID) conference
China’s Policy Reform: Progress and Challenges
Stanford University
14-16 October 2004
Property Rights and “Original Sin” in China:
Transaction Costs, Wealth Creation, and Property Rights Infrastructure
By Andrew SHENG, XIAO Geng, and WANG Yuan 1
1. Introduction
This is one of a series of papers by the authors examining how China can reform its capital and
financial markets by drawing lessons from the experiences of Hong Kong and other market
economies. The first paper was presented in this conference series at Stanford last year and
examined the development experiences in other economies 2 . The second paper, presented in
Beijing and Shanghai looked at the need for a property rights infrastructure as a pre-condition for
efficient capital market development and good corporate governance 3 . This paper presents for the
first time in English a Chinese version of a paper on property rights disputes in China presented in
Beijing, Shanghai, and Hong Kong 4 . An overview of the role of property rights infrastructure
(PRI) and the function of efficient markets was presented recently in Beijing 5 . There is a further
paper, as yet unpublished, that examines the historical reasons why China did not evolve its own
property rights infrastructure 6 .
1 Andrew SHENG and WANG Yuan work for the Securities and Futures Commission, Hong Kong. XIAO Geng
works for the University of Hong Kong. The paper reflects entirely the authors’ personal view and does not represent
the views of their employers. Xiao Geng would like to acknowledge the financial support for this research from Hong
Kong’s University Grants Committee (Project No: AOE/H-05/99) and the Stanford Center for International
Development. The authors would like to thank Wu Jinglian, Gao Xiqing, Zhang Jun, Liang Zhiping, Zhou Qiren,
Liang Hong, Gaik-Looi Tan and seminar participants in Beijing, Shanghai and Hong Kong for helpful comments and
discussions.
2 Sheng, Xiao and Wang (2003b).
3 Sheng, Xiao and Wang (2004b).
4 Sheng, Xiao and Wang (2003a).
5 Sheng (2004).
6 Sheng, Xiao and Wang (2004d).
1

China’s economic reform has now advanced to a stage in which more attention should be turned
to developing an integrated property rights infrastructure so as to derive lasting benefits to the
economy. Hong Kong, which has a well functioning PRI including very effective regulatory and
anti-corruption institutions, could serve as a live knowledge base for building and maintaining a
modern PRI in China. The historical experiences of U.S. and other matured economies could also
provide useful lessons for China.
2. What is a Property Rights Infrastructure?
A market is actually a property rights delineation, transfer and protection system. It depends on
an infrastructure, comprising information and accounting services, legal and regulatory services
and the judicial system, together with other supporting institutions, that gives legal protection of
property rights. The concept, role and functions of PRI are discussed elsewhere in detail. 7 The
PRI comprises three broad categories of institutions/ processes:
(i) Institutions/processes for delineation of property rights:
• Central registry of property rights for land, property, shares, and other assets. The formal
record of property rights is crucial in reducing the costs of enforcing property rights and of
resolving property rights disputes.
• Accounting and legal process to define property rights in complicated forms of assets such
as shares, bonds, options, and other ownership instruments.
(ii) Institutions/processes for exchange of property rights:
• Trading process such as retail and wholesale markets, auction houses, stock exchanges,
futures markets, banks and insurance companies.
• Regulated intermediaries to facilitate complicated financial and non-financial transactions,
including lawyers, accountants, auditors, credit rating agencies, credit bureaus, sponsors
and other information service providers. These intermediaries are used for identifying,
providing and verifying information about the value and quality of property rights, which
is indispensable for due diligence when the property rights are traded.
• Clearing, settlement and payment systems to complete financial and non-financial
transactions safely, timely, efficiently, and conveniently.
(iii) Institutions/processes for protection, enforcement, adjudication, and fine-tuning of property
rights:
• The general rules of the game that forms the legal and economic system of a market
economy: laws, regulations, standards, codes, and norms that protect property rights of all
participants across space and time.
• Independent and transparent judiciary to adjudicate disputes over property rights and finetune
property rights as necessary.
• Enforcement infrastructure including police, regulators, and armed forces that can enforce
the judicial decisions and protect property rights firmly and fairly at a cost that is lower
than the benefits to the society and the market.
7 Sheng, Xiao and Wang (2004c).
2

• Mandatory disclosure regimes to ensure that important information about property rights,
such as the financial statements of listed companies, are independently verified and
accountable so as to facilitate self, regulatory and market disciplines on the corporate
sector.
• Active and independent public watchdogs such as media, consumer councils, councillors/
parliamentarians, and other civil society organizations to promote proper conduct and
behaviour and accountability through public pressures and reputations.
• A well-functioning government with effective checks and balances that can provide basic
political and social order.
A well-functioning PRI helps to build and maintain proper market behaviour and good credit
culture and is the foundation for good governance in corporations, government agencies, market
regulators and other market participants. The ultimate result of strong PRI will be reflected in the
quality of corporate decision-making and government policy-making that is essential for risk
management at all levels. Specifically good PRI leads to good capital market, which then provide
low-cost financing to good corporations.
3. “Original Sin” and Relationship with Property Rights
Since its opening up strategy was implemented in 1979, China has enjoyed rapid growth and
unprecedented wealth creation. China’s economy has expanded at around 8% per annum for
more than two decades. From a position where most property was owned by the state, the sale of
state-owned enterprises to the private sector, the leasing of land use rights to individuals and
foreign firms, as well as the establishment of the stock market have resulted in the emergence of
private sector wealth. The private sector has expanded to a scale which is now as large as
accounting for about three quarters of the employment, two thirds of GDP, one half of industrial
and residential property value, one third of stock market capitalisation, and one fifth of bank
loans. China’s constitution now protects private property rights.
This rapid emergence of private sector wealth happened in China before the pre-conditions for a
robust and efficient property rights infrastructure was firmly established. The resulting uncertainty
about property rights has led to many disputes on the legitimacy and clarity of ownership. How
did the private sector obtain this wealth? Was it through corrupt practices, tax evasion,
smuggling, fraud or other illegal activities? The lack of clarity in ownership of property rights for
the private sector is commonly called “original sin” within China, as the entrepreneurs or owners
of private business are unable to explain clearly the origin of such accumulated wealth.
The concern on “original sin” has created huge moral and political debates. At one extreme, there
is moral outrage over such illegally gotten wealth that should be confiscated and those responsible
charged criminally. At the other extreme, there are calls for amnesty in the same way that some
Western countries give tax amnesties to enable past defaulters to start afresh. This paper does not
attempt to get into the moral or political issues, but uses a Coasian new institutional economics
framework of transactions costs to examine the economic dimensions of “original sin” and its
3

possible resolution. It concludes that there is ample Western experience in dealing with this but
all requires the pre-condition of a robust PRI.
One of the key difficulties in dealing with “original sin” and the associated property rights
disputes lies in the confusion about the substantive differences between two types of economic
behaviour: criminal wealth transfer activities and non-criminal property rights disputes. The
confusion of the two creates dilemmas in government policy-making, judicial decisions, and
enforcement actions. To analyse the problem of “original sin” in China objectively and find
constructive solutions, some clear and useful principles to distinguish the two categories of
behaviour are needed.
Applying new institutional economics, 8 this paper develops an analytic framework to distinguish
“original sin” of criminal nature from non-criminal property rights disputes based on two
principles: the transaction cost principle and the wealth creation principle. Our analysis suggests:
• When transaction costs are high and there is net wealth creation, the conflicts between the
private businessmen and the state/public should be treated as property rights disputes and
should be dealt with according to principles similar to the “liability rule” as applied to the
non-criminal cases in the western legal system. The persons inflicting harms or losses to
others should pay damages but should not be punished.
• When transaction costs are low and there is no net wealth creation, the conflicts should be
treated as criminal cases and should be dealt with according to principles similar to the
“property rule” as applied to the criminal cases in the western legal system. The persons
inflicting harm or losses to others should be punished and pay damages.
The above economic and legal principles on dealing with “original sin” and property rights
disputes could be useful in guiding the design and implementation of reforms in China’s judicial
system, which is one of the key pillars for well-functioning PRI. These conceptual principles
could also contribute to current debates in China on the issues of reform of state-owned
enterprises and state asset management and the improvement of corporate governance 9 .
4. Wealth Creation, Wealth Transfer, and Social Cost
We need to define a few key concepts before developing the analytic framework for studying
“original sin” and property rights disputes. Let’s separate conceptually the costs related to
“original sin” into two parts: Wealth Transfer (α) and Social Cost (β). Let’s also separate
conceptually the Private Sector Value Added (ε) from the “original sin” related Wealth Transfer
(α).
Wealth Transfer (α): Transfer of wealth and benefits related to private taking of stateowned
assets or other stealing and rent-seeking activities.
8 Werin (2003).
9 Sheng, Xiao, and Wang (2004b).
4

Social Cost (β): The money, time, and other resources spent on getting α. β is a social
cost, or a waste of society’s resources, from wealth transfer activities. It is a burden on the
society and increases the cost of doing business.
Private Sector Value Added (ε): The net creation of wealth from the legitimate business of
the private sector.
In the above definition, α could involve both state-owned and privately owned enterprises and
it can lead to quasi-fiscal costs such as non-performing loans in the state banks and unfunded
pension liabilities for the government. This transfer is clearly inequitable and discourages
legitimate wealth creation activities. But the wealth transfer itself is just redistribution and
would not directly destroy wealth. It is difficult to avoid α when property rights are not
defined clearly and when there is too much unnecessary regulation. α, if getting out of control,
may become a threat to social stability.
Now let’s look at a simplified national income account. We break national income into net state
sector income and net private sector income.
Net State Sector Income = Tax Revenues + State Sector Value Added − α;
Net Private Sector Income = ε + α − β;
National Income = Tax Revenues + State Sector Value Added + ε − β;
Since Wealth Transfer α is simply a transfer from the state sector to private sector, it does not
appear in the consolidated National Income equation. In other words, the size of α does not affect
directly the size of National Income. 10 To increase National Income, it is necessary to reduce
social cost β.
But β is closely related to α. α is what motivates “original sin”-related activities such as stealing,
tunnelling, asset stripping and other rent seeking. These activities then will generate Social Cost
β. If there are no effective measures to stop people from rent-seeking, the competition among
people who are trying to get Wealth Transfer α would increase Social Cost β to the extent that β
could be greater than α.
Hence, to increase National Income, we need to minimize not only β but also α. If there are no
state assets and no regulation-induced opportunities for wealth redistribution, α would be zero and
β would also fall to zero automatically. One must recognize that “original sin” involves two
parties: the state sector and the private sector. Opportunities for committing “original sin” exist
because of discretionary authority by government officials. The greater the market distortion
caused by laws and administrative rules, the greater the opportunity for wealth transfer (i.e. larger
α).
10 For simplicity, we assume here there are no income effects.
5

The “original sin” problem in China is complicated because wealth transfer-related criminal
activities are often mixed up with non-criminal property rights disputes. Conceptually the total
accumulated wealth of private businessmen in China can be represented by ∑(ε + α), which
includes both ∑ε and ∑α. While ∑ε is conceptually “clean” of criminal activities, ∑α is often
related to illegal or “extra-legal” gains from private usage of state-owned assets, evasion of
taxation, smuggling, gambling, vice, fraud in IPOs, and market manipulation etc.
However, in reality, it is difficult to measure ∑ε and ∑α separately without a well-functioning
PRI. A transparent and equitable “due process” is needed to unravel the historical legacy of
“original sin” and this cannot be done purely by administrative or political means because of the
moral issues and perceived inequities this brings. This is the dilemma in resolving the “original
sin” of private entrepreneurs in China. There is a national interest in promoting ∑ε as it creates
employment, growth, and tax revenues, but there is also public “bad” with respect to ∑α as it is
related to rent-seeking, unfair practices and corruption. Depending on which component of ∑(ε
+ α) is larger, you can have dramatically different views on the “original sin” problem in China.
The analytic framework we propose here however provides a more objective and constructive,
and perhaps less emotional approach to look at the issue. We regard the “original sin” in China as
a problem of co-existence and conceptual confusion between criminal wealth transfer activities
and non-criminal/civil property rights disputes.
Clearly China needs to develop institutions that are able to distinguish ∑ε from ∑α. Good
systems for property rights registration and accounting would make it easier to measure ∑ε.
Given the complexity of both criminally oriented “original sin” and non-criminal property rights
disputes, China needs a strong, independent, and transparent judicial system to resolve the two
categories of conflicts through non-political, routine, and case-by-case processes. The judiciary in
the western legal and economic system plays this function routinely without much interaction
with its executive and legislative arms of government.
The lawyers and judges in the common law tradition have to identify which categories of the law
would apply to each case (criminal or non-criminal laws such as tort). Facts have to be sorted out
before they move to next stage of adjudication. Hence, problems of original sin have to be
resolved on a case-by-case basis, and cannot be resolved on the basis of “broad principles”. This
is where experienced lawyers and judges are needed to separate the criminal elements from civil
cases. Clearly China can learn a lot from the development experiences of the legal and economic
system in the mature Western market economies.
Putting aside the difficulties of developing PRI in general and a well-functioning judiciary in
particular, we still need some clear principles on how to make proper distinctions between
“original sin” of criminal nature and the non-criminal property rights disputes. Traditionally, we
use the existing legal and regulatory rules as the only criteria when investigating corruption,
criminal behaviour and property rights disputes. But this approach has a serious problem: the
existing rules may be outdated and inconsistent with efficiency and equity principles. In fact,
6

China’s reform in the past decades is clearly a history of how the outdated rules inherited from the
central planning era are changed gradually over time. To move from such a regime to a full
market-based regime where property rights are clearly delineated and protected would require a
clear institution-building path that involves a clear vision on how the PRI can and should be built.
5. Property Rule versus Liability Rule: The Transaction Costs Principle
We need to distinguish “original sin” of criminal nature from non-criminal property rights
disputes conceptually in order to differentiate the two categories of behaviour more effectively in
practice. A problem with property rights enforcement in China is that historically, the system is
based on criminal sanctions, which is not necessarily the most appropriate in market-based
property disputes.
The Western legal tradition distinguishes between civil and criminal cases, through what is now in
economic terms called the property rule and liability rule. Swedish economist Lars Werin in his
survey of law and economics literature provides the following definition on property rule and
liability rule based on the concept of transaction costs 11 :
Property Rule: “If a person wants to expose someone else to the risk of harm or loss under
circumstances where the transaction costs associated with a voluntary agreement are low,
then he should buy the right to do so from the other person. If he inflicts a harm or loss
without having bought this right, he will be punished, provided the court finds a
sufficiently close connection between the harm or loss and his act. He may also have to
pay damages to the victim.”
Liability Rule: “If a person wants to expose someone else to the risk of harm or loss under
circumstances where the transaction costs associated with a voluntary agreement are high,
then he may do it. If he inflicts a harm or loss, he will have to pay damages to the victim,
provided the court finds a sufficiently close connection between the harm or loss and his
act. A court determines the size of the damages, in principle calculated so as to correspond
to the harm or loss. The acting person will not be punished.”
Many judges in the Western legal system apply the property rule and liability rule in their
adjudication, without totally understanding the economic concept of transaction costs, as
expounded by Nobel Laureate Ronald Coase.
In the context of transitional economies, where property rights need to move from statedominated
holdings to private holdings, it is important to understand that the lower the total
transactions costs (including taxes and rent-seeking activity costs), the greater the ability of the
market to function efficiently. In many emerging markets, such wealth transfers as theft, fraud,
false accounting, corruption and the like result in huge unreported transaction costs. Accordingly,
the move towards efficient market economies requires the building of PRI that reduces transaction
costs.
11 Werin (2003), pg 204.
7

The transaction costs principle being articulated explicitly in the property rule and liability rule
can be abstracted from common sense practices through a simple example:
• A person stealing some medicine from a drugstore would face criminal charges of
stealing. The reason is there is an open market with zero transaction costs for the person
to buy the medicine, but he preferred to steal it for personal use at a loss to the drugstore.
• If, however, the person rushed into the drugstore, and without paying, took and used the
medicine in order to save life of some other person on the street, he may not only not be
punished for stealing, but could be rewarded for being a public-spirited hero. The
transaction costs of paying immediately for the medicine were high relative to the urgency
of saving a human life.
6. The Wealth Creation Principle
The Western legal tradition, which operated on the basis of the need to protect individual property
rights, including against interference from the state, has intuitively operated on the basis of
lowering market transaction costs. When transaction costs are low, people would prefer to use the
market to obtain the resources they want in order to minimize the total costs to the society. When
transaction costs are high, using the market to obtain resources may be too costly, hence there
may be an incentive to engage in criminal activities, i.e. steal or cheat. Hence, the transaction
costs principle ultimately is consistent with the wealth creation principle. Lars Werin uses the
wealth creation principle to describe the judge-made law in the common law tradition: 12
• “Property rights and rules on rights of transfer instituted by judge-made law tend
systematically to produce incentives that promote efficiency, that is, encourage wealthincreasing
acts and counteract wealth-decreasing acts, with no direct consideration of
the consequences for the distribution of wealth.”
• “Property rights and restrictions on rights of transfer instituted by politically-based law
are of two kinds. They either concern “constitutional” and “night watch” matters, basic
to any society and which require a purely political decision process; they then tend to
be efficiency promoting. Or else they are framed so as to promote distributional
objectives, with no regard to efficiency. The latter category dominates.”
The above analysis suggests that any market reforms, including the building of the PRI, would
require a clear vision or social objective of reducing transaction costs and maximizing wealthcreation
risk-taking by the private sector. This implies that the appropriate institutional
framework, such as the judicial and regulatory structure (and in enforcement work), should be
built with these objectives in mind.
What the above analysis suggests is that whilst economists can explain these conceptual issues,
the resolution of these complex property rights disputes lies in the realm of law and regulation.
This is why we conclude that China needs to focus on developing a well-functioning PRI and
especially an effective judicial system that is specialized in handling these complicated cases. The
function of PRI is not just to resolve “original sin” and property rights disputes. As the historical
12 Werin (2003), pg 61.
8

issues are resolved, the gap between the actual practices and the existing laws and rules will be
narrowed, reducing the probability of new “original sin” from emerging. Each society has to go
through this stage of development when it is modernizing its legal and economic system.
7. Historical Lessons from U.S.
Finally, it is important to point out that the presence of “original sin” happens in all societies.
Each dealt with this problem through its own evolving legal, economic and political systems.
Entrepreneurs with “original sin” will want to legitimize themselves in order to preserve their
wealth. As Hernando de Soto correctly pointed out 13 , the United States confronted this problem
in the 19 th century. The U.S. opened up new frontier territory, e.g. the Wild West, before proper
title deeds were registered and law and order were imposed. As a result, most settlers became
illegal squatters or miners. In this extra-legal situation, the lawlessness or extra-legality at the
grass-root level conflicted with actual laws in the established society:
“The crucial change had to do with adapting the law to the social and economic needs of the
majority of the population. Gradually, Western nations became able to acknowledge that
social contracts born outside the official law were a legitimate source of law and to find ways
of absorbing these contracts 14 .”
English common law, which the U.S. was originally based on, did not have means of handling
transfers of dubious property titles, such as squatting rights. The common law protected
established landlords against illegal squatters. However, in a situation of mass migration into new
lands with unclear title and boundaries, the squatters in the U.S. became the majority, and their
rights had to be legitimised. This situation is not unlike the mass migration of rural labour into
China’s urban areas where the property title has not yet been made clear, since all land belonged
to the state. It is also conceptually equivalent to the situation where entrepreneurial individuals
created net wealth for society by using state-assets, that were inefficiently managed under stateowned
enterprises. If there are any disputes over such property rights, how should we deal with it?
In America’s Wild West, attempts by the established landlords to enforce their rights created huge
squatter/homestead owners’ rebellion and disorder. When the squatters became the majority, new
laws were passed to legalize their extra-legality. The legal device to legitimise their newly
accumulated wealth ∑(ε + α) was the concept of “pre-emption”, which was an innovation to
allow a squatter to buy the land that he had improved on (e.g. pay ∑α to the original land owner
to legitimize ∑ε) 15 . By legitimising extra-legal activities, the frontier states could then collect tax
revenues and enforce property rights to land. This was a win-win situation for all concerned.
In other words, faced with the conflicts between the existing landowners and the extra-legal
activities of the squatters, who became a strong political force by sheer numbers, “American
politicians thus had three choices. They could continue to try to thwart or ignore extra-legal
13 This section draws heavily from de Soto (2000), Chapter 5, The Missing History of US History.
14 de Soto (2000), pg 106.
15 Op cit, pg 120.
9

activities, grudgingly make concessions, or become champions of extralegal rights 16 .” The U.S.
Congress gradually consolidated the diffuse and conflicting land laws that were out of touch with
reality on the ground into a more consistent property rights system that recognized “the two great
principles of equity in [American] statutory law: The right of occupants … to their improvements
and the right of settlers on privately owned land, unchallenged for seven years and paying taxes
thereon, to a firm and clear title to their land no matter what adverse titles may be outstanding. 17 ”
Indeed, “it took the [U.S.] politicians some time before they awakened to the fact that alongside
the official law, extralegal social contracts for property had taken shape and that they constituted
an essential part of the nation’s property rights system. To establish a comprehensive legal
system that could be enforced throughout the nation, they would have to catch up with the way
people were defining, using and distributing property rights 18 .” For example, in addressing illegal
mining on state land, the U.S. Mining Law of 1866, which legalized individual mining, was “an
explicit recognition that value added to assets was something the law needed to encourage and
protect 19 .”
To sum up, “the recognition and integration of extralegal property rights was a key element in the
United States becoming the most important market economy and producer of capital in the
world 20 .” “The American experience is very much like what is going on in Third World and
former communist countries. The official law has not been able to keep up with popular
initiatives, and government has lost control.” For law to be obeyed, it must respond to the needs
of the people. “In the long and arduous process of integrating extralegal property rights [into a
new formal property law system], American legislators and jurists created a system much more
conducive to a productive and dynamic market economy 21 .”
Even today, the method to resolve “original sin” in the US is evolving and innovating. The U.S.
courts use “plea bargaining”, or a legal settlement of their past sins by bargaining for a lower fine,
to recognize and resolve economic misconduct quickly and efficiently. This is fiscally efficient
because it takes considerable tax resources to investigate and determine the scale of “original sin”.
For example, in the investigation of securities analyst misconduct after the technology bubble, the
U.S. Courts settled for a US$1.4 billion fine on 10 investment banks, which did not admit the
liability involved but acknowledged that they had to pay for their misconduct. This was a legal
device to settle economic issues of disputes over property rights that harmed society that is largely
consistent with the liability rule.
The experience of other Asian economies shows that if corruption and market misconduct cannot
be stopped, businesses will begin to legitimize themselves by taking over politics. The Asian
experience is that business cartels may choose to “backward integrate” into political parties in
16 Op cit, pg 130.
17 Op cit, pg 130.
18 Op cit, pg 136.
19 Op cit, pg 146
20 Op cit. pg 148.
21 Op cit. pg 150.
10

order to achieve “regulatory capture”. This has created the unhealthy “crony-capitalism” that was
one of the causes of the Asian financial crisis.
Hernando de Soto sums up the situation very well: “Today in many developing and former
communist nations, property law is no longer relevant to how the majority of people live and
work. How can a legal system aspire to legitimacy if it cuts out 80 percent of its people? The
challenge is to correct this legal failure. The American experience shows that this is a threefold
task: We must find the real social contracts on property, integrate them into the official law, and
craft a political strategy that makes reform possible 22 .”
The historical experiences of U.S. are consistent with both the transaction costs principle and
wealth creation principles. Outdated laws make property rights unclear and transaction costs high
and they should not stop entrepreneurs from creating new wealth. China can learn from the U.S.
experience by focusing on resolving the historical conflicts with clear principles and practical
reform action.
8. Next Steps
Historian Ray Huang described the process of China’s modernization and the establishment of a
market economy in China as completing three parts of the Chinese word “ 立 ” (e.g. meaning
“standing up” in English), which consists of (1) the superstructure (the central bureaucracy), (2)
the connecting networks and channels (property rights infrastructure), and (3) the grass-root
organizations and individuals. 23 According to Huang, China has already built up the upper and
bottom parts but still needs to develop the middle part, e.g. the connecting networks and channels
between the central bureaucracy and the grass-root organizations and individuals in order to make
China mathematically manageable. Put in another way, China needs to build an effective
property rights infrastructure to resolve property rights disputes and deter/reduce corruption and
rent-seeking activities related to “original sin”.
The concept of PRI can be likened to a highway. A PRI is an institutional highway for the flow of
wealth and the creation and exchange of property rights. Recurring symptoms of economic and
financial crisis, such as bad loans, corruption, commercial fraud, poor corporate governance,
market manipulation and property rights disputes are rooted in the flaws of the PRI. When an
accident happens in the institutional highway, the immediate reaction is to blame drivers or cars.
Any investigation will look at the driver (the individual), the vehicle (the enterprise), the traffic
rules (policies and regulations), and even whether traffic police were on the beat. But they often
forget two fundamental factors: the quality of the highway (property rights infrastructure) and the
brightness of street lamps (transparency), both of which are necessary conditions for a market
economy. In other words, the design of the PRI is a pre-condition for a well-functioning market
economy.
22 Op cit. pg. 151.
23 Huang (1999), Chinese edition, page 3.
11

In 2000, China had one lawyer per 11,000 citizens, compared with one per 300 in the US, one per
700 in the UK, and one per 6,300 in Japan. Similarly, China had one accountant per 9,650
persons, compared with 412 in Hong Kong and 166 in US. In 2001, China had 28% employment
in the service sector, considerably less than above 70% in U.S., France, U.K., Singapore and
Hong Kong. China today therefore has considerable way to go towards building capacity in its
service (or property delineation, transfer and protection) sector.
The United States spend over US$1 trillion on regulatory activities, which is roughly 10% of
GDP. Above-the-line transaction costs are expensive, since legal, accounting and regulatory
costs are high. However, the market works, because below-the-line transaction costs are relative
low compared to many emerging markets, where such costs are estimated at more than 10% of
GDP, although they spend considerably less on regulatory activities. What is unseen is the “lost
opportunity” in wealth creation and growth, which is held back by costly wealth transfers or
criminal activities.
The advantage of the judge-made common law system in a market economy is that this is a
pragmatic and empirical system that is truly “feeling the stones, as you cross the river.” The
market place or social system throws up every day very special and complex situations of
property disputes that are tested at different levels of courts. The written law requires objective
interpretation. When new situations or knowledge arises, judges have to make a decision on the
legal or social principles that define such issues. The accumulation of knowledge of cases and
their judicial decisions forms an empirical base for society to resolve conflicts, build stable
expectations and make decisions that have social legitimacy.
The robustness and durability of common law system in resolving conflicts lies in its transparency
and legitimacy. Every judge knows that he needs to know the law and the precedent decisions
made by his predecessors. The opposing sides must present both the evidence and the legal
principles for the judge to decide. If the judge makes an error of judgement, it can be appealed to
a higher court, to clarify matters of legal principle.
The Chinese judiciary has made considerable progress in recent years in evolving case law
precedents. However, considerable resources must be devoted to this area in order to match the
urgent need to complement the rapid progress to a market system.
The National People’s Congress has also made considerable progress in adapting new laws. But,
copying law is easy. During last two decades, China has copied considerable best-practice
legislations from advanced economies, such as contract law, company law, securities law, and
banking laws. The problem lies in enforcement. The current judicial system is not yet able to
apply these laws efficiently and fairly since the judges have very limited independence from the
local party and government bureaucracy. Some judges, who came from such background as
retired army officers or party officials, have little professional trainings in the legal principles.
The Chinese bureaucracy is efficient in providing basic social and economic order but it attempts
to define and enforce property rights through administrative instruments. For a market economy
12

to function efficiently, an independent judiciary and regulatory structure [key components of PRI]
is vital.
China needs to review the development of the accounting profession to strengthen audit and
disclosure quality. Areas such as a national credit reference agency, national network of property
title registry, and market-based rating agencies, professional valuation agencies, and related
infrastructure and services are all urgently needed to build the PRI.
After a quarter of century of reforms, China has reached the stage of economic development
where the macroeconomic conditions provide a favourable opportunity for the next stage of
reform: construction of a robust PRI to allow more efficient and orderly exchange and protection
of property rights. China is no longer in shortage of savings and funds. Indeed, arguably it is
suffering from an excess of savings. China’s advantage as a latecomer to the market economy is
that there is already enough experience and “software” to bring in the people, processes and
experiences, so that a sustainable and equitable market economy can be built to global standards.
Since Hong Kong is already an international financial centre with a PRI competitive and
transparent by world standards, Hong Kong can bring in a wealth of market experience in
building the PRI to facilitate China’s transition to a fully competitive market economy that
operates on global standards. Building PRI will take time and political will. China should not
under-use and under-estimate the value of the Hong Kong PRI in its reform efforts. How to build
a modern and institutional property rights infrastructure is an important but complex task. Further
research and discussion are needed before a clear action plan could be mapped out.
13

Reference
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Sheng, Andrew, Geng Xiao and Yuan Wang. (2003a) “China’s Financial Reform: Property Rights
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China’s Equity Markets.” Paper presented at Stanford Center for International
Development conference China’s Market Reforms, Stanford, 19 September 2003.
(http://www.econ.hku.hk/~xiaogeng/research/Paper/030919-Stanford.pdf).
──────. (2004a). “A New Institutional Economic Analysis of ‘Original Sin’.” In Chinese.
Perspectives, 4(2), 1-4.
(http://www.oycf.org/Perspectives/Chinese/Chinese_14_04302004/1a_shen_final.pdf).
──────. (2004b). “Corporate Governance, Capital Market, and Property Rights Infrastructure:
The Experiences of Hong Kong and Lessons for China.” Paper presented at Shanghai
Academy of Social Science & 1990 Institute conference State-owned Enterprise
Governance in China, Shanghai, 28-29 May 2004.
(http://www.econ.hku.hk/~xiaogeng/research/Paper/CorpGov&PRI-English.pdf).
──────. (2004c). “China’s Financial Reform and Property Rights Infrastructure.” Forthcoming
in October 2004 issue of Perspectives.
(http://www.econ.hku.hk/~xiaogeng/research/Paper/FinancialReform&PRI-
Perspectives.pdf).
──────. (2004d). “The Property Rights Micro-Foundations of Macro-History: Ray Huang’s
Analysis of Market Reform in China.” Unpublished manuscript.
(http://www.econ.hku.hk/~xiaogeng/research/Paper/MacroHistory&PRI.pdf).
Werin, Lars. (2003). Economic Incentives and Legal System: An Introductory Survey, London:
World Scientific.
14

1
F E B R U A R Y 2 0 1 0
Is the renminbi the next
global currency?
Geng Xiao, director of the Brookings-Tsinghua Center for
Public Policy, discusses how divergent growth rates
of the Chinese and US economies will erode the hegemony
of dollar—but not right away.

2
The US dollar’s run as the world’s stable currency has stumbled with the recent
financial crisis. Waiting in the wings is the renminbi. But according to economist Geng
Xiao, it’s still in China’s—and the world’s—best interest not to dump the dollar just yet.
In this video interview, Geng Xiao, director of the Brookings-Tsinghua Center for Public
Policy, explains why China needs time to push through difficult economic reforms at home
before it can allow its currency to float freely against the dollar. McKinsey Publishing’s
Clay Chandler conducted the interview with Xiao in Hong Kong.
The Quarterly: The United States has long held that the currency of China is
undervalued, that it gives an unfair advantage to Chinese exporters, and that it costs
Americans jobs. Authorities in China beg to differ; they say that it helps to preserve
stability. Can you help us to understand the arguments on both sides of this debate?
Geng Xiao: There’s no argument about the imbalance: China has the trade surplus, US
has the trade deficit. So both sides want to improve that. But the question is how. From the
American perspective, the emphasis is on the short-term adjustment through price and
through the exchange rate. So the US wants a quick adjustment in RMB exchange rate, and
that means appreciation so it can correct the trade imbalances.
But the Chinese put more emphasis on medium- and long-term structural and institutional
change. So that’s the debate. It’s very difficult for the exchange rate to correct the trade
balance. And on the other hand, there are some negative consequences of the exchangerate
uncertainty.
Foreign investors, including American investors, want to invest in RMB assets because of
the expectation of RMB appreciation. This is what we call “hot money.” And these capital
flows are creating a lot of bubbles in the property market, in the stock market.
And that creates difficulties for China’s central bank in terms of monetary policy making.
So you can see that there are a lot of concerns from the Chinese side about using the
exchange rate to correct the trade balance. Some prices are so high in China. Some are
so low. So you need a benchmark. China needs a benchmark so that the price can be
compared to the global price, to the price structure, which is compatible with efficiency.
So that’s why price reform is more important than exchange-rate change. Exchange-rate
change would not really change the inefficiencies in the use of energy, for example, because
people will still waste energy. Even though you change the exchange rate, the internal
subsidies are still there. So I think the point is that China needs to eliminate a lot of these
structural distortions, structural inefficiencies. And then if there’s little distortion, I think
a floating exchange rate will apply and will be useful for China.

3
The Quarterly: What are these reforms and how long will they take?
Geng Xiao: China has already started a lot of its reforms. But it’s going to take anywhere
from 5 to 10 years’ time, really, for China to correct its distortions—land reform, reform
of the energy sector, state-owned-enterprise reform, and social welfare. During the last
30 years, most of the tradable-goods prices have become more or less consistent with the
global price structure. Only the nontradable sectors still have a different price structure
compared to the global price structure.
So the nontradables are the key. And you have to understand, nontradable prices in China
have to be lower than in the United States because China still is a developing country and
still has low productivity. Only when the productivity of China’s nontradable sector reaches
that of the United States will the two countries’ price structures converge. And that is a
long process.
It actually is in America’s interest to allow China to carry out structural and institutional
reforms instead of exchange-rate change. Let me explain why. China is not really
competing with the United States. Even if you change the exchange rate, it will have very
little impact on US trade deficit because the US is going to buy from some other countries.
US people should realize that in the past, the US production was largely for American
consumers. But because of the global financial crisis, American consumers are not
consuming.
So in the future, the US needs to produce for consumers from emerging markets, like
China. That’s the key. They need to think about what to sell to Chinese consumers—not just
Chinese consumers in China but also Chinese consumers who will go out and spend in the
United States.
The Quarterly: China is now sitting on a stash of something like $2 trillion in foreigncurrency
reserves. How much larger can this get?
Geng Xiao: If China actually followed the advice of the US and allowed the RMB to
continue to appreciate, I would say that China will continue to increase its foreignexchange
reserves, because that bubble, that expectation generated by the holding of RMB,
nobody can predict. It can be $4 trillion, you know, $6 trillion.
I think as time goes on, China can do a lot in terms of diversification. But there’s a limit,
because if there is expectation on RMB appreciation, you will get even more reserves. And
most of the reserves start with the US dollar, because that’s the most liquid, the most
stable currency. So I don’t see that there’s any way that China can significantly reduce its
holding of the dollar assets, because the world is just basically dominated by the dollar.
In that sense, you know, I don’t think there’s much choice for China. But if pushed hard,

4
China can always do more. And even marginally, a little bit more is going to have a big
impact in the market.
I think the worst scenario is that China allows this RMB appreciation expectation to
continue. So more and more people try to hold RMB. And that generates more and more
foreign-exchange reserves.
And then China also wants to diversify from the dollar to other assets. All this is going to
create a huge amount of disturbance, not just in the market but also pressures on the US
Treasury. And that’s entirely unnecessary. I think the most effective way is for China to
tolerate moderate inflation, which would certainly allow real appreciation of the Chinese
currency, which would contribute to the rebalancing of the global economy and also would
encourage Chinese people to hold the dollar, because the RMB will have much higher
inflation than the dollar.
And China, when its economy is growing 10, 15 percent a year, I think a 5 percent or 7
percent inflation rate is entirely normal. And once that happens, I think China will have,
actually, a shortage of foreign-exchange reserves because people will want to hold dollar
assets. And they will want to invest overseas. And that is going to create a balance. Right
now, though, it is not a balance. It’s a [temporary] solution. Everybody wants to dump US
dollars and hold RMB. And not just Chinese. The entire world, everybody in the world,
wants to hold RMB. And that’s really a danger.
The Quarterly: Does a global financial crisis have any bearing on China’s ability to
diversify out of US dollars?
Geng Xiao: Well, I think it’s not in China’s interest to dump the dollars that they are
holding. Because that would hurt China as a whole. China is a net holder of dollar assets.
And I think more importantly, China actually benefits tremendously from the two-way
capital flows, you know, the US investment in China, which helps to improve China’s
investment efficiency. The problem is that the US has this authority as a global currency.
But US monetary policy is entirely focused on the domestic policy, in the domestic
unemployment.
So, that creates an intrinsic problem. In principle, US monetary policy should take care of
global stability. The interest rate for the global economy cannot be zero. But, effectively, if
the US is adopting a zero-interest-rate policy, the whole world is going to be flooded with
cheap money. That’s the fundamental problem. China is having difficulty dealing with that
problem because US interest rates are zero. And China is flooded with hot money. But for
China, there aren’t many alternatives.

5
Related thinking
“How corporate China is
evolving”
“Is China recession proof?”
“The looming deleveraging
challenge”
“Economic Conditions
Snapshot, December
2009: McKinsey Global
Survey results”
The Quarterly: So, what do you foresee for the US dollar? Will it continue in its current
role as the dominant global currency? Or is that role soon to come to an end?
Geng Xiao: Well, if you look at the history, I think this will happen, definitely. It’s just
a matter of time. In the past, we had the gold standard. We had the pound. We have the
dollar. And just think about it, if the Chinese economy continues its growth at the current
pace, the Chinese economy will be the biggest in the world. And if you think about the
reforms in China in 10, 20 years’ time, China will be able to finish all the reforms. And the
Chinese economy would be a modern market economy, and the RMB will become one of
the important reserve currencies, just like the US dollar.
The Quarterly: Professor Xiao, thank you so much for joining us and sharing
your views.
Copyright © 2010 McKinsey & Company. All rights reserved.

China’s Exchange Rate and Monetary Policies
China’s Exchange Rate and Monetary
Policies: Structural and Institutional
Constraints and Reform Options
Geng Xiao
Brookings–Tsinghua Center for
Public Policy and Senior Fellow
Brookings Institution
School of Public Policy and
Management
Tsinghua University
Beijing, China 100084
gxiao@brookings.edu
gxiao@tsinghua.edu.cn
Abstract
This paper argues that declining transaction costs in exporting on
the one hand and the structural and institutional barriers to importing
and consumption on the other hand are the main causes
for China’s rising current account surplus. Reforms in China’s planning,
financial, and regulatory systems are more important than
adjustment in nominal exchange rate for balancing China’s trade
and for China’s surplus capital to hire more of its surplus labor.
Although structural inflation and currency appreciation are necessary
for China’s price level to catch up step-by-step with those in
the advanced economies, the pace of inflation and appreciation
need to be compatible with China’s underlying productivity
growth. An “inflation first and appreciation second” approach
would help China avoid the risks of both deflation and runaway
inflation. The United States and China can have win–win results if
both focus on the real constraints behind their external imbalances.
1. Introduction
The objective of this paper is to clarify some of the confusion
related to the debate on China’s exchange rate policy
and to identify the real barriers to greater ºexibility in
China’s exchange rate. 1 To my mind, there is no doubt that
1 The literature on China’s exchange rate policy is expanding rapidly.
Anderson (2005) provides the most comprehensive review
and related statistics. McKinnon (2005) gives the most comprehensive
analysis on why China should adopt a ªxed exchange
rate regime. A large number of articles and congressional testimonies
advise China to appreciate its currency aggressively, including
Goldstein (2007), Goldstein and Lardy (2005), Cline
(2005), and Makin (2007). Some experts, such as Prasad (2007),
Williamson (2003), and Yu (2007) discussed the usefulness of a
ºexible exchange rate regime for more independent monetary
polices in China. Bhagwati (2007), Koivu and Garcia-Herrero
Asian Economic Papers 7:3
© 2008 The Earth Institute at Columbia University and the Massachusetts
Institute of Technology

China’s Exchange Rate and Monetary Policies
on the issues of exchange rate and global imbalance, China, the United States, and
the world can have a win–win solution. However, this can only come from a stronger
mutual understanding of the real constraints facing each side and from each
side helping the other.
China’s main challenge today is to develop smoothly functioning ªnancial, planning,
and regulatory systems that can employ the remaining rural surplus labor and
surplus capital—that now show up as a sustained current account surplus and rising
foreign exchange reserves—in an efªcient, harmonious, and environmentally
friendly way. What is special for China (and perhaps a few other Asian economies)
is the co-existence of both surplus (i.e., under-employed) labor and surplus capital.
Despite its extremely low capital stock per person, China actually maintains surplus
capital, which it is exporting to capital-rich countries, such as the United States, to
ªnance their excessive consumption. If anything, we should focus on this issue
rather than the renminbi exchange rate, which is a distraction from the root problems.
Why does the surplus capital in China not lead to the hiring of more surplus labor,
and thereby to increased wages, income, and consumption among Chinese workers?
If that were to happen rapidly, it would naturally lead to the reduction of China’s
global current account surplus and to the appreciation of China’s exchange rate. It is
a pity that economists in developed countries tend to ignore this basic question because
it does not exist in their world of general equilibrium with full employment of
labor and capital. The question is assumed away in the neoclassical production
function framework where there are no transaction costs in getting capital and labor
to work together. Too much attention has been put on the role of prices, interest
rates, and exchange rates in correcting market disequilibrium. In China, both before
and since the advent of market-oriented reforms, hidden transaction costs have been
the single most important barrier to growth, development, and prosperity.
The rapid rise in China’s global current account surplus and the slow appreciation
of the renminbi has led to a strong Washington consensus: China should be pressed
hard to raise the value of its currency in order to reduce its global current account
surplus and its current account surplus with the United States. In U.S. congressional
hearings on 28 March 2007, Peterson Institute for International Economics scholar
Morris Goldstein claimed that China’s currency was under-valued by about 40 per-
(2007), Roach (2007), Woo (2006), and Woo and Xiao (2007) provided analysis on why exchange
rate policy alone might not be able to eliminate China’s external imbalance. Dooley,
Folkerts-Landau, and Garber (2005), Sheng and Ng (2007), and Truman (2007) discussed the
issue of developing a new international monetary system that could take into account the
large current account surplus in China.
32 Asian Economic Papers

China’s Exchange Rate and Monetary Policies
cent against the dollar. He suggested, “China should deliver right away a meaningful
‘down payment’ of a 10–15 percent appreciation of the renminbi from its current
level.” In my view, the current single-minded focus on the renminbi exchange rate
by the Washington elite is unlikely to be helpful in addressing the imbalances in
China’s trading patterns. If the suggested change is so good for China, why has
China not already adopted the approach that the Washington elite are advising?
What has stopped Chinese policymakers from doing something that is supposedly
both good and important for China, the United States, and the world? Has the
Washington elite really considered carefully the constraints faced by Chinese
policymakers? Moreover, as rightly pointed out by Stephen S. Roach of Morgan
Stanley in his congressional testimony on 28 March 2007 (Roach 2007):
You in the Congress need to ask yourselves an important hypothetical question:
How would you feel if you got your way on the Chinese currency adjustment
but found that after three or four years the pressures bearing down on American
workers had only intensiªed? (p. 1)
In some ways, the current situation in U.S.–Chinese economic relations can be compared
to that of United States–European economic relations in the immediate postwar
period when the Marshall Plan was designed to restore the European economy
in order to beneªt both Europeans and Americans. In this context, the speech by
U.S. Treasury Secretary Henry Paulson (Paulson 2007) in Shanghai on “The Growth
and Future of China’s Financial Markets” is comparable to the Marshall Plan by being
the “Paulson Plan” for China. I certainly believe that the cooperative spirit of the
Marshall Plan, if applied to China, would be much more productive than the current
Washington consensus to pressure China to appreciate its exchange rate. The fact is,
as I will explain in detail, China currently faces unprecedented challenges and opportunities
not dissimilar to those of post-war reconstruction in Europe. Without the
help and cooperation of the United States and other developed nations, China is unlikely
to be able to proceed smoothly in its economic, social, and political modernization.
2. China’s export competitiveness: Low labor costs and declining transaction
costs
The stylized facts about China and its global imbalances in trade and capital ºows
are well known: the United States has run global current account deªcits in most of
the last 25 years. 2 In 2006, its current account deªcit reached US$ 857 billion, or
2 Cheong and Xiao (2003) reviews capital ºows into China in the context of global trade and
foreign direct investment.
33 Asian Economic Papers

China’s Exchange Rate and Monetary Policies
6.5 percent of GDP. The huge U.S. deªcits have been ªnanced mainly by the current
account surpluses of Japan, China, and oil-exporting countries.
In 2006 China’s global current account surplus jumped to a record high of US$ 184
billion, or about 9 percent of GDP. As a result, China’s foreign exchange reserves
have reached US$ 1.07 trillion, the largest in the world. China also became the second-largest
holder of U.S. Treasury securities, holding as much as US$ 353.6 billion,
trailing only Japan, which holds US$ 648.8 billion. On the other hand, the Chinese
currency was basically pegged to the U.S. dollar from 1994 to 2005. Starting in July
2005, the renminbi was de-linked from the dollar and has since been under a managed
ºoat with reference to a basket of currencies. However, from July 2005 to
March 2007, the renminbi appreciated only about 7 percent.
Low wages are not the only, nor even the most important, factor in explaining
China’s recent increase in export competitiveness. Wages in India, Indonesia, and
many parts of Africa are probably much lower than in China today and China’s
wages are increasing steadily, especially for skilled labor. Why then do foreign investors
still prefer to invest in China? Why do China’s exports continue to expand
as the wages of its workers increase? The reason is declining transaction costs in
China.
The concept of transaction costs is crucial in explaining many myths in the debate
about China’s currency. Unlike the costs of inputs, which are determined by supply
and demand in a market, transaction costs are synthetic and determined by how
well a society’s political, social, and economic institutions function. For example, before
China’s reforms began in 1979, when foreign trade and investment by private
individuals and ªrms were prohibited, the transaction costs of foreign trade and investment
in China were artiªcially set at a prohibitively high level.
Even though transaction costs are sometimes hidden, they are part of the real cost of
doing business, and when they are high, they reduce the competitiveness of the
economy. No country in the world worried about China’s export competitiveness
before 1979 even though the average wage for factory workers was only US$ 24 dollars
a month (under the ofªcial exchange rate of 1.5 yuan per dollar) compared with
the current monthly wage for migrant workers of about US$ 120 dollars (under the
2006 exchange rate of 8 yuan per dollar).
Unfortunately, none of the experts testifying before the U.S. Senate Finance Committee
on 28 March 2007 touched upon declining transaction costs in their analyses of
China’s export competitiveness. Morgan Stanley’s Stephen Roach said, “China competes
not just on the basis of its currency but also from the standpoint of cheap labor
34 Asian Economic Papers

China’s Exchange Rate and Monetary Policies
costs, modern infrastructure, access to state-of-the-art technology, and increasing investment
in human capital and basic research.” (p. 1) He was right in highlighting
many factors affecting China’s export competitiveness other than currency, but even
Roach missed the important factor of declining transaction costs in China’s export
and foreign-invested sectors.
Declining transaction costs are particularly signiªcant for China’s export and foreign-invested
sectors due to the globalization of the production process, characterized
by supply chain management technology and the active role of multinational
corporations. Thanks to the information technology (IT) revolution, the supply
chain management technology championed by Hong Kong trading companies is
now able to identify rapidly consumer preferences for a great variety of goods
across vast geographical areas. Modern logistics infrastructure allows companies to
sign contracts with low-cost producers around the world for each part of the supply
chain, and deliver the products on time to consumers overseas. In effect, international
supply chain technology has reduced the transaction costs of exporting from
China.
Unfortunately, the international supply chain system does not yet work as smoothly
for imports into China as for exports from China. Exports from China involve only a
small part of the international supply chain, usually the labor-intensive processing
or manufacturing part. As a result of China’s open-door policy and the efforts of
multinational corporations located there, exporters can now handle this part of the
production process efªciently, using China for reliable low-cost labor and production
facilities. In particular, such exporters do not need to worry about consumer
ªnancing or supplier credit because these concerns are all handled outside of China
through international ªnancial markets in New York, London, or Hong Kong.
In contrast, the transaction costs of importing to China are very high. The supply
chain has to ascertain Chinese consumer demand and then ªnd the lowest-cost supplier.
Consumer demand in China, however, is affected by many factors outside the
control of the international supply chain, including lack of efªcient consumer
ªnancing, the absence of a functioning social safety net, a shortage of medical insurance,
the weaknesses of the pension system, an absence of basic urban and rural infrastructure
for individual consumption, lack of basic regulations and enforcement
of environmental protection, shortfalls in the regulation of product quality, and
weak protection of intellectual property rights. Hence, the international supply
chain faces tremendous obstacles when it comes to importing goods into China.
Clearly many of China’s domestic economic challenges have also hindered the
growth of imports and are at the root of China’s sustained global current account
surplus.
35 Asian Economic Papers

China’s Exchange Rate and Monetary Policies
Although a change in the exchange rate can directly affect the relative cost of labor,
it cannot affect transaction costs very much. In my view, thanks to China’s continued
reform and opening, including its accession to the World Trade Organization,
transaction costs in China’s export sector will continue to fall in the near future; this
will further enhance the competitiveness of China’s export sector even as labor costs
in China are rising steadily due to expected currency appreciation, inºation, and
other causes. In other words, if we take into account the rapidly declining transaction
costs for exports in China, the hypothetical question raised by Stephen Roach
earlier could become a real risk.
In summary, China is likely to gain even more export competitiveness in the future
due to the declining transaction costs of exporting. In order for China to balance its
trade, it has to work hard to reduce the transaction costs for imports. 3 Exchange rate
adjustments would not be as effective in addressing the trade imbalance as reducing
the hidden barriers and constraints on imports.
3. What is the “correct” level for China’s nominal exchange rate?
Many economists would regard the purchasing power parity (PPP) exchange rate,
which is a hypothetical benchmark exchange rate derived from the law of one price
for the same bundle of goods, as the best theoretical deªnition of the “right” level
for the nominal exchange rate. When we buy the same bundle of goods in China using
renminbi and in the United States using dollars, the PPP exchange rate is the
amount of renminbi divided by the amount of dollars spent on the sample bundle of
goods in the two locations.
The usefulness of this benchmark PPP exchange rate is obvious, but the problem is
how to select the same bundle of representative goods in both countries. For tradable
goods such as computers and cameras it is easy to ªnd the same bundle and,
surprisingly, the PPP exchange rate calculated using only tradable goods is likely to
be equal to the prevailing nominal exchange rate. For example, if you were to buy a
Dell notebook computer in both Shanghai and New York today, the amount of
renminbi spent in Shanghai divided by the amount of dollars spent in New York is
likely to be close to 8 yuan per dollar. Any discrepancy from this ratio should be less
than the cost of ordering and shipping the notebook computer between the two locales.
If it were not, somebody would be able to make a fortune by buying comput-
3 For a review on the transaction costs on imports into China, see USTR (2007), which examines
various barriers to imports into China, although the USTR report did not use the concept
of transaction costs in its analysis and did not trace the root of the problem to China’s
weakness in planning, ªnancial sector development, and regulation.
36 Asian Economic Papers

China’s Exchange Rate and Monetary Policies
ers in one place and selling them in the other. In other words, claims that China’s
nominal exchange rate is under-valued are nonsensical unless they are based on a
PPP exchange rate derived from buying a bundle of goods that also includes nontradable
goods.
The Economist calculates a PPP exchange rate based on a McDonald’s restaurant Big
Mac, which is a non-tradable good because it must be consumed where it is purchased.
According to The Economist, in 2006, a Big Mac cost 10.4 yuan in China and
US$ 3.15 in the United States, implying a PPP exchange rate of about 3.3 yuan to a
dollar, which suggests that the renminbi was under-valued by almost 60 percent
considering China’s nominal exchange rate of 8 yuan per dollar in 2006.
So why does a Big Mac in China cost 60 percent less than in the United States? The
answer is simple: the costs of non-tradable goods such as labor and rent used in producing
a Big Mac are much lower in China than in the United States. In fact, the
prices of non-tradable goods in a developing country are generally lower than the
prices of non-tradable goods in a developed country. Hence, given the different
stages of economic development prevailing in China and the United States, it
should be expected that the actual nominal exchange rate of the renminbi would be
under-valued compared to the Big Mac PPP exchange rate. In fact, using the Big
Mac PPP exchange rate as a benchmark, the nominal exchange rates of most Asian
economies are similarly under-valued.
This exercise shows that it is exceptionally difªcult to claim convincingly that a
country’s nominal exchange rate is under- or over-valued. The intellectual basis for
such a claim is questionable at best because of the theoretical difªculties in deªning
the “correct” nominal exchange rate.
4. The transitory and lasting effects created by changes in the nominal
exchange rate
Although it is difªcult to deªne the “correct” level for China’s nominal exchange
rate, it is still possible and important to analyze the effects of changes in the nominal
exchange rate on the economy. In the short-run, changes in the nominal exchange
rate will immediately redistribute wealth between exporters and importers and
thereby affect their competitiveness. However, in theory, the nominal revaluation
will have only temporary effects on the competitiveness of importers and exporters
through a redistribution of income and will have no lasting effects on competitiveness
after the economy adjusts to the shock.
37 Asian Economic Papers

China’s Exchange Rate and Monetary Policies
To illustrate how this economic logic functions, suppose China were to revalue its
currency by 15 percent tomorrow. This would immediately redistribute a large sum
of wealth from exporters to importers in the short-run, artiªcially reducing the competitiveness
of China’s exporters by 15 percent, and increasing the competitiveness
of importers to China by 15 percent. However, the effects on the Chinese economy
will not stop after this 15 percent revaluation. Many exporting ªrms will have to
close down, which may lead to deºation in China. The deºation would continue until
it has produced a 15 percent decline in the price level exactly matching the revaluation.
After the deºation, wages and other costs will be 15 percent lower and exporting
ªrms will regain the competitiveness they had lost. Importers to China
would ªnd that the prices of domestically produced substitutes had dropped by
15 percent, offsetting their 15 percent gain in advantage from the revaluation.
In reality, things are much more complicated. Fortunately, we can consult the experience
of Japan, which allowed its currency to appreciate steadily and signiªcantly for
many years during the 1980s and 1990s, with little effect on reducing or eliminating
its current account surplus. What Japan got from the appreciation of the yen was little
more than a decade of deºation! If Japan had held its nominal exchange rate constant
throughout 1990s, it would most likely have faced inºation, but excessive appreciation
of the yen eliminated the necessity for inºation and even required some
deºation to compensate.
The argument that changes in the nominal exchange rate would have a lasting effect
on current account balances is misleading. If a country could gain real competitiveness
through the nominal devaluation of its currency, economic growth and development
would be easy and would have occurred a long time ago in many developing
countries. Lasting improvements in competitiveness are determined by factor
costs, transaction costs, technological progress, infrastructure, human capital, and
other real variables, but not by the nominal exchange rate. Sustained current account
imbalances have very little to do with the level of the nominal exchange rate.
Current account imbalances are the results of the savings and investment gaps (Liu
and Woo 1994).
5. The Balassa–Samuelson effect and structural inºation
In order to understand the economic role of currency appreciation, we go back to
the point I made in our discussion of the Big Mac exchange rate that the prices of
non-tradable goods in China are lower than in the United States. Because the prices
of tradable goods in China equal the prices of tradable goods in the United States
due to price arbitrage, the result of the lower prices of non-tradable goods in China
38 Asian Economic Papers

China’s Exchange Rate and Monetary Policies
is that the general price level in China is lower than the general price level in the
United States.
Bela Balassa and Paul Samuelson have found that because the productivity growth
in the non-tradable goods sector is generally substantially lower than the productivity
growth in the tradable goods sector during the economic development process,
there is the secular trend of the prices of non-tradable goods rising relative to the
prices of tradable goods. In an open economy, where the prices of tradable goods are
ªxed by the value of the exchange rate and by the prices of foreign substitutes, the
Balassa–Samuelson effect of a relative rise in the prices of non-tradable goods is
achieved by either inºation (rise in the absolute price level of non-tradable goods)
or currency appreciation (fall in the absolute price level of tradable goods), or by a
combination of inºation-cum-appreciation. Hence, in a growing economy with a
ªxed exchange rate regime, there is an inherent structural inºation to accommodate
the Balassa–Samuelson effect.
The implication of this discussion is that, as long as China keeps its exchange rate
ªxed, the process of economic development would naturally generate structural
inºation to bring the general price level in China up to the general price level in the
United States. 4 The underlying mechanism is that rising productivity in China’s
tradable sector (manufacturing) would raise the wages of engineers. This development
would then entice workers from the non-tradable sector, such as hair stylists
or barbers, to shift to the manufacturing sector. As a result, if there is no surplus labor
in the economy, wages for hair stylists will also rise even though there has been
no productivity gain in haircutting. Increases in wages for all sectors will either lead
to inºation or require appreciation of the currency to accommodate the increase in
the general level of prices stemming from the rising productivity in the manufacturing
sector.
According to this theory, productivity growth in the tradable goods sector is the
driver of structural inºation and currency appreciation. However, before inºation
and currency appreciation can take off signiªcantly, the economy ªrst needs to reach
a state of full employment. This process has worked smoothly previously in economies
like Japan, Korea, and Hong Kong, which achieved full employment after industrialization
started.
4 The gap in price levels between China and the United States can be measured by the difference
between China’s nominal exchange rate and the PPP exchange rate for GDP. In 2006, the
gap was 67.5 percent based on China’s nominal exchange rate of 8 yuan per dollar and the
2.6 yuan per dollar PPP exchange rate for GDP as calculated by the World Bank.
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China’s Exchange Rate and Monetary Policies
From 1950 to 1960, Japan’s average inºation rate was 5.3 percent, exceeding the
2.6 percent average for the United States. From 1960 to 1971, Japan’s average
inºation rate was about 5.5 percent, exceeding the 3.4 percent average U.S. inºation.
Following high inºation during the ªrst oil crisis in the early 1970s, however, Japan’s
central bank started to clamp down very hard on inºation. As a result, from
1979 to 1993, Japan’s inºation rate averaged about 2.3 percent, which was below the
average U.S. rate of 4.7 percent. With inºation under control, the only alternative
way to accommodate the continued growth in domestic price levels was through
yen appreciation. The yen, previously pegged to the dollar at 360 yen per dollar,
started to appreciate in 1971 and then after the 1984 Plaza Accord rose to approximately
100–120 yen per dollar in the 1990s. The Plaza Accord, in which a U.S.-led
coalition forced Japan to appreciate its currency, would not have been necessary if
Japan had allowed its domestic inºation to exceed the rate in the United States during
the 1970s and 1980s. However, the government-engineered appreciation of the
yen in the 1990s was so excessive that it led to a decade of deºation in Japan.
The story in Hong Kong is much simpler but is also consistent with the Balassa–
Samuelson theory. With the Hong Kong dollar pegged to the U.S. dollar, Hong
Kong’s inºation rate, brought about by strong productivity growth, averaged about
3 percentage points above the average U.S. inºation rate from 1980 to 2000. Annual
inºation in Hong Kong was around 10 percent for a number of years in the 1990s.
The productivity gains brought about by developments in supply chain management
technology in the international trade sector and by the rapid development of
the Hong Kong ªnancial sector pushed up prices in all sectors because labor, land,
and capital were all at full employment. The unemployment rate in Hong Kong at
the peak of the 1990s business cycle was as low as 2 percent.
The story for China is a bit complicated, but still appears to be consistent with the
Balassa–Samuelson theory. A number of studies (Xiao and Tu 2005; Xiao 2006; Lu
2007, Xiao and Weiss 2007) have shown that rapid labor productivity growth in
China’s industrial sector has occurred and is continuing. This productivity growth
has led to a steady increase in the wages of urban workers. High and rising urban
wages attracted as many as 119 million workers from China’s rural areas to its
coastal cities in recent years. However, due to the large pools of rural and migrant
labor, which may amount to as many as 481 million people, the wages of rural and
migrant workers have risen slowly until recently. As a result, inºation has been low
and currency appreciation slow during the last decade despite China’s tremendous
growth rates.
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China’s Exchange Rate and Monetary Policies
In the next decade or two, however, as China’s baby boom generation starts aging
and the economy continues to grow rapidly, China is likely to get closer and closer
to full employment. When this happens, China will probably experience rapid structural
inºation and/or currency appreciation similar to that experienced by Japan
and Hong Kong. The key underlying assumption of this model, of course, is continued
productivity growth in the manufacturing sector.
6. China should adopt an inºation-ªrst and appreciation-second strategy
It is clear from the previous section that inºation and currency appreciation are substitutes
because they are equivalent ways of facilitating a rise in a country’s domestic
price level. So, the people who are pushing China to revalue the renminbi by 15
to 40 percent are really asking China to raise its domestic price level upward by 15
to 40 percent. Why not just recommend to Chinese policymakers a 15 to 40 percent
inºation?
A large currency appreciation affects all members of society immediately through a
forced redistribution of wealth, followed by forced wage and price adjustments.
Inºation, on the other hand, is an aggregation of price adjustments in each market
where rational individuals and companies make decisions about how to respond to
changes in wages and prices; and, hence, in my opinion, causes much less shock to
the society.
In my view, China should be encouraged to run a stable but low rate of inºation to
accommodate the structural inºation from the Balassa–Samuelson effect. The
inºation rate should be about 5 percent a year, to facilitate the steady approach of its
domestic price level to the level in more developed economies. This structural
inºation strategy also has the advantage of deterring currency speculation, as speculators
would need to worry about inºation in China whenever they bet on appreciation
of the renminbi. 5 When structural inºation, which is different from pure monetary
inºation, is expected to surpass 5 percent, China should also add currency
appreciation as an additional instrument to absorb pressure for increases in domestic
prices. The extent of currency appreciation should be determined by the market,
5 Furthermore, speculators and investors can still bet on real estate, which will rise in value
with both inºation and appreciation. But the catch-up in property prices should be viewed as
a leading indicator for the catch-up in the overall price level and should not concern the Chinese
authorities too much as long as property investors are required to make sizable down
payments.
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China’s Exchange Rate and Monetary Policies
in the sense that appreciation should not be so extensive as to push inºation below
3 percent.
The most useful way to consider the question of how fast the renminbi should appreciate
is to examine the combination of inºation and renminbi appreciation to determine
China’s domestic price level relative to that of the United States. We approach
an understanding of the best pace for renminbi appreciation in the coming
years by also considering a realistic pace for convergence between price levels in
China and other countries.
For simplicity, let us assume that China will maintain an inºation rate exactly the
same as the U.S. rate. Using this assumption, we can then calculate the number of
years needed for the price level in China to catch up to the level in the United States,
assuming also a constant annual rate of renminbi appreciation. The result from this
simple arithmetic shows that it will take 57 years for China’s price level to match
that of the United States if the currency appreciates at 2 percent a year, 38 years with
appreciation at 3 percent a year, 23 years at 5 percent, 15 years at 8 percent, and
8 years if the currency appreciates at a rate of 15 percent a year. As pointed out previously,
the nominal exchange rate is just one of two variables that ªgures in the determination
of domestic price levels; the other variable is the inºation rate. If its currency
appreciates too fast, China will experience deºation; if it appreciates too
slowly, China will experience inºation.
Moreover, in 2006 China’s domestic price level was 32.5 percent that of the United
States. China’s domestic price level, which determines the costs of goods made in
China for American consumers, is determined by the underlying growth of productivity
in China, not by China’s premier, not by the governor of China’s central bank,
and not by congresspersons in Washington. This point cannot be emphasized
enough if we want to discuss China’s currency policy scientiªcally and objectively.
Now let’s ask: how long would it take for China’s domestic price level to reach the
U.S. price level based on past experiences in price level convergence among developed
and developing countries? The answer could very well range from 15 to
38 years. This timeframe for convergence, in turn, would imply annual renminbi appreciation
ranging from 3 to 8 percent, assuming inºation in China is no higher than
inºation in the United States. In my view, it is not possible for China’s domestic
price level to reach that of the United States’ level within 15 years. For this judgment
to make any sense, China’s average annual currency appreciation plus its extra
inºation could not exceed 8 percent. Hence, on average, 4 percent per year extra
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China’s Exchange Rate and Monetary Policies
inºation and 4 percent per year currency appreciation would probably be the best
we could expect for China in the next two decades.
The actual pace of inºation and appreciation in China at the present is far below this
“limit.” In 2006, China’s inºation rate was only 1.5 percent, much lower than the 2.5
percent inºation rate in the United States. In fact, relative to the Unites States, China
had deºation in 2006! At the same time, the average rate of currency appreciation
was around 3 percent. So in 2006 relative to the United States, China’s domestic
price level increased only about 2 percent (1.5 2.5 3 2) and stood at 32.5 percent
of that of the United States. At this pace, it will take 57 years for the price level
in China to catch up to the U.S. level. No wonder so many in Washington are getting
impatient about China’s currency policy! However, although it is easy to complain
about China’s slow adjustment, it is difªcult to ªnd a solution to speed up the convergence
of China’s price level.
7. Why has China’s inºation rate been so low and at the same time its
currency appreciation rate also so slow?
The structural constraints associated with China’s surplus labor pool are the main
causes for the slow catch-up in China’s price level, although difªculties in macroeconomic
policies also play an important role. In 2006, inºation in China was
1.5 percent while it was 2.5 percent in the United States, 2.2 percent in Korea,
5.5 percent in India, 7.9 percent in Pakistan, 13.1 percent in Indonesia, 7.5 percent in
Vietnam, and 6.2 percent in the Philippines. It seems fair to say that in the global
context, China experienced deºationary pressure in 2006 even though its economy
grew 10.7 percent.
Surprisingly, although China recorded one of the lowest inºation rates in the world
in 2006, both the Chinese government and international organizations like the Asian
Development Bank (ADB), the World Bank, and the IMF have urged China to
tighten monetary policy to restrain investment. In contrast, the ADB, among other
organizations, recommended that other Asian economies with much higher
inºation rates raise investment, especially in infrastructure, which is the exact policy
China followed in the past.
According to a survey by the Ministry of Agriculture, total employment in China
was 764 million in 2006. Of this total, only 283 million jobs belonged to the urban
sector. The number of migrant workers reached 119 million in 2006, an increase of
7 million over the previous year, and their average monthly wage was about
958 yuan, or US$ 120 dollars. Subtracting the 283 million urban jobs and 119 million
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migrant workers from total employment of 764 million, suggests China still has
362 million rural workers. Combining the number of rural workers with the 119 million
migrant workers yields 481 million unskilled workers who currently earn an
average of US$ 120 dollars a month or less. Many of these workers are likely underemployed
and would be eager to shift to a job that paid a higher wage.
These 481 million unskilled workers face two choices: stay in the villages or migrate
to urban regions to ªnd a job in the industrial or service sector. If they stay in the villages,
they can maintain a standard of living more or less the same as that of an average
Chinese peasant, which is barely above subsistence. If they migrate to the cities,
they have to compete with other migrants for the limited number of urban jobs.
Fierce competition in the unskilled labor markets, which are linked nation-wide
through the newly completed inter-province highway system, mobile phones, bus
and rail routes, as well as informal township associations, has driven wages for unskilled
labor down to a level close to the subsistence income of the average peasant.
None would envy the position of rural or migrant Chinese workers.
In recent years, the Chinese government has tried hard to increase wages for migrant
workers as well as incomes of peasants. Wages for migrant workers increased
as much as 12 percent in 2006 after the government’s effort to raise the minimum
wage. Shenzhen, the special economic zone next to Hong Kong, increased its minimum
wage by 17 percent last year. Nevertheless, the income of rural residents in
China increased only 1.2 percent in 2006. As explained previously, the incomes of
migrant workers and rural residents are closely linked due to their freedom to move
between urban and rural jobs. In order to raise the income of one group, it is necessary
to raise the income of both.
This huge pool of unskilled workers is what is slowing the growth of wages in
China, and this pool of underutilized labor is what ultimately dampens inºationary
pressures in China. If the Chinese economy were to slow down, for example as a result
of a 15 percent revaluation of the renminbi, China could easily see deºation and
massive unemployment due to the competition of 481 million unskilled workers
who are surviving barely above subsistence. 6
6 It must be pointed out that the low wages of unskilled workers have also adversely affected
the environment and public health; the vast number of unskilled workers may encourage
low-cost production that generates huge environmental and public health damage when the
government and industries with low proªt-margins do not have enough resources and incentives
to take necessary precautions and preventive measures. Although it is difªcult to
get reliable data, from my own experience in visiting many rural enterprises, I conclude that
for many of these enterprises the costs of pollution and energy-inefªcient technology could
be much greater than the thin proªts and low wages they generate. Unfortunately, the central
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China’s Exchange Rate and Monetary Policies
Why did international organizations like the ADB recommend that one economy,
such as India, increase investment when inºation is high, while recommending that
another economy, such as China, reduce investment when inºation is low? The typical
answer is that “China is special,” that it has over-capacity, and that therefore it
should reduce investment and increase consumption.
The advice to increase consumption cannot be wrong. However, consumption in
China today is largely under the control of individuals and ªrms. They have probably
already tried to optimize their consumption given all the constraints they face,
and are unlikely to welcome the government telling them how to spend their
money.
8. China’s real challenges in managing external balances
To accelerate the catch-up in China’s domestic price level, the international community
should encourage China to adopt a loose monetary policy, which means less
sterilization of its rising foreign exchange reserves. A loose monetary policy is necessary
to accommodate steady structural inºation, and a low and stable inºation
rate is a necessary condition for facilitating an orderly renminbi appreciation that
would not risk deºation. However, in order to convince China to adopt a loose
monetary policy, it is necessary to help China to develop a robust ªnancial, planning,
and regulatory system that can distinguish productive from unproductive investments.
Chinese leaders are trying to change China’s growth model from export-led to consumption-led
development, but they need help from the international community.
For example, health insurance and social security networks in China are in their infancy,
and therefore, many Chinese people choose to save a great deal as a hedge
against uncontrollable expenses. In the absence of student-loan programs, families
also choose to save a great deal for their children’s education. Betting on capital
gains, many middle-class Chinese families decide to buy property in new residential
communities, but refrain from moving until roads, subway networks, schools, and
other infrastructure are completed. These are the best choices given the structural
and economic constraints of Chinese society. As a result of the individual best
choices available to Chinese households, consumption remains low and savings
government has not yet found an effective way to limit the low-efªciency activities that provide
socially costly employment for the pool of unskilled labor. China needs to ªnd ways immediately
to identify and stop these value-subtracting industries before they permanently
damage the environment and the people.
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China’s Exchange Rate and Monetary Policies
rates remain high. All of this begs the question, how can China best increase domestic
consumption?
In the context of these examples, the answers are quite straightforward: build an integrated
health insurance system; create student loan or scholarship programs; and
build more roads, subways, and schools. All these solutions, not surprisingly, require
investment. These are productive investments, and productive public investments
are fundamentally different from investments that generate unproductive
over-capacity. These productive investments will free up the consumption power of
Chinese households, which currently is held back to hedge against potential negative
future eventualities.
What China needs, then, is a set of macroeconomic policies that increase productive
investment and consumption while reducing unproductive investments. Unfortunately,
this is almost impossible, because the macroeconomic instruments available
to the government, such as control over the money supply, the exchange rate, interest
rates, and bank reserve ratios, do not distinguish productive from nonproductive
investment. Without much choice, the Chinese government was forced
to go back to its old tools: administrative controls, industrial policy, and political
discipline including an anti-corruption campaign.
Unfortunately, China’s National Bureau of Statistics cannot distinguish productive
from unproductive investment. When reported statistics suggested the overall investment
rate was too high, the Chinese government put a brake on investment, depressing
both productive and unproductive investment. When investment, especially
productive investment, is constrained, imports do not grow fast enough to
keep up with exports. As discussed previously, investment in the supply chain system
that supports China’s exports has been carried out largely by foreign-invested
companies and is not affected by the Chinese government’s macroeconomic control
policies. On the other hand, imports depend heavily on domestic consumption and
domestic investment. Hence, China developed a large current account surplus because
the government failed to allow enough productive investment.
9. Conclusion
The essential function of a good modern ªnancial, planning, and regulatory system
is to reduce the transaction costs between capital and labor so that they can work
productively together. Without this system, China will not be able to employ productively
and fully its 481 million rural and migrant workers. Instead, China creates
hundreds of socially costly rural enterprises, which generate more pollution and so-
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China’s Exchange Rate and Monetary Policies
cial instability than they generate in proªts and wages. China’s imports will not be
able to balance off its exports, which will continue costing the United States and
other nations jobs while encouraging protectionism. China’s potential purchasing
power will be locked up in its foreign exchange reserves instead of becoming productive
investment and consumption. It is for this reason that I regard Treasury Secretary
Paulson’s Shanghai speech on China’s ªnancial sector reform as a “Marshall
Plan” draft that could bring a win–win result for China and the United States in the
21st century.
The strength of the ªnancial sector in the United States contrasts sharply with its
weakness in China. With a strong ªnancial sector, average Americans can afford to
maintain a low savings rate since they can secure capital gains on their investments
in property and capital markets. With a weak ªnancial sector, Chinese consumers
have to maintain a high savings rate and lower consumption (and lower standard of
living). China’s surplus capital cannot be used to hire all its own people productively.
Americans today worry about the competition from China just as Hong Kong
did a decade ago. People in Hong Kong today, however, realize that when China is
growing productively, there will be more work than all of Hong Kong’s labor pool
can handle. I have no doubt that if the United States can help China ªx its ªnancial
sector, China will create enormous demand for U.S. goods and services, with consequent
beneªts and employment opportunities for the people of the United States.
Supply creates demand only if we have an efªcient ªnancial sector and if the transaction
costs are decreasing toward zero.
How to build a robust ªnancial, planning, and regulatory system in China with help
from the international community is a topic beyond the scope of this paper. However,
efforts by the United States and the international community to increase consumption
in China should focus on this broad fundamental issue, not simply on a
renminbi exchange rate revaluation.
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49 Asian Economic Papers

Nonperforming Debts in Chinese Enterprises
Nonperforming Debts in Chinese
Enterprises: Patterns, Causes, and
Implications for Banking Reform *
Geng Xiao
The University of Hong Kong
Hong Kong, SAR, China
xiaogeng@hku.hk
Abstract
Given the domination of bank financing, nonperforming debts
(NPDs) in large Chinese enterprises are a proxy for nonperforming
loans (NPLs) in China’s major banks. Using a firm-level survey
of more than 20,000 large and medium-sized industrial enterprises
conducted by the National Bureau of Statistics of China,
this paper estimates both the level and ratio of NPDs across
ownership type, industry, and region for the period 1995–2002.
The results show that NPD ratios have been falling since 2000 as
a result of the rapid expansion of better-performing non-state enterprises
(NSEs), the improved performance of state-owned enterprises
(SOEs), and the exit of poor-performing enterprises
(which has been facilitated by asset management companies and
other merger and acquisition activities). SOEs, however, are still
much more likely than NSEs to generate NPDs. This paper provides
useful tools and sector information for assessing enterprise
debt risks and draws lessons for banking reform in China.
1. Introduction
Since early 2004, the newly established China Banking
Regulatory Commission (CBRC) has announced quarterly
* This paper was presented at the Asian Economic Panel meeting
in Hong Kong on 12–13 April 2004, and at the Hong Kong Monetary
Authority workshop on 8 July 2004. The author would like
to acknowledge research collaboration with the Industry and
Transportation Department of the National Bureau of Statistics
(NBS) of China. Xing Junling and Yu Xiaoyun provided extensive
technical support at NBS. Tu Zhengge provided excellent
research assistance. The author would like to thank the Research
Grant Council of Hong Kong and the University Grant Council
of Hong Kong for ªnancial support (project nos. HKU7167/98H
and AOE/H05/99). This research work also beneªted from a
1 LINE SHORT
REGULAR
1 LINE LONG
Asian Economic Papers 4:3
© 2006 The Earth Institute at Columbia University and the Massachusetts
Institute of Technology
Asian Economic Papers (ASEP) 4:3
Job No. 1055
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Nonperforming Debts in Chinese Enterprises
statistics on the ratio of nonperforming loans (NPLs) for China’s major banking institutions.
It reported a sharp decline in the NPL ratio from above 24 percent in 2002
to 19.6 percent in June 2003, 17.8 percent in December 2003, 13.3 percent in June and
December 2004, and only 8.7 percent in June 2005. During the 2-year period between
June 2003 and June 2005, the outstanding amount of NPLs in China dropped from
RMB2.538 trillion to RMB1.276 trillion, a decrease of RMB1.262 trillion. This is
clearly a dramatic turnaround in terms of banking sector performance. Are the
ofªcial statistics reliable? What happened to the quality of bank loans and debt in
China’s enterprises? These questions motivate this paper. Outside observers interpreted
the ofªcial reports cautiously because they did not understand how China’s
banks calculated their NPL ratios. Most analysts and commentators would still estimate
China’s NPL ratio to be at a much higher level than the ofªcial ªgure—usually
two to three times that of the ofªcial NPL ratio. For example, UBS, an investment
bank and global asset management ªrm, (Anderson 2005) estimates that China’s
NPLs fell from about 50–55 percent in 1997–98 to about 25–30 percent by the end of
2004. These market estimations of NPL ratios are usually based on macroeconomic
data because it is difªcult to get reliable and representative microeconomic data
from Chinese banks.
This paper attempts to develop an alternative approach to the study of NPLs in
China using ªrm-level microeconomic data. As a result of the limited development
of stock markets and enterprise bond markets in China, banks are still the major
holders of enterprises’ long-term and short-term debt. In recent years, Chinese
banks have expanded rapidly in the business of consumer loans, especially mortgage
loans. The outstanding amounts of consumer loans rose from below 1 percent
in 1998 to above 10 percent in 2004. Because the quality of consumer loans is generally
much better than that of enterprise loans, the quality of bank loans depends
largely on the quality of the bank lending to enterprises. The quality of enterprise
debt is directly linked to the proªtability of the enterprises. The ability to pay the interest
and principal of loans derives ultimately from proªtability and cash income
ºows of the enterprises. This is especially true if we are examining a large group of
enterprises, in which the variations in the enterprise-speciªc timing of cash income
ºows and the structures of ªnancing within the group will be averaged out statistically
through the law of large numbers, making the proªtability of each enterprise
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seed fund for strategic research in corporate and ªnancial law and policy from The University
of Hong Kong. The author is also grateful to Wing Thye Woo, Dwight Perkins, Jeffrey Sachs,
Alan Siu, Richard Wong, Sung Yun Wing, Zhang Weiying, Erh-Cheng Hua, Ren Ruoen, Peng
Wensheng, and Guonan Ma for comments and suggestions. The author takes responsibility
for any errors.
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the single most important contribution to the quality of the enterprise group’s portfolio
of debts.
This paper uses the proªtability conditions of each enterprise to measure and characterize
the quality of the enterprise group’s portfolio of debts. It uses both reported
proªtability and imputed proªtability (the latter is derived from the components of
value-added) to give two alternative estimates of the quality of debt portfolios for
different groups of enterprises classiªed by ownership, industry, and region. The
method is applied to a comprehensive annual survey of all the large and mediumsized
industrial enterprises in China conducted by the National Bureau of Statistics
of China. Information about the survey data can be found in tables A.1 to A.6 in the
appendix. The survey sample includes more than 20,000 enterprises and covers the
period from 1995 to 2002 (see table A.6). In 2002, the sample enterprises had 26 million
employees in total, which is about 16.7 percent of China’s total industrial employment.
These enterprises incurred RMB5.7 trillion in debt, an amount equal to
43.6 percent of the total loans in China’s ªnancial institutions. The sample enterprises
contributed about 19.2 percent of China’s GDP. Clearly these enterprises are
the most important leaders in the Chinese industrial sector. Aggregate ªnancial information
about the sample enterprises has been regularly reported in the Statistical
Yearbook of China.
The contribution of this paper is the methodology of using the disaggregated ªrmlevel
data to study the enterprise proªtability of the enterprises and the quality of
their debts. The paper derives both the level and ratio of NPD across enterprise
groups by ownership, industry, and region for the period 1995–2002. The results
show that NPDs have indeed been falling as a result of both the rapid expansion of
better-performing non-state enterprises (NSEs) and improvements in the performance
of state-owned enterprises (SOEs), as well as rapid exit of poor-performing
state-owned enterprises, which has been facilitated by newly established asset management
companies that specialize in dealing with NPLs. The micro-level evidence
uncovered here is largely consistent with the CBRC reports on falling NPLs and
NPL ratios in China’s banking sector. This study, however, provides a more transparent,
simpler, and more objective method of estimating NPDs and allows outsiders
to examine the detailed causes and dynamics of the changing patterns of NPDs
in Chinese enterprises. In particular, it was found that the SOEs had consistently
generated higher NPD ratios than the NSEs, providing a challenge as well as an opportunity
for future banking reform.
Section 2 deªnes our concepts of NPDs; section 3 shows the patterns of NPD and
NPD ratios across enterprises’ ownership type, industry, and region; and section 4
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examines the trend of NPD ratios during the period 1995–2002 and provides scenarios
of the future of NPD ratios in China. Section 5 uses panel data regressions to
identify the impacts of various factors on the proªtability and debt quality of the enterprises.
Section 6 addresses the sample-selection bias in the measure of NPD ratios
resulting from the exit of poor-performing enterprises from the sample over the
study period. Section 7 discusses the implications of the empirical results for banking
reform in China.
2. Defining and estimating NPDs
In recent years, the CBRC has been trying hard to monitor and supervise the NPLs
in China’s banking institutions. It developed detailed rules on the reporting of the
amount of NPLs and the NPL ratios. The purpose is to manage and reduce ªnancial
risk by monitoring both the changing distribution of NPLs and the changing NPL
ratios of individual banks and bank branches. This is clearly necessary and useful.
Poor governance of banks is a sufªcient condition for creating NPLs, even when the
enterprise sector is doing well.
The efforts of the CBRC and the individual banks to reduce NPLs, however, are only
necessary conditions. Ultimately, the quality of China’s banking assets and enterprise
debts depends directly on the proªtability of China’s enterprises. For example,
in the short run it is easy for banks to reduce NPL ratios, or even the amount of
NPLs, by simply expanding the total amount of loans. New loans are much less
likely to have repayment problems in the short run, but they could create more bad
loans in the future if they are extended to potentially loss-making enterprises. New
loans can help existing loss-making enterprises continue to pay their interest on old
loans, thereby also shifting the underlying risks to the future. The problem is especially
serious when the economy is booming. These are the main reasons why the reliability
of NPL statistics as reported by China’s banks can vary considerably, depending
on how they are calculated. Outsiders are unable to completely understand
how the NPLs and NPL ratios in China’s banks are actually calculated because the
decisions in each individual case require judgments that are too complex for outsiders
to assess. This is why analysts and commentators rely more on the study of
China’s macroeconomic conditions, such as business cycles and sector performance,
to gauge the level of NPLs in China. Based on their personal impressions and understandings
about the Chinese economy, they report NPL ratios that are usually
two to three times larger than the ofªcial ratio.
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This paper attempts to develop an objective measure of the quality of enterprise
debts in China. Proªtability is the only criterion used in measuring the quality of
these debts. The concept and its implementation are straightforward. If the enter-
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prises are making proªts, the quality of their debts (more speciªcally their total liabilities)
are termed “performing.” If they are making losses, their debts are regarded
as “nonperforming.” The amount of NPD for a speciªc enterprise group is then the
sum of the total liabilities in the loss-making enterprises for that group. The NPD ratio
for the group is simply the ratio of the sum of total liabilities in the loss-making
enterprises divided by the sum of total liabilities in both the loss-making and proªtmaking
enterprises in the group. These simple deªnitions of NPD and the NPD ratio
make our NPD statistics objective, easy to measure, and easy to understand.
Our concept of the NPD ratio, however, is not applicable to an individual enterprise,
because according to our deªnition, an enterprise cannot have part of its total debt
be performing and the other part be nonperforming: all the debts in any given enterprise
have the same quality. For instance, one enterprise cannot have 70 percent of
its debts performing and 30 percent nonperforming. For an individual enterprise,
losses might occur in the ªrst few years, but the ªrm would make proªts in the future.
After a close examination by its creditors, such a ªrm would be considered to
have high-quality debt. Our deªnition of NPD would not be fair to this particular
enterprise. On the other hand, a currently proªtable enterprise might become a loss
maker. Then its debt quality would be bad upon close examination. Our assessment,
based only on current proªtability, might not do justice to this particular enterprise.
The difference between current proªtability and longer-term proªtability, however,
could be seen as a random distribution for a large group of enterprises, such as
groups in our sample separated by time, ownership, industry, and region. With a
sizable group, the variability in the timing of cash ºows, proªt streams, payments to
creditors, and other proªtability-related variables for enterprises within the group
would offset each other, leaving the average NPD ratio for the group a much more
reliable and accurate measure of the quality of the group’s portfolio of debts. This is
why our concept of the NPD ratio is useful only for measuring debt quality for
groups of enterprises. This study would be very useful as complementary research
to the traditional method of estimating NPLs.
For our method to be useful, it needs to be applied to a representative sample with
sizable groups of enterprises. The annual survey of large and medium-sized industrial
enterprises conducted by China’s National Bureau of Statistics (NBS) is a suitable
data set for our method. The NBS data are in fact census data, not really sample
data, because the survey covers all large and medium-sized industrial enterprises in
China. In 2002, China had more than 180,000 industrial enterprises with sales above
RMB5 million. The NBS sample includes only about 21,000–23,000 large and medium-sized
industrial enterprises out of a total of 180,000 ªrms. Many small industrial
enterprises are not included in our study, but most of them have limited access
to bank ªnance under the current ªnancial system in China.
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One major weakness of using our method for the NBS data is sample selection bias.
The group of enterprises included in the NBS survey each year is not always the
same. About 20 percent of the group consists of enterprises that enter and exit the
survey sample each year as a result of changes in their size classiªcation or organizational
changes such as mergers and acquisition, privatization, reorganization, and
bankruptcy. The proªtability of exiting ªrms is not necessarily the same as that of
the new entries. This means that we are studying only the largest and most dynamic
frontier industrial enterprises in China and leaving out the poor-performing ones.
We will address this issue in section 6 and show the impact of this sample selection
bias on the estimated ratio of NPD.
Our sample covers not only SOEs but also other types of enterprises in all industries
and regions, including rural and urban collectives, private enterprises, domestic
mixed-ownership corporations, foreign-invested enterprises, and enterprises with
investment from Hong Kong, Macau, and Taiwan. Our sample does not include
nonindustrial enterprises, however, such as China Telecom, a big service sector ªrm.
It is entirely possible that the enterprises not included in our sample have worse
performance records than the enterprises in the NBS sample. If that is the case, the
NPD ratios for the entire Chinese enterprise sector would be higher than the ratios
reported in this study. Also, if the banking institutions in China are performing
worse than the enterprises in the NBS sample, as a consequence of their own weak
governance, the overall NPL situation of the Chinese economy as a whole would be
worse than that for the sample enterprises used in this study. In addition, we cannot
directly compare the NPL ratios reported by the CBRC with the NPD ratios estimated
in our study because they are deªned differently. The NPD ratios here are designed
to examine the trend and the cross-sectional patterns of the quality of Chinese
enterprise debts.
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During the period from 1995 to 2002, the sample enterprises created about 16–25
percent of China’s industrial employment and 33–43 percent of China’s industrial
value added (see table A.6). Most signiªcantly, the sample enterprises contributed
about 14–19 percent of China’s GDP. Their total liabilities, one of the key variables
we examine in this paper, amount to about 43–65 percent of China’s total banking
loans during the 1995–2002 period. Of course, not all of the total liabilities in the
sample enterprises correspond to loans from banks. But even assuming that 60 percent
of the total liabilities in the sample are related to various bank loans, the statistical
analysis in the paper provides an in-depth study of the quality of about 27–29
percent of China’s total loans. In summary, although the members of the sample enterprises
group are changing each year, as a whole they form a stable club of China’s
elite industrial enterprises. The performance of this elite group of enterprises is
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Nonperforming Debts in Chinese Enterprises
much more representative of the performance of China’s industrial economy than,
for example, the performance of China’s listed companies or any small sample of
Chinese enterprises. Given the growing importance of China’s industrial sector for
both the domestic and global economy, our analysis in this paper ªlls a crucial gap
in understanding the dynamics of China’s industrial reform and development.
Tables 1, 2, and 3 show the distribution of the total liabilities for the sample enterprises
by ownership, industry, and region. The objective is to ªnd out how much of
these debts are located in proªt-making and loss-making enterprises and then calculate
the amounts and ratios of the NPD. There are two underlying forces affecting
the NPD ratios: the shifting distribution of debts across enterprise groups with different
proªtability and the changing proªtability of each group.
Table 1 shows the distribution of total liabilities (or total debts) across ownership
types. The share of total debts by SOEs fell sharply, from 76.4 percent in 1995 to 48.2
percent in 2002, to the beneªt of domestic mixed-ownership corporations and private
enterprises. The total debt for SOEs increased from RMB2.5 trillion in 1995 to
RMB3.2 trillion in 1998, immediately before the Asian ªnancial crisis, and then fell
to RMB2.8 trillion in 2002. The total debt for collectives followed the same pattern as
that for SOEs, rising from RMB227 billion in 1995 to RMB287 billion in 1998 and
then falling to RMB219 billion in 2002. The shifting of debt toward private, mixed,
foreign, or overseas Chinese enterprises was steady and rapid throughout the 1995–
2002 period, without any interruption resulting from the Asian ªnancial crisis in
1998–99. For the 8 years from 1995 to 2002, total debt in the sample enterprises increased
by RMB2,436 billion. Of this net increase, RMB246 billion ended up in the
SOEs, RMB1,411 billion went to mixed-ownership enterprises, RMB467 billion to
foreign enterprises, and RMB95 billion to private enterprises. The drastic changes in
the distribution of total debt are strong evidence of the rapid but quiet privatization
and opening up of the most dynamic part of China’s industrial sector. In the next
section, we will show that the redistribution of total debt from SOEs toward the
better-performing NSEs contributed to the larger part of the observed fall in average
NPD ratios for the sample enterprises.
How were ªnancial resources allocated among the Chinese industrial enterprises
during 1995–2002, which can be characterized as a period of high growth and steady
reform? Which industries and regions were getting more ªnancial resources for their
elite industrial enterprises? Tables 2 and 3 provide the answer. The two tables give
us detailed information about credit allocation among China’s large and mediumsized
industrial enterprises and illustrate the changing landscape of Chinese enterprise
ªnancing. In tables 2 and 3 the total debt for each industry or region are sorted
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Table 1. Distribution of total liabilities by ownership, 1995–2002 (RMB billion)
Change in total
liabilities during
1995–2002 as percentage
of total in 1996
Change in total
liabilities during
1995–2002
1995 1996 1997 1998 1999 2000 2001 2002
Amount of debt for
Private 0 1 2 11 18 31 61 95 95 9,500.0%
Collective 227 268 285 287 284 254 221 219 8 3.0%
Mixed 231 279 380 514 690 1,033 1,424 1,642 1,411 505.7%
Foreign 152 232 285 329 371 400 561 619 467 201.3%
Hong Kong, Macau, and Taiwan 164 190 214 276 297 305 359 389 225 118.4%
State-owned 2,512 2,737 3,035 3,193 3,145 2,940 2,703 2,758 246 9.0%
Total 3,286 3,707 4,201 4,610 4,805 4,963 5,329 5,722 2,436 65.7%
Share of debt for
Private 0.0% 0.0% 0.0% 0.2% 0.4% 0.6% 1.1% 1.7% 1.7%
Collective 6.9% 7.2% 6.8% 6.2% 5.9% 5.1% 4.1% 3.8% 3.1%
Mixed 7.0% 7.5% 9.0% 11.1% 14.4% 20.8% 26.7% 28.7% 21.7%
Foreign 4.6% 6.3% 6.8% 7.1% 7.7% 8.1% 10.5% 10.8% 6.2%
Hong Kong, Macau, and Taiwan 5.0% 5.1% 5.1% 6.0% 6.2% 6.1% 6.7% 6.8% 1.8%
State-owned 76.4% 73.8% 72.2% 69.3% 65.5% 59.2% 50.7% 48.2% 28.2%
Total 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
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by their amount in 2002, to make it easy to look for the winners and losers. The last
two columns show the amount of change and the growth rate for total debts during
the 1995–2002 period.
As shown in table 2, the top ªve industries in 2002, ranked by the level of their total
debts, were electric power, steam and hot water; transport equipment manufacturing;
smelting and pressing of ferrous metals; electronic and telecommunications
equipment; and raw chemical materials and chemicals. The top ªve industries together
attracted RMB2.692 trillion in debt, or 47 percent of the total debt for the
whole sample. The net gains in debt for the top ªve industries during 1995–2002
amounted to RMB1.465 trillion, or 60 percent of the gains by the whole sample.
China’s ªnancial risks are heavily inºuenced by the performance of the above ªve
sectors.
From the last column of table 2, the top ªve industries ranked by the growth of their
total debts during 1995–2002 were tap water production and supply; electric power,
steam, and hot water; electronic and telecommunications equipment; papermaking
and paper products; and gas production and supply.
Clearly, the above leading industries, which have attracted investment in the last
decade, are largely related to industrial infrastructure, intermediate inputs, raw materials,
production equipment, and utilities. Rapid development of these industries
would lay a solid foundation for China’s further industrialization. In this sense,
China’s enterprise ªnance looks increasingly driven by market forces. Of course, a
risk-based regulation strategy would require extra attention to be paid to the sectors
with heavy concentrations of investment. As we will see in the next section, some of
the above sectors with rapid growth in enterprise debts do have high NPD ratios,
especially the SOE-dominated utilities sector.
From table 3 we see that the top ªve regions ranked by the level of their total enterprise
debts in 2002 are Guangdong, Jiangsu, Shandong, Shanghai, and Liaoning.
These regions are clearly becoming China’s new industrial centers. In section 5, we
will examine region-speciªc enterprise performance, which is relevant for assessing
debt risks across regions. Xiao (2005) examines enterprise performance in the northeast
region of China in detail, and Xiao and Tu (2005) study China’s industrial productivity
growth using the same set of data.
In the next section, we will show how much of the total debt shown in tables 1–3 is
located in loss-making enterprises. Proªtability of enterprises becomes the crucial
variable for our study. Reported proªts, however, present several problems. First, it
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Table 2. Distribution of total liabilities by industry, 1995–2002, by total liability in 2002 (RMB billion)
Change in total liabilities
during 1995–
2002 as percentage of
total in 1995
Change in total
liabilities during
1995–2002
1995 1996 1997 1998 1999 2000 2001 2002
[44] Electric power 296 317 361 521 614 719 802 934 638 215.5%
[37] Transport equipment 229 276 324 360 385 400 440 491 262 114.4%
[32] Pressing ferrous 331 356 396 416 440 407 417 443 112 33.8%
[41] Electronic and telecommunications 145 167 198 229 251 286 366 424 279 192.4%
[26] Raw chemicals 226 264 326 365 369 388 380 400 174 77.0%
[17] Textile 258 274 287 275 244 234 230 234 24 9.3%
[40] Electric equipment 136 164 185 195 194 195 218 226 90 66.2%
[35] Ordinary machinery 157 180 194 207 202 205 209 222 65 41.4%
[06] Coal mining 129 147 168 182 206 209 217 215 86 66.7%
[31] Nonmetal products 138 166 186 195 201 195 209 215 77 55.8%
[36] Special equipment 148 161 176 187 186 191 184 192 44 29.7%
[25] Petroleum processing 101 113 163 180 180 184 178 173 72 71.3%
[33] Pressing nonferrous 95 101 116 132 140 140 153 162 67 70.5%
[07] Petroleum extract 151 157 164 170 160 158 149 153 2 1.3%
[27] Medical 59 73 81 91 97 105 121 133 74 125.4%
[22] Papermaking 53 65 72 73 80 88 121 125 72 135.8%
[15] Beverage 73 83 99 103 108 111 111 114 41 56.2%
[13] Food processing 87 107 112 114 106 101 103 111 24 27.6%
[16] Tobacco 70 76 82 72 71 74 109 108 38 54.3%
[28] Chemical fiber 62 71 76 83 91 83 75 73 11 17.7%
[34] Metal products 46 53 59 62 63 59 65 68 22 47.8%
[14] Food production 37 41 42 46 48 48 56 65 28 75.7%
[30] Plastic 31 38 43 46 48 49 55 61 30 96.8%
[29] Rubber 36 43 48 50 51 49 52 51 15 41.7%
[46] Tap water 14 15 23 27 30 34 39 46 32 228.6%
[42] Instruments 29 32 37 34 35 34 40 40 11 37.9%
[18] Garments 18 23 24 26 29 33 38 39 21 116.7%
[10] Nonmetal mining 16 16 18 19 23 28 23 29 13 81.3%
[23] Printing 14 17 19 20 22 23 27 27 13 92.9%
[19] Leather 16 19 21 21 21 21 23 24 8 50.0%
[45] Gas production 10 13 13 16 18 20 19 23 13 130.0%
[12] Timber logging 19 20 22 23 22 22 22 22 3 15.8%
[20] Timber 10 12 16 16 18 19 21 22 12 120.0%
[09] Nonferrous mining 18 18 19 19 19 19 20 21 3 16.7%
[43] Other manufacturing 9 11 11 10 12 11 13 13 4 44.4%
[08] Ferrous mining 6 7 8 11 9 8 8 10 4 66.7%
[24] Cultural 5 8 8 9 9 9 8 10 5 100.0%
[21] Furniture 4 4 5 5 5 5 6 6 2 50.0%
Total 3,282 3,708 4,202 4,610 4,807 4,964 5,327 5,725 2,443 74.4%
Note: See appendix 2 for full industry names corresponding to industry codes.
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Table 3. Distribution of total liabilities by region, 1995–2002, by total liability in 2002, (RMB billion)
Change of total liabilities
during 1995–
2002 as percentage of
total in 1995
Change of total
liabilities during
1995–2002
1995 1996 1997 1998 1999 2000 2001 2002
[44] Guangdong 299 348 414 436 434 468 509 559 260 87.0%
[32] Jiangsu 226 269 300 320 328 369 456 503 277 122.6%
[37] Shandong 262 295 336 354 416 436 455 490 228 87.0%
[31] Shanghai 231 273 323 337 347 334 349 376 145 62.8%
[21] Liaoning 293 310 346 362 320 323 335 354 61 20.8%
[50] Sichuan Chongqing 183 199 233 240 319 295 303 325 142 77.6%
[13] Hebei 143 166 184 199 213 224 249 257 114 79.7%
[41] Henan 133 156 165 204 210 219 234 254 121 91.0%
[42] Hubei 135 164 182 217 219 233 229 253 118 87.4%
[23] Heilongjiang 149 149 167 190 183 191 189 195 46 30.9%
[33] Zhejiang 121 143 153 157 159 166 170 187 66 54.5%
[12] Tianjin 108 110 119 156 155 144 153 175 67 62.0%
[22] Jilin 115 136 153 155 159 170 163 173 58 50.4%
[11] Beijing 98 113 132 166 154 157 187 169 71 72.4%
[61] Shaanxi 78 89 99 101 134 133 142 156 78 100.0%
[35] Fujian 47 55 54 55 62 66 135 149 102 217.0%
[43] Hunan 78 86 99 112 119 124 140 149 71 91.0%
[34] Anhui 81 92 108 108 113 131 129 145 64 79.0%
[14] Shanxi 78 89 100 129 129 135 126 133 55 70.5%
[53] Yunnan 58 64 68 75 76 75 103 114 56 96.6%
[62] Gansu 54 59 79 93 83 84 88 94 40 74.1%
[45] Guangxi 60 62 71 80 85 90 89 90 30 50.0%
[36] Jiangxi 58 68 72 78 87 88 90 88 30 51.7%
[15] Inner Mongolia 51 55 63 71 78 72 83 87 36 70.6%
[54] Tibet Qinghai Ningxia 34 34 43 56 57 63 55 79 45 132.4%
[52] Guizhou 44 40 47 59 63 74 72 78 34 77.3%
[65] Xinjiang 58 68 75 79 79 80 80 78 20 34.5%
[46] Hainan 12 15 19 20 23 20 15 16 4 33.3%
Total 3,287 3,707 4,204 4,609 4,804 4,964 5,328 5,726 2,439 74.2%
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is difªcult to check the consistency of reported proªts with enterprises’ other
ªnancial variables because of China’s complicated accounting regulations. In other
words, we do not know how reported proªts are calculated from other ªnancial
variables reported in the NBS survey. Second, it is widely reported that enterprises
sometimes manage their proªt numbers for many purposes, including legal or illegal
tax evasion. For this paper, it seems useful to develop an alternative measure of
proªtability, one that is based on a consistent set of ªnancial variables available from
the NBS survey. Because the main purpose of the NBS survey is to calculate the
value-added of industrial enterprises, it is possible to develop a measure of an enterprise’s
proªtability or potential proªtability based on the reconstructed components
of its value-added.
We use the following variables available from the NBS survey to deªne the imputed
proªtability of the sample enterprises:
VA value-added, including value-added taxes and ªnancial changes
W wages and other employee compensation expenses
FC ªnancial charges, mainly interest payments
D current depreciations
T all tax payments, including those for value-added taxes
TA total assets
We can classify enterprises into eight proªtability groups:
[4]: if VA ≤ 0
[3]: if VA W ≤ 0 and VA 0
[2]: if VA W FC ≤ 0 and VA W 0
[1]: if VA W FC D ≤ 0 and VA W FC 0
[1]: if VA W FC D T ≤ 0 and VA W FC D 0
[2]: if VA W FC D T 0 and (VA W FC D T)/TA ≤ .05
[3]: if (VA W FC D T)/TA .05 and (VA W FC D T)/TA ≤ .15
[4]: if (VA W FC D T)/TA .15
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Table 4 shows the number of enterprises in each of the eight proªtability groups
over the period from 1995 to 2002. This imputed proªtability by group allows us to
separate the NPDs into more disaggregated groups according to the qualitative and
quantitative extent of loss making. Chinese banks are in the process of changing
from four loan classiªcation categories (normal, overdue, doubtful, and poor) to the
international standard of ªve categories (normal, special mention, substandard,
doubtful, and loss). Unlike the classiªcation of bank loans, the proªtability
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Table 4. Number of enterprises and share of total enterprises, by profitability, 1995–2002
Average
1995–2002
Profitability 1995 1996 1997 1998 1999 2000 2001 2002
[4]: if VA 0 867 1,006 969 901 569 458 450 602 728
[3]: if VA W 0 and VA 0 2,995 2,977 3,102 3,085 2,503 2,260 1,963 1,928 2,602
[2]: if VA W FC 0 and VA W 0 2,152 2,199 1,988 1,749 1,307 955 811 698 1,482
[1]: if VA W FC D 0 and VA W FC 0 1,815 1,757 1,839 1,943 1,841 1,684 1,740 1,724 1,793
[1]: if VA W FC D T 0 and VA W FC D 0 3,059 2,644 2,705 2,579 2,399 2,396 2,396 2,138 2,540
[2]: if VA W FC D T 0 and (VA W FC D T) /TA 0.05 5,095 5,106 5,336 5,284 5,292 5,129 5,225 4,985 5,182
[3]: if (VA W FC D T)/TA 0.05 and (VA W FC D T) /TA 0.15 4,371 4,327 4,297 4,253 4,490 4,579 5,208 5,365 4,611
[4]: if (VA W FC D T)/TA 0.15 2,189 2,958 2,721 2,499 3,062 3,277 4,105 4,780 3,199
Total 22,543 22,974 22,957 22,293 21,463 20,738 21,898 22,220 22,136
[4]: if VA 0 3.8% 4.4% 4.2% 4.0% 2.7% 2.2% 2.1% 2.7% 3.3%
[3]: if VA W 0 and VA 0 13.3% 13.0% 13.5% 13.8% 11.7% 10.9% 9.0% 8.7% 11.8%
[2]: if VA W FC 0 and VA W 0 9.5% 9.6% 8.7% 7.8% 6.1% 4.6% 3.7% 3.1% 6.7%
[1]: if VA W FC D 0 and VA W FC 0 8.1% 7.6% 8.0% 8.7% 8.6% 8.1% 7.9% 7.8% 8.1%
[1]: if VA W FC D T 0 and VA W FC D 0 13.6% 11.5% 11.8% 11.6% 11.2% 11.6% 10.9% 9.6% 11.5%
[2]: if VA W FC D T 0 and (VA W FC D T) /TA 0.05 22.6% 22.2% 23.2% 23.7% 24.7% 24.7% 23.9% 22.4% 23.4%
[3]: if (VA W FC D T) /TA 0.05 and (VA W FC D T) /TA 0.15 19.4% 18.8% 18.7% 19.1% 20.9% 22.1% 23.8% 24.1% 20.8%
[4]: if (VA W FC D T)/TA 0.15 9.7% 12.9% 11.9% 11.2% 14.3% 15.8% 18.7% 21.5% 14.5%
100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Note: VA value-added, including value-added taxes and financial changes; W wages and other employee compensation expenses; FC financial charges, mainly interest payments; D current depreciations;
T all tax payments including value-added taxes; TA total assets.
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classiªcation proposed here reveals the underlying economic conditions, for
example:
• Enterprises in proªtability group [4] create negative value-added. They should
be closed immediately according to economic principles. The quality of their
debts is the worst among the eight groups by proªtability.
• Enterprises in group [3] have positive value-added but cannot pay all of their
wage bills. In economics, they cannot even cover their variable costs. They should
also be closed as soon as possible to avoid incurring new losses. The quality of
their debts will worsen every day as the losses accumulate.
• Enterprises in group [2] can pay their wage bills but cannot pay all of their
ªnancial charges. The quality of their debts is poor, but because their investment
is sunk, such ªrms may have reasons to continue operations in the short run to
maintain employment while waiting for a turnaround after reorganization.
• Enterprises in group [1] can pay their wage bills and ªnancial charges but cannot
cover all of their depreciation charges. The quality of their debts will fall as
capital is depleted.
We will leave the more detailed analysis of NPDs based on the above proªtability
classiªcations for a separate paper. Here we focus on the big picture ªrst and classify
enterprises in the ªrst four groups as loss making and the last four groups as
proªt making, based on imputed proªtability.
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Table 5 shows the number of enterprises making proªts or losses based on both reported
and imputed proªts over the period from 1995 to 2002. The number of lossmaking
enterprises by imputed proªtability was stable at about 8,000 (34–35 percent)
during 1995–98 and fell rapidly afterward to 4,952 (22.3 percent) in 2002. The
number of loss-making enterprises by reported proªtability was 6,937 (30.8 percent)
in 1995 and rose sharply to 8,987 (40.3 percent) in 1998, then dropped to 6,295 (or
28.3 percent) in 2002. In the next section, we will use both imputed and reported
proªtability to estimate the amount and ratio of NPD. Although the two proªtability
measurements are different in concept and measurement, both are useful for
assessing the quality of enterprise debt. Imputed proªtability is more useful for
comparing enterprise performance across groups because it is based on a consistent
set of reported ªnancial variables, but it is different from actually reported
proªtability. Imputed proªts can be larger than reported proªts for several reasons.
First, when output is not sold or is still in inventory, some of the value-added might
not turn into actual proªts. Second, reported proªts are likely to be lower than imputed
proªts as a result of legal or illegal tax evasion or proªt hiding. In other re-
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Nonperforming Debts in Chinese Enterprises
Table 5. Number and share of enterprises making profits or losses, 1995–2002
1995 1996 1997 1998 1999 2000 2001 2002
Average
1995–2002
Based on imputed profits
Number of enterprises
Making profits 14,714 15,035 15,059 14,615 15,243 15,381 16,934 17,268 15,531
Making losses 7,829 7,939 7,898 7,678 6,220 5,357 4,964 4,952 6,605
Total 22,543 22,974 22,957 22,293 21,463 20,738 21,898 22,220 22,136
Share
Making profits 65.3% 65.4% 65.6% 65.6% 71.0% 74.2% 77.3% 77.7% 70.2%
Making losses 34.7% 34.6% 34.4% 34.4% 29.0% 25.8% 22.7% 22.3% 29.8%
Total 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Based on reported profits
Number of enterprises
Making profits 15,606 15,088 14,476 13,306 14,328 15,144 15,510 15,925 14,923
Making losses 6,937 7,886 8,481 8,987 7,135 5,594 6,388 6,295 7,213
Total 22,543 22,974 22,957 22,293 21,463 20,738 21,898 22,220 22,136
Share
Making profits 69.2% 65.7% 63.1% 59.7% 66.8% 73.0% 70.8% 71.7% 67.4%
Making losses 30.8% 34.3% 36.9% 40.3% 33.2% 27.0% 29.2% 28.3% 32.6%
Total 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
lated papers (Liu and Xiao 2004; Cai, Liu, and Xiao 2005), we examine the issue of
proªt disguising in detail.
3. Estimated level and ratio of NPD
Using the method developed in section 2, we report the main NPD statistics for the
whole sample as well as for groups classiªed by ownership, industry, and region.
Table 6 shows the amount of NPD as well as the NPD ratio for the whole sample
during the 1995–2002 period. There are two sets of NPD statistics in the table: the
upper part is derived from imputed proªts and the lower part from reported proªts.
The amount and ratio of NPD are calculated separately for three categories of debts:
total liabilities, long-term liabilities, and short-term liabilities. They are similar in
size and trend, with the NPD ratio for short-term liabilities declining slightly faster
than the ratio for long-term liabilities.
According to imputed proªtability, the NPD ratio for the whole sample was stable at
around 27–30 percent during 1995–99 but declined rapidly afterward to only 18.4
percent in 2002, with the amount of NPD at about RMB1 trillion.
According to reported proªtability, the NPD ratio for the whole sample was 24.1
percent in 1995, rising to 34.3 percent in 1998 and then falling to 22.9 percent in 2002,
with the amount of NPDs at about RMB1.3 trillion. According to the CBRC, China’s
NPL ratio fell sharply to 19.6 percent, with the amount of NPLs at RMB2.5 trillion
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Table 6. Amount of nonperforming debt and nonperforming debt ratio for whole sample, 1995–2002
Change in
1998–2002
Change in
1995–2002
1995 1996 1997 1998 1999 2000 2001 2002
Based on imputed profits
Amount of nonperforming debt (RMB billion)
Within total liabilities 914 1,095 1,204 1,371 1,315 1,128 1,091 1,051 137 320
Within long-term liabilities 308 370 389 470 472 395 365 343 35 127
Within short-term liabilities 605 724 812 895 836 727 716 709 104 186
Nonperforming debt ratio (percent)
Within total liabilities 27.8 29.5 28.7 29.7 27.4 22.7 20.5 18.4 9.5 11.4
Within long-term liabilities 26.6 29.5 28.2 30.3 29.2 24.2 21.9 19.9 6.7 10.4
Within short-term liabilities 28.5 29.6 29.1 29.5 26.5 22.2 19.8 17.9 10.6 11.6
Based on reported profits
Amount of nonperforming debt (RMB billion)
Within total liabilities 792 1,002 1,167 1,580 1,427 1,185 1,392 1,311 519 269
Within long-term liabilities 282 327 368 556 504 411 441 408 126 148
Within short-term liabilities 509 674 793 1,014 916 759 930 891 382 123
Nonperforming debt ratio (percent)
Within total liabilities 24.1 27.0 27.8 34.3 29.7 23.9 26.1 22.9 1.2 11.4
Within long-term liabilities 24.4 26.1 26.7 35.9 31.1 25.1 26.5 23.7 0.7 12.3
Within short-term liabilities 24.0 27.5 28.4 33.4 29.0 23.2 25.8 22.5 1.5 11.0
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Nonperforming Debts in Chinese Enterprises
Table 7. Amount of nonperforming debt and nonperforming debt ratio, estimated from
imputed profitability, by ownership, 1995–2002
1995 1996 1997 1998 1999 2000 2001 2002
Amount of nonperforming debt estimated
from imputed profitability (RMB billion)
Private 0 0 0 2 2 4 5 7
Collective 53 55 60 50 47 32 25 22
Mixed 39 63 90 107 165 191 207 178
Foreign 36 69 77 94 74 63 98 94
Hong Kong, Macau, and Taiwan 26 32 37 68 54 53 53 49
State-owned 761 876 938 1,049 972 786 702 701
Total 915 1,095 1,202 1,370 1,314 1,129 1,090 1,051
Nonperforming ratio estimated from
imputed profitability (percent)
Private 0.0 0.0 0.0 18.2 11.8 12.9 8.2 7.4
Collective 23.3 20.6 21.1 17.4 16.5 12.6 11.3 10.0
Mixed 16.9 22.5 23.7 20.8 23.9 18.5 14.5 10.8
Foreign 23.7 29.7 27.0 28.7 20.0 15.8 17.5 15.2
Hong Kong, Macau, and Taiwan 15.9 16.8 17.3 24.6 18.2 17.4 14.8 12.6
State-owned 30.3 32.0 30.9 32.9 30.9 26.7 26.0 25.4
Total 27.8 29.5 28.6 29.7 27.4 22.7 20.5 18.4
Share of nonperforming debt estimated
from imputed profitability (percent)
Private 0.0 0.0 0.0 0.1 0.2 0.4 0.5 0.7
Collective 5.8 5.0 5.0 3.6 3.6 2.8 2.3 2.1
Mixed 4.3 5.8 7.5 7.8 12.6 16.9 19.0 16.9
Foreign 3.9 6.3 6.4 6.9 5.6 5.6 9.0 8.9
Hong Kong, Macau, and Taiwan 2.8 2.9 3.1 5.0 4.1 4.7 4.9 4.7
State-owned 83.2 80.0 78.0 76.6 74.0 69.6 64.4 66.7
Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0
by the middle of 2003. Given the different deªnitions of NPL and NPD, the results
for the NPD statistics look consistent with the CBRC statistics for NPLs. In the next
section, we will further examine the trend of NPD ratios for the whole sample.
We compare the NPD statistics for different types of enterprises by ownership,
where NPD is derived from both imputed proªtability (table 7) and reported
proªtability (table 8). These tables show that NPD ratios vary signiªcantly across
types of enterprises by ownership and that SOEs have much higher NPD ratios than
NSEs. In 2002, the NPD ratio for SOEs was 25.4 percent by imputed proªtability and
25.8 percent by reported proªtability. The NPD ratio for private enterprises was 7.4
percent by imputed proªtability and 15.8 percent by reported proªtability. The NPD
ratio for domestic mixed-ownership enterprises was 10.8 percent by imputed
proªtability and 20.2 percent by reported proªtability.
From the NPD statistics in tables 7 and 8, it is possible to decompose the fall of the
average NPD ratio for the whole sample into two parts: one resulting from improvement
in NPD ratios in each type of enterprise and the other resulting from the redistribution
of debts from SOEs to the better-performing NSEs.
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Table 8. Amount of nonperforming debt and nonperforming debt ratio, estimated from
reported profitability, by ownership 1995–2002
1995 1996 1997 1998 1999 2000 2001 2002
Amount of nonperforming debt estimated
from reported profitability (RMB billion)
Private 0 0 0 4 4 7 12 15
Collective 53 67 74 84 69 52 48 42
Mixed 28 37 69 136 172 214 296 332
Foreign 44 82 102 136 107 98 177 139
Hong Kong, Macau, and Taiwan 29 45 52 89 74 63 77 71
State-owned 638 770 869 1,131 999 752 782 712
Total 792 1,001 1,166 1,580 1,425 1,186 1,392 1,311
Nonperforming debt ratio estimated from
reported profitability (percent)
Private 0.0 0.0 0.0 36.4 23.5 22.6 19.4 15.8
Collective 23.3 25.0 26.1 29.3 24.3 20.5 21.7 19.2
Mixed 12.2 13.3 18.2 26.5 24.9 20.7 20.8 20.2
Foreign 28.9 35.3 35.8 41.3 28.9 24.5 31.6 22.4
Hong Kong, Macau, and Taiwan 17.7 23.7 24.3 32.4 24.9 20.7 21.4 18.2
State-owned 25.4 28.1 28.6 35.4 31.8 25.6 28.9 25.8
Total 24.1 27.0 27.8 34.3 29.7 23.9 26.1 22.9
Share of nonperforming debt estimated
from reported profitability (percent)
Private 0.0 0.0 0.0 0.3 0.3 0.6 0.9 1.1
Collective 6.7 6.7 6.3 5.3 4.8 4.4 3.4 3.2
Mixed 3.5 3.7 5.9 8.6 12.1 18.0 21.3 25.3
Foreign 5.6 8.2 8.7 8.6 7.5 8.3 12.7 10.6
Hong Kong, Macau, and Taiwan 3.7 4.5 4.5 5.6 5.2 5.3 5.5 5.4
State-owned 80.6 76.9 74.5 71.6 70.1 63.4 56.2 54.3
Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0
Let us assume that R i t is the NPD ratio in year t for enterprise group i and S i t is the
share of debts for group i in year t. Then the NPD ratio for the whole sample in year
t can be calculated from the following formula:
2002 1995 2002 1995
NPD ratio Σ i
05 . ∗ ( R i
+ R i
) ∗( S i
− S i
) +
2002 1995 2002 1995
NPD ratio Σ 05 . ∗Σ
( R − R ) ∗ ( S + S ),
i i i i i i
where i private enterprises, collective enterprises, mixed enterprises, foreign enterprises,
Hong Kong, Macau, or Taiwanese enterprises (HK-M-Taiwan), or SOEs.
The change in NPD for the whole sample from 1995 to 2002 can be presented equivalently
in the following formats:
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R 2002 R 1995 2002 2002 1995 1995
ΣiRi ∗Si − ΣiRi ∗Si
R 2002 R 1995 2002 1995 2002 1995
Σ i
05 . ∗ ( R i
+ R i
) ∗( S i
− S i
) +
R 2002 R 1995 2002 1995 1995 2002
Σ i
05 . ∗( R i
− R i
) ∗ ( S i
+ S i
).
The ªrst term in the above equation is the ªrst component of the change in the NPD
ratio for the whole sample during 1995–2002 that can be attributed to the shift of the
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Nonperforming Debts in Chinese Enterprises
total liabilities across ownership groups while holding the individual ownership
group’s NPD ratio at its average level for 1995 and 2002. Using statistics from tables
1, 7, and 8, this ªrst component is 3.86 percent for the imputed-proªtability
method and 2.33 percent for the reported-proªtability method.
The second term in the NPD equation is the component of change in the NPD ratio
for the whole sample during 1995–2002 that can be attributed to the fall in individual
ownership groups’ NPD ratio while holding constant the distribution of total liabilities
across ownership groups at its average level for 1995 and 2002. This second
component is 4.74 percent for the imputed-proªtability method and 1.13 percent
for the reported-proªtability method.
Hence, according to the imputed-proªtability method, the NPD ratio for the whole
sample fell from 27.8 percent in 1995 to 18.4 percent in 2002, a drop of 9.4 percentage
points. Out of these 9.4 percentage points, 3.86 percentage points can be attributed
to the shift of ªnancial resources from SOEs to the better-performing NSEs, which
have lower NPD ratios than SOEs.
According to the reported-proªtability method, the NPD ratio for the whole sample
fell only slightly, from 24.1 percent in 1995 to 22.9 percent in 2002, a drop of only 1.2
percentage points. The decomposing of this 1.2 percentage points shows that the
shift of ªnancial resources from SOEs to the better-performing NSEs led to a 2.33-
percentage-point drop in the NPD ratio for the whole sample, whereas the changes
in the NPD ratios for individual ownership groups led to an increase of 1.13 percentage
points in the NPD ratio for the whole sample.
Clearly, the decline in the NPD ratio is more signiªcant according to the imputedproªtability
method, compared to the reported-proªtability method. As previously
noted, we are not clear how reported proªts are calculated because of large variations
in accounting and proªt-reporting practices across types of enterprises, but we
know exactly how imputed proªts are calculated from the ªnancial variables that
are used for measuring GDP. We think both measures are useful. The NPD statistics
derived from imputed proªtability can be used for comparing the underlying performance
of different groups of enterprises, and the NPD statistics from reported
proªtability better reºect the actual outcomes that creditors are going to face when
they deal with enterprises.
Tables 9–12 present NPD statistics by industry for 1995–2002. The results shown in
tables 9 and 10 are derived using imputed proªtability, and the results in tables 11
and 12 are derived from reported proªtability. Tables 13–16 present NPD statistics
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Table 9. Amount of nonperforming debt by industry, estimated from imputed profitability,
1995–2002, by nonperforming debt in 2002 (RMB billion)
1995 1996 1997 1998 1999 2000 2001 2002
[44] Electric power 52 86 80 143 188 169 174 177
[26] Raw chemicals 52 65 92 127 108 88 97 89
[06] Coal mining 63 76 77 81 112 102 67 77
[36] Special equipment 69 74 86 103 98 93 83 76
[37] Transport equipment 63 81 90 101 96 93 103 72
[41] Electronic and telecommunications 47 52 60 64 54 56 52 60
[31] Nonmetal products 42 56 72 65 59 49 48 51
[35] Ordinary machinery 52 71 74 81 74 65 62 51
[17] Textile 113 124 106 105 72 47 44 44
[40] Electric equipment 39 51 58 53 52 45 48 40
[22] Papermaking 13 13 22 28 21 19 25 27
[28] Chemical fiber 17 22 21 33 26 22 24 24
[32] Pressing ferrous 75 70 85 81 85 62 35 23
[27] Medical 13 20 19 20 15 11 13 19
[46] Tap water 7 7 12 9 10 12 13 19
[13] Food processing 32 42 41 42 32 21 17 18
[33] Pressing nonferrous 28 35 36 47 28 22 22 16
[42] Instruments 15 17 19 17 14 13 14 16
[14] Food production 13 13 16 14 11 8 12 14
[34] Metal products 16 19 23 27 22 18 13 14
[45] Gas production 9 12 11 10 10 13 13 14
[15] Beverage 11 12 13 14 12 13 9 13
[07] Petroleum extract 3 4 13 0 13 11 18 12
[25] Petroleum processing 3 9 7 15 18 8 17 10
[10] Nonmetal mining 7 5 7 7 6 6 7 9
[29] Rubber 9 9 9 11 18 9 9 9
[30] Plastic 12 12 14 16 14 10 7 9
[09] Nonferrous mining 5 6 6 9 6 5 6 7
[12] Timber logging 4 4 6 7 9 8 7 7
[20] Timber 5 4 6 8 7 6 5 6
[18] Garments 4 5 4 7 5 4 6 5
[23] Printing 4 4 6 5 6 6 6 5
[08] Ferrous mining 5 4 1 5 2 2 1 3
[19] Leather 6 5 5 7 4 5 3 3
[43] Other manufacturing 3 2 3 3 3 3 3 3
[24] Cultural 1 2 1 3 2 3 2 2
[16] Tobacco 1 1 1 3 1 2 3 1
[21] Furniture 2 1 1 1 2 2 2 1
Total 915 1,095 1,203 1,372 1,315 1,131 1,090 1,046
Note: See appendix 2 for full industry names corresponding to industry codes.
by region during 1995–2002. Tables 13 and 14 are derived from imputed proªtability,
and tables 15 and 16 are derived from reported proªtability. Tables 9–16 are sorted
by the results in the last column (for 2002) so that readers can easily see the best and
worst performers in the quality of enterprise debts by region.
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The information here shows the big picture on the quality of enterprise debts across
industry and region and can be used by policymakers, as well as by banks, investors,
and enterprises as a benchmark against which to check the performance of
their own debt portfolios. This information is a public good and contributes to more
scientiªc management of debt risks in China. Bankers from Shanghai and
Guangdong might want to know the NPD statistics in their regions. Ofªcials in
charge of utilities might want to know how bad that sector’s enterprise debts are
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Nonperforming Debts in Chinese Enterprises
Table 10. Nonperforming debt ratios by industry, estimated from imputed profitability,
1995–2002, by nonperforming debt ratio in 2002 (percent)
1995 1996 1997 1998 1999 2000 2001 2002
[45] Gas production 90.0 92.3 84.6 58.8 58.8 68.4 72.2 60.9
[46] Tap water 50.0 43.8 50.0 34.6 32.3 34.3 33.3 41.3
[36] Special equipment 46.3 46.0 48.9 55.1 52.7 48.9 45.1 39.6
[42] Instruments 51.7 53.1 51.4 50.0 40.0 38.2 35.0 39.0
[06] Coal mining 49.2 51.7 45.8 44.5 54.6 48.8 30.9 35.8
[09] Nonferrous mining 27.8 35.3 31.6 47.4 33.3 26.3 30.0 35.0
[28] Chemical fiber 27.4 31.0 28.0 39.8 28.9 26.5 32.0 32.9
[12] Timber logging 21.1 20.0 27.3 30.4 40.9 34.8 33.3 31.8
[10] Nonmetal mining 41.2 33.3 38.9 36.8 27.3 21.4 30.4 31.0
[08] Ferrous mining 83.3 57.1 12.5 45.5 25.0 22.2 12.5 30.0
[20] Timber 55.6 33.3 37.5 50.0 38.9 31.6 23.8 28.6
[31] Nonmetal products 30.4 33.7 38.7 33.3 29.5 25.1 23.0 23.8
[43] Other manufacturing 30.0 20.0 27.3 30.0 25.0 27.3 25.0 23.1
[35] Ordinary machinery 33.1 39.7 38.1 39.1 36.6 31.7 29.5 23.0
[26] Raw chemicals 23.0 24.6 28.3 34.8 29.3 22.7 25.5 22.3
[22] Papermaking 24.5 20.3 30.6 38.4 26.3 21.6 20.7 21.6
[14] Food production 35.1 31.7 38.1 29.8 22.9 16.7 21.1 21.5
[34] Metal products 34.8 35.8 39.0 43.5 34.9 30.5 20.0 20.6
[24] Cultural 20.0 25.0 12.5 33.3 22.2 33.3 25.0 20.0
[44] Electric power 17.6 27.1 22.2 27.4 30.6 23.5 21.7 19.0
[17] Textile 44.0 45.3 36.9 38.2 29.5 20.0 19.1 18.8
[23] Printing 28.6 25.0 31.6 25.0 26.1 26.1 22.2 18.5
[29] Rubber 25.0 21.4 18.8 22.0 35.3 18.4 17.3 18.0
[40] Electric equipment 28.5 31.1 31.4 27.2 26.8 23.1 22.0 17.7
[21] Furniture 50.0 25.0 20.0 20.0 40.0 40.0 33.3 16.7
[13] Food processing 36.4 39.3 36.6 36.5 30.2 20.8 16.5 16.2
[30] Plastic 38.7 31.6 32.6 34.8 29.2 20.4 12.7 15.0
[37] Transport equipment 27.5 29.3 27.7 28.1 24.9 23.3 23.4 14.7
[27] Medical 22.0 27.4 23.5 22.2 15.5 10.5 10.7 14.3
[41] Electronic and telecommunications 32.2 31.1 30.3 27.9 21.5 19.6 14.2 14.2
[18] Garments 23.5 21.7 16.7 25.9 16.7 12.5 16.2 13.2
[19] Leather 37.5 26.3 23.8 33.3 19.0 23.8 13.0 12.5
[15] Beverage 15.1 14.5 13.1 13.7 11.1 11.7 8.1 11.4
[33] Pressing nonferrous 29.5 34.7 30.8 35.6 20.0 15.7 14.4 9.9
[07] Petroleum extract 2.0 2.5 7.9 0.0 8.1 7.0 12.1 7.8
[25] Petroleum processing 3.0 7.9 4.3 8.3 10.0 4.3 9.6 5.8
[32] Pressing ferrous 22.7 19.7 21.5 19.5 19.3 15.2 8.4 5.2
[16] Tobacco 1.4 1.3 1.2 4.2 1.4 2.7 2.8 0.9
Total 27.9 29.6 28.6 29.8 27.4 22.8 20.5 18.3
Note: See appendix 2 for full industry names corresponding to industry codes.
compared with those of other industries. These patterns of NPD ratios at the aggregate
levels by ownership, industry and region are useful for illustrating the overall
quality and distribution of enterprise debts in China as well as for contributing to
informed policy debates.
4. Patterns of NPDs
By applying a simple regression method to the disaggregated NPD ratios, we can
summarize the variability in NPD ratios for two relevant dimensions: one is the declining
trend in NPD ratios and the other is the gap in NPD ratios across ownership
type, industry, and region. Tables 17–19 show the results of six regressions using the
group NPD ratios reported in tables 7 and 8, 9 and 11, and 13 and 15, respectively. In
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Table 11. Amount of nonperforming debt by industry, estimated from reported profitability,
1995–2002, by nonperforming debt in 2002 (RMB billion)
1995 1996 1997 1998 1999 2000 2001 2002
[44] Electric power 83 39 76 119 161 147 173 183
[26] Raw chemicals 39 51 103 174 158 123 134 140
[37] Transport equipment 57 68 89 106 114 117 108 117
[25] Petroleum processing 4 22 16 76 39 86 98 76
[41] Electronic and telecommunications 31 41 53 60 54 35 59 73
[31] Nonmetal products 43 64 83 88 74 54 70 72
[17] Textile 104 135 128 135 88 51 74 69
[35] Ordinary machinery 36 52 58 72 64 59 68 65
[36] Special equipment 50 57 68 88 81 76 86 65
[40] Electric equipment 30 41 52 61 52 42 62 45
[28] Chemical fiber 11 20 16 34 27 17 32 32
[33] Pressing nonferrous 18 35 35 68 46 21 33 32
[13] Food processing 29 52 53 68 51 28 29 31
[22] Papermaking 13 17 26 32 27 23 40 30
[15] Beverage 18 21 22 29 27 25 27 29
[32] Pressing ferrous 45 61 69 68 81 41 43 25
[06] Coal mining 29 33 31 79 99 78 67 23
[27] Medical 12 17 24 23 15 14 17 20
[34] Metal products 15 21 26 30 27 21 19 19
[14] Food production 12 15 17 18 13 12 17 18
[30] Plastic 11 12 14 17 14 13 13 15
[46] Tap water 4 5 10 12 9 9 11 15
[16] Tobacco 5 6 7 6 5 8 25 14
[42] Instruments 10 12 15 17 14 9 11 13
[10] Nonmetal mining 7 6 6 7 6 7 5 11
[29] Rubber 11 11 10 13 19 18 15 11
[45] Gas production 4 10 9 8 8 10 8 10
[07] Petroleum extract 28 40 6 22 7 2 3 9
[18] Garments 3 5 7 8 6 5 9 8
[20] Timber 4 5 7 8 7 6 8 8
[19] Leather 5 6 6 6 5 5 5 7
[09] Nonferrous mining 7 8 6 9 6 3 5 6
[12] Timber logging 3 5 8 7 7 8 7 6
[23] Printing 3 3 5 5 4 3 4 4
[08] Ferrous mining 5 3 2 2 3 3 2 3
[43] Other manufacturing 2 3 3 3 4 3 3 3
[21] Furniture 1 1 2 1 1 1 2 1
[24] Cultural 1 1 1 2 1 1 1 1
Total 793 1,004 1,169 1,581 1,424 1,184 1,393 1,309
Note: See appendix 2 for full industry names corresponding to industry codes.
each of the six regressions, the independent variables include a time trend (year)
and a categorical variable (ownership, industry, or region). Each categorical variable
has the “whole sample” dummy to match the NPD ratio for the whole sample. The
regression equations can be written as
NPD ratio f (year, categorical variable).
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We use weighted regressions to discount the impact of the NPD ratios in the early
years. (The weights used are listed in the footnotes of tables 17, 18, and 19.) The regression
coefªcients for the time trend variable (year) indicate how fast the NPD ratio
would fall every year based on the variability of the NPD ratios reported for each
group in the relevant tables. In principle, the declining trend of NPD ratios for all
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Nonperforming Debts in Chinese Enterprises
Table 12. Nonperforming debt ratios by industry, estimated from reported profitability,
1995–2002, by nonperforming debt ratio in 2002 (percent)
1995 1996 1997 1998 1999 2000 2001 2002
[25] Petroleum processing 4.0 19.3 9.8 42.2 21.7 46.7 54.7 43.9
[28] Chemical fiber 17.7 28.2 21.1 41.0 29.7 20.5 42.1 43.8
[45] Gas production 40.0 76.9 69.2 50.0 44.4 50.0 44.4 41.7
[10] Nonmetal mining 43.8 37.5 33.3 35.0 27.3 25.9 21.7 37.9
[20] Timber 40.0 41.7 43.8 50.0 41.2 31.6 38.1 36.4
[26] Raw chemicals 17.3 19.3 31.6 47.7 42.8 31.7 35.3 34.9
[36] Special equipment 33.8 35.6 38.6 47.1 43.5 39.8 46.7 33.9
[31] Nonmetal products 31.2 38.3 44.9 45.4 37.0 27.7 33.5 33.6
[46] Tap water 26.7 31.3 43.5 44.4 29.0 26.5 28.2 32.6
[42] Instruments 34.5 37.5 40.5 51.5 40.0 26.5 27.5 31.7
[08] Ferrous mining 71.4 37.5 25.0 18.2 33.3 37.5 25.0 30.0
[17] Textile 40.3 49.3 44.6 49.1 35.9 21.8 32.0 29.5
[35] Ordinary machinery 22.8 28.9 29.9 34.8 31.7 28.8 32.5 29.4
[19] Leather 31.3 31.6 28.6 28.6 23.8 22.7 21.7 29.2
[09] Nonferrous mining 38.9 47.1 31.6 47.4 33.3 15.8 25.0 28.6
[34] Metal products 31.9 38.9 44.1 48.4 42.9 35.6 29.2 28.4
[13] Food processing 33.3 48.6 47.7 59.1 48.1 28.0 28.2 27.9
[14] Food production 32.4 36.6 40.5 39.1 27.1 24.5 30.4 27.7
[12] Timber logging 15.8 25.0 36.4 30.4 31.8 34.8 31.8 26.1
[15] Beverage 24.7 25.3 22.2 28.4 25.2 22.5 24.5 25.4
[30] Plastic 35.5 31.6 32.6 37.0 29.2 26.5 23.6 24.6
[22] Papermaking 24.5 26.2 36.1 43.8 33.8 26.4 33.1 24.0
[37] Transport equipment 24.9 24.6 27.4 29.4 29.6 29.2 24.5 23.8
[29] Rubber 30.6 25.6 20.8 25.5 37.3 36.7 28.8 21.6
[43] Other manufacturing 22.2 27.3 27.3 33.3 33.3 27.3 23.1 21.4
[18] Garments 17.6 21.7 29.2 29.6 20.7 15.2 23.7 20.5
[40] Electric equipment 22.1 25.0 28.1 31.3 26.8 21.5 28.4 19.9
[33] Pressing nonferrous 18.9 34.7 30.2 51.5 32.9 15.1 21.4 19.8
[44] Electric power 28.0 12.3 21.1 22.8 26.2 20.5 21.6 19.6
[41] Electronic and telecommunications 21.4 24.6 26.6 26.2 21.5 12.2 16.1 17.2
[21] Furniture 25.0 33.3 40.0 20.0 20.0 20.0 33.3 16.7
[27] Medical 20.3 23.6 29.3 25.3 15.5 13.3 14.0 15.0
[23] Printing 21.4 17.6 25.0 23.8 18.2 13.0 14.8 14.8
[16] Tobacco 7.0 7.9 8.5 8.3 7.0 10.8 22.9 13.0
[24] Cultural 16.7 12.5 12.5 22.2 11.1 11.1 12.5 11.1
[06] Coal mining 22.5 22.3 18.5 43.4 48.1 37.3 30.9 10.7
[07] Petroleum extract 18.5 25.5 3.7 12.9 4.4 1.3 2.0 5.9
[32] Pressing ferrous 13.6 17.1 17.5 16.3 18.4 10.1 10.3 5.6
Total 24.1 27.1 27.8 34.3 29.6 23.9 26.1 22.9
Note: See appendix 2 for full industry names corresponding to industry codes.
the groups is related to the improvement of the general market environment of the
Chinese economy as a result of reform and opening. The regression coefªcients for
the categorical variable indicate the average gap between the NPD ratio of that particular
category and the NPD ratio of the base category (which is indicated by a zero
value for the coefªcient and a blank value for the t-statistics in the tables) after removing
the inºuence of the declining trend in NPD ratio. The negative sign means
“lower than” the NPD ratio of the base category.
For example, table 17 shows that based on the NPD ratios estimated from imputed
proªtability (reported in table 7), the NPD ratio for a particular group is likely to decline
on average by 1.5 percentage points each year. For private enterprises, NPD ratios
in a given year are likely to be 21.3 percentage points lower than those for SOEs
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Table 13. Amount of nonperforming debt by region, estimated from imputed profitability,
1995–2002, by nonperforming debt in 2002 (RMB billion)
1995 1996 1997 1998 1999 2000 2001 2002
[31] Shanghai 70 94 95 98 92 78 69 81
[44] Guangdong 64 90 113 131 106 90 86 80
[41] Henan 23 39 37 63 61 64 69 72
[23] Heilongjiang 60 58 56 69 71 62 56 58
[21] Liaoning 105 117 115 110 87 63 75 57
[50] Sichuan Chongqing 71 71 109 88 127 124 104 57
[12] Tianjin 52 32 38 61 53 24 39 56
[42] Hubei 27 53 39 36 34 36 35 46
[13] Hebei 33 45 41 42 47 45 49 45
[37] Shandong 47 48 50 64 69 58 44 45
[11] Beijing 27 45 67 99 68 64 55 42
[22] Jilin 36 35 38 39 35 32 39 41
[32] Jiangsu 39 49 57 57 59 51 49 40
[61] Shaanxi 37 49 49 46 48 38 46 38
[14] Shanxi 24 33 29 50 44 33 24 35
[54] Tibet Qinghai Ningxia 12 18 23 18 14 11 11 34
[43] Hunan 29 28 33 37 35 34 30 32
[52] Guizhou 16 15 15 28 25 28 26 31
[34] Anhui 26 27 26 35 31 44 14 23
[45] Guangxi 18 18 23 20 21 17 16 22
[15] Inner Mongolia 17 16 14 27 46 25 34 21
[53] Yunnan 9 11 20 24 23 17 20 21
[35] Fujian 7 10 11 11 6 8 34 20
[62] Gansu 12 22 29 30 28 26 15 15
[36] Jiangxi 20 26 29 30 32 19 18 12
[33] Zhejiang 19 25 24 37 25 18 17 11
[65] Xinjiang 9 13 14 16 21 17 15 11
[46] Hainan 4 7 9 5 8 2 4 3
Total 913 1,094 1,203 1,371 1,316 1,128 1,093 1,049
Table 14. Nonperforming debt ratios by region, estimated from imputed profitability, 1995–
2002, by nonperforming debt ratio in 2002 (percent)
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1995 1996 1997 1998 1999 2000 2001 2002
[54] Tibet Qinghai Ningxia 35.3 52.9 53.5 31.6 24.6 17.7 20.0 42.5
[52] Guizhou 36.4 37.5 31.9 47.5 39.7 37.8 36.1 40.3
[12] Tianjin 48.1 29.4 32.2 39.1 34.2 16.6 25.5 32.0
[23] Heilongjiang 40.0 38.9 33.7 36.3 38.8 32.6 29.5 29.7
[41] Henan 17.3 25.0 22.3 30.9 29.0 29.2 29.5 28.3
[14] Shanxi 30.4 37.1 29.0 38.5 34.1 24.4 19.0 26.5
[11] Beijing 27.6 39.8 51.1 59.6 44.2 40.8 29.6 24.9
[45] Guangxi 30.5 29.5 32.9 24.7 24.7 18.9 18.0 24.4
[61] Shaanxi 47.4 55.7 50.0 45.1 35.8 28.6 32.4 24.2
[15] Inner Mongolia 33.3 28.6 22.2 38.6 59.0 34.7 41.0 24.1
[22] Jilin 31.3 25.5 24.8 25.2 22.0 18.8 23.9 23.7
[31] Shanghai 30.3 34.3 29.4 29.1 26.5 23.4 19.8 21.6
[43] Hunan 36.7 32.6 33.3 33.0 29.4 27.4 21.3 21.5
[46] Hainan 33.3 43.8 50.0 25.0 34.8 10.5 25.0 18.8
[53] Yunnan 15.5 17.5 29.4 32.4 30.3 22.7 19.2 18.4
[42] Hubei 20.0 32.3 21.4 16.7 15.5 15.5 15.3 18.2
[13] Hebei 23.1 27.1 22.2 21.1 22.1 20.0 19.7 17.6
[50] Sichuan Chongqing 38.8 35.7 46.8 36.7 39.8 42.0 34.3 17.5
[21] Liaoning 35.8 37.7 33.3 30.5 27.2 19.5 22.3 16.1
[34] Anhui 32.1 29.7 24.1 32.4 27.4 33.8 10.9 16.0
[62] Gansu 22.2 37.3 37.2 32.6 33.3 31.0 16.9 16.0
[44] Guangdong 21.4 25.9 27.3 30.0 24.4 19.3 16.9 14.3
[65] Xinjiang 15.8 19.1 18.9 20.3 26.3 21.3 18.5 13.9
[36] Jiangxi 34.5 38.2 40.3 38.5 36.8 21.3 20.0 13.6
[35] Fujian 14.9 18.2 20.0 20.0 9.7 12.1 25.2 13.3
[37] Shandong 17.9 16.3 14.8 18.1 16.6 13.3 9.7 9.2
[32] Jiangsu 17.3 18.2 19.1 17.8 18.0 13.8 10.7 8.0
[33] Zhejiang 15.8 17.5 15.7 23.6 15.6 10.8 10.0 5.9
Total 27.8 29.5 28.7 29.8 27.4 22.7 20.5 18.3
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Table 15. Amount of nonperforming debt by region, estimated from reported profitability,
1995–2002, by nonperforming debt in 2002 (RMB billion)
1995 1996 1997 1998 1999 2000 2001 2002
[21] Liaoning 89 87 95 117 77 46 94 114
[44] Guangdong 68 121 137 170 151 118 131 111
[50] Sichuan Chongqing 61 60 71 94 129 101 91 88
[32] Jiangsu 41 54 63 83 74 64 96 73
[31] Shanghai 34 50 63 82 72 47 63 69
[12] Tianjin 28 33 41 66 55 57 55 67
[37] Shandong 46 45 51 68 67 56 72 63
[22] Jilin 35 42 64 78 57 46 52 62
[42] Hubei 33 54 60 77 73 79 65 62
[23] Heilongjiang 47 59 58 104 69 74 74 56
[43] Hunan 24 31 45 54 37 48 41 55
[13] Hebei 28 30 40 54 47 48 64 53
[61] Shaanxi 31 34 38 49 53 46 48 45
[41] Henan 34 44 45 51 51 55 69 43
[62] Gansu 16 16 17 41 36 11 31 40
[35] Fujian 9 10 8 11 9 10 38 36
[36] Jiangxi 19 24 26 35 36 32 32 31
[54] Tibet Qinghai Ningxia 14 17 21 26 21 25 10 30
[45] Guangxi 14 27 31 35 30 23 25 29
[14] Shanxi 15 20 24 54 53 38 35 28
[15] Inner Mongolia 18 16 16 30 36 24 30 28
[34] Anhui 21 22 25 52 49 25 33 26
[53] Yunnan 8 9 15 21 25 19 24 26
[65] Xinjiang 10 36 16 21 25 22 28 26
[11] Beijing 11 18 37 40 39 37 51 22
[33] Zhejiang 19 22 28 38 26 20 23 14
[52] Guizhou 15 13 20 18 16 11 11 11
[46] Hainan 4 8 11 8 12 4 6 4
Total 792 1,002 1,166 1,577 1,425 1,186 1,392 1,312
Table 16. Nonperforming debt ratios by region, estimated from reported profitability, 1995–
2002, by nonperforming debt ratio in 2002 (percent)
1995 1996 1997 1998 1999 2000 2001 2002
[62] Gansu 29.1 27.1 21.5 44.6 42.9 13.1 35.2 43.0
[12] Tianjin 25.9 30.0 34.5 42.6 35.5 39.6 35.9 38.5
[54] Tibet Qinghai Ningxia 41.2 50.0 48.8 45.6 36.8 39.7 18.2 38.0
[43] Hunan 30.8 36.0 45.5 48.6 31.1 38.7 29.1 37.2
[22] Jilin 30.2 30.7 41.8 50.3 35.8 27.1 31.9 35.8
[36] Jiangxi 32.8 35.3 36.1 44.3 41.4 36.0 35.6 35.2
[65] Xinjiang 17.5 52.2 21.3 26.9 31.6 27.5 35.0 32.9
[45] Guangxi 23.7 43.5 44.3 43.2 35.3 25.3 27.8 32.2
[21] Liaoning 30.4 28.0 27.5 32.3 24.1 14.3 28.1 32.2
[15] Inner Mongolia 34.6 28.6 25.4 42.9 45.6 32.9 36.1 31.8
[61] Shaanxi 39.7 38.6 38.4 48.5 39.6 34.6 33.8 28.8
[23] Heilongjiang 31.3 39.6 34.9 54.7 37.7 38.7 38.9 28.6
[50] Sichuan Chongqing 33.3 30.2 30.5 39.0 40.4 34.2 30.0 27.1
[46] Hainan 36.4 53.3 61.1 40.0 50.0 20.0 37.5 25.0
[42] Hubei 24.4 32.9 33.0 35.5 33.5 34.1 28.5 24.5
[35] Fujian 19.1 18.2 14.8 20.4 14.5 15.2 28.1 24.0
[53] Yunnan 13.8 14.1 22.1 28.0 33.3 25.3 23.3 22.8
[14] Shanxi 19.0 22.7 24.0 41.9 41.4 27.9 27.8 21.2
[13] Hebei 19.6 18.1 21.7 27.1 22.1 21.4 25.8 20.6
[44] Guangdong 22.8 34.8 33.1 39.0 34.8 25.2 25.7 19.9
[31] Shanghai 14.7 18.2 19.5 24.4 20.7 14.1 18.1 18.4
[34] Anhui 25.9 24.2 23.1 48.1 43.0 19.2 25.8 17.9
[41] Henan 25.6 28.0 27.3 25.1 24.3 25.1 29.5 16.9
[32] Jiangsu 18.1 20.1 21.1 25.9 22.6 17.3 21.1 14.5
[52] Guizhou 34.1 32.5 41.7 30.5 25.0 14.9 15.3 14.3
[11] Beijing 11.2 16.1 28.2 24.1 25.3 23.4 27.3 13.0
[37] Shandong 17.6 15.3 15.2 19.2 16.1 12.8 15.8 12.9
[33] Zhejiang 15.7 15.4 18.3 24.2 16.4 12.0 13.5 7.5
Total 24.1 27.0 27.8 34.2 29.7 23.9 26.1 22.9
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Nonperforming Debts in Chinese Enterprises
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Table 17. Regression summarizing trend and cross-ownership patterns of nonperforming debt ratios (dependent variable nonperforming debt ratio)
Nonperforming debt ratio estimated
from reported profitability
as shown in table 8
Nonperforming debt ratio
estimated from imputed profitability
as shown in table 7
Independent variables Coefficient t-statistic Coefficient t-statistic
Intercept 2,996.8 10.9 1,092.6 2.0
Year 1.5 10.7 0.5 1.9
Ownership private enterprises 21.3 18.2 13.9 5.9
Ownership collective enterprises 18.2 15.5 10.7 4.6
Ownership mixed-ownership domestic enterprises 18.3 15.7 16.3 7.0
Ownership foreign-invested enterprises 13.3 11.4 5.1 2.2
Ownership enterprises with investment from Hong Kong, Macau, and Taiwan 13.6 11.7 6.9 3.0
Ownership whole sample 12.4 10.6 11.0 4.7
Ownership state-owned enterprises 0 0
Number of observations 56 56
Adjusted R 2 0.906 0.538
Note: Regression equation: NPD ratio f(year, ownership). Weighted least-squares regression with weights of 100 to 2002, 95 to 2001, 90 to 2000, 85 to 1999, 80 to 1998, 75 to 1997, 70 to 1996, and 65 to
1995.
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Nonperforming Debts in Chinese Enterprises
Table 18. Regression summarizing trend and cross-industry patterns of nonperforming debt ratios (dependent
variable nonperforming debt ratio)
Nonperforming debt ratio
based on imputed profitability
as shown in table 9
Nonperforming debt ratio
based on reported profitability
as shown in table 11
Independent variables Coefficient t-statistic Coefficient t-statistic
Intercept 3,571.4 15.7 1,754.7 6.4
Year 1.8 15.6 0.9 6.3
[07] Petroleum extract 25.3 11.1 17.3 6.3
[44] Electric power 13.9 6.1 13.1 4.8
[16] Tobacco 26.6 11.7 13.0 4.7
[24] Cultural 7.1 3.1 8.5 3.1
[27] Medical 15.6 6.9 7.8 2.9
[23] Printing 1.2 0.5 7.5 2.7
[18] Garments 9.5 4.2 5.3 1.9
[21] Furniture 7.3 3.2 4.6 1.7
[43] Other manufacturing 8.2 3.6 4.0 1.5
Industry whole sample 8.4 3.7 4.0 1.5
[26] Raw chemicals 8.4 3.7 3.0 1.1
[10] Nonmetal mining 3.2 1.4 2.1 0.8
[15] Beverage 18.0 7.9 1.4 0.5
[40] Electric equipment 5.4 2.4 1.0 0.4
[41] Electronic and telecommunications 1.0 0.4 0.6 0.2
[25] Petroleum processing 15.5 6.8 0.5 0.2
[22] Papermaking 11.3 5.0 0.1 0.0
[46] Tap water 0.0 0.0
[19] Leather 5.9 2.6 0.0 0.0
[06] Coal mining 8.6 3.8 0.2 0.1
[33] Pressing nonferrous 6.9 3.0 0.6 0.2
[09] Nonferrous mining 7.3 3.2 0.7 0.3
[08] Ferrous mining 1.3 0.6 1.4 0.5
[29] Rubber 7.2 3.2 1.8 0.6
[37] Transport equipment 0.3 0.1 2.1 0.8
[35] Ordinary machinery 1.0 0.4 3.3 1.2
[30] Plastic 4.9 2.1 3.8 1.4
[34] Metal products 1.2 0.5 4.2 1.5
[32] Pressing ferrous 4.9 2.1 4.4 1.6
[31] Nonmetal products 6.8 3.0 4.6 1.7
[28] Chemical fiber 3.5 1.5 4.6 1.7
[12] Timber logging 4.7 2.1 4.6 1.7
[14] Food production 4.8 2.1 5.1 1.8
[17] Textile 5.0 2.2 5.4 2.0
[42] Instruments 9.5 4.2 5.5 2.0
[36] Special equipment 6.9 3.0 6.9 2.5
[13] Food processing 4.9 2.2 8.7 3.1
[20] Timber 2.6 1.1 8.7 3.2
[45] Gas production 35.0 15.4 22.1 8.0
Number of observations 312 312
Adjusted R 2 0.850 0.610
Note: Regression equation: NPD ratio f(year, industry). Weighted least-squares regression with weights of 100 to 2002, 95 to 2001,
90 to 2000, 85 to 1999, 80 to 1998, 75 to 1997, 70 to 1996, and 65 to 1995. See appendix 2 for full industry names corresponding to industry
codes.
in that year. The NPD ratio for the whole sample for a given year is likely to be 12.4
percent lower than the NPD ratio for SOEs in that year.
The regression results shown in tables 17–19 can be used to make rough predictions
about NPD ratios for a particular group in the future. But these rough predictions
are based only on the pattern of NPD ratios during 1995–2002. Figures 1 and 2 show
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Nonperforming Debts in Chinese Enterprises
Table 19. Regression summarizing trend and cross-region patterns of nonperforming debt
ratios (dependent variable nonperforming debt ratio)
Nonperforming debt ratio
based on imputed profitability
as shown in
table 13
Nonperforming debt ratio
based on reported profitability
as shown in
table 15
Independent variables Coefficient t-statistic Coefficient t-statistic
Intercept 4,537.3 16.1 2,022.1 5.5
Year 2.2 16.0 1.0 5.4
[37] Shandong 24.9 10.2 28.2 8.9
[33] Zhejiang 24.1 9.9 25.1 8.0
[35] Fujian 18.5 7.6 22.3 7.0
[32] Jiangsu 24.0 9.9 21.1 6.7
[11] Beijing 5.4 2.2 20.6 6.5
[31] Shanghai 10.8 4.4 19.3 6.1
Region whole sample 17.6 7.2 19.3 6.1
[13] Hebei 15.7 6.5 18.8 5.9
[15] Inner Mongolia 16.5 6.8 14.4 4.6
[41] Henan 17.6 7.2 14.0 4.4
[14] Shanxi 7.8 3.2 12.5 3.9
[53] Yunnan 6.0 2.5 10.4 3.3
[34] Anhui 19.1 7.8 9.5 3.0
[44] Guangdong 13.2 5.4 9.3 2.9
[50] Sichuan Chongqing 7.3 3.0 9.1 2.9
[42] Hubei 14.8 6.1 7.2 2.3
[21] Liaoning 4.3 1.8 6.1 1.9
[12] Tianjin 4.0 1.7 5.0 1.6
[54] Tibet Qinghai Ningxia 4.5 1.9 4.9 1.6
[22] Jilin 4.3 1.8 4.0 1.3
[23] Heilongjiang 4.9 2.0 3.5 1.1
[45] Guangxi 14.0 5.8 3.3 1.0
[36] Jiangxi 8.1 3.3 2.7 0.8
[46] Hainan 7.7 3.2 2.1 0.7
[62] Gansu 3.4 1.4 2.1 0.7
[52] Guizhou 2.4 1.0 1.5 0.5
[43] Hunan 3.7 1.5 1.0 0.3
[61] Shaanxi 1.4 0.6 0.6 0.2
[65] Xinjiang 0.0 0.0
Number of observations 232 232
Adjusted R 2 0.790 0.629
Note: Regression equation: NPD ratio f(year, region). Weighted least-squares regression with weights of 100 to 2002, 95 to 2001, 90
to 2000, 85 to 1999, 80 to 1998, 75 to 1997, 70 to 1996, and 65 to 1995.
the actual and predicted value of NPD ratios using the regression coefªcients in tables
17–19 when the categorical variable is set to the whole sample. Figure 1 is based
on imputed proªtability and shows a much faster rate of decline in NPD ratios than
ªgure 2, which is based on reported proªtability.
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A more sophisticated method for assessing likely NPD ratios in future years for the
whole sample is to build a few likely scenarios based on alternative assumptions
about the possible NPD ratios for individual groups and the possible distribution of
total liabilities. Table 20 outlines nine scenarios for the NPD ratios for the whole
sample by the year 2007 by providing speciªc alternative assumptions about the
possible NPD ratios for each group of enterprises and about the possible distribu-
88 Asian Economic Papers
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Nonperforming Debts in Chinese Enterprises
Figure 1. Predicting nonperforming debt ratios: Imputed proªtability and weighted
regression
Figure 2. Predicting nonperforming debt ratios: Reported proªtability and weighted
regression
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Nonperforming Debts in Chinese Enterprises
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Table 20. Scenarios for nonperforming debt ratio of the whole sample by 2007 (percent)
Optimistic case: Two years faster
than predicted by trend
Likely case: As predicted
by trend
Pessimistic case: Two years
slower than predicted by trend
Alternative assumptions about
distribution of total liabilities
Alternative assumptions about value of
nonperforming debt ratios
Private 2.9 3.7 4.5
Collective 2.6 1.8 1.0
Mixed 38.0 44.2 50.4
Foreign 13.5 15.3 17.1
Hong Kong, Macau, and Taiwan 7.7 8.3 8.9
State-owned 36.2 28.2 20.2
Optimistic case: 2002 nonperforming debt ratios
estimated from imputed profitability
Private 7.4 16.8 15.8 14.7
Collective 10.0
Mixed 10.8
Foreign 15.2
Hong Kong, Macau, and Taiwan 12.6
State-owned 25.4
Weighted average for all 18.4
Likely case: 2002 average nonperforming debt ratio
(average over nonperforming debt statistics from both
imputed and reported profitability)
Private 11.6 19.6 18.9 18.3
Collective 14.6
Mixed 15.5
Foreign 18.8
Hong Kong, Macau, and Taiwan 15.4
State-owned 25.6
Weighted average for all 20.6
Pessimistic case: 2002 nonperforming debt ratio
estimated from reported profitability
Private 15.8 22.4 22.1 21.8
Collective 19.2
Mixed 20.2
Foreign 22.4
Hong Kong, Macau, and Taiwan 18.2
State-owned 25.8
Weighted average for all 22.9
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tion of total liabilities across groups. These simulated scenarios can facilitate policy
debates by showing the magnitude of reforms necessary to achieve various speciªc
objectives. For example, table 20 shows that to lower the overall NPD ratio to 14.7
percent by the year 2007, it is necessary for individual groups to achieve NPD ratios
in the optimistic case (e.g., 2002 NPD ratios estimated from imputed proªtability)
and for the distribution of total liabilities also to achieve the optimistic case, in
which the SOE sector share of total liabilities falls to 20.2 percent. The nine scenarios
in table 20 are built for illustrative purposes. The alternative assumptions are subjective
and debatable but are all based on the patterns of NPD statistics estimated in
this paper.
5. Explaining profitability and quality of debts
The NPD statistics for each group of enterprises reºect the total effects from all factors
that might cause NPD. For example, a major factor that might contribute to a
high NPD ratio for SOEs is that many enterprises in the utilities industry are SOEs
and the utilities industry as a whole is not proªtable because of heavy price regulation
by the government. In this case, the high NPD ratio for the group of SOEs actually
reºects both ownership and industry risks. The purpose of this section is to use
regression analysis to isolate different sources of bad debt risks. Because we have
classiªed enterprise debts by their proªtability, we need to explain what factors are
driving enterprise proªtability and returns on assets.
Tables 21 and 22 summarize the characteristics of the key variables used in the
proªtability regressions. Table 23 reports the results of four panel data regressions:
two logistic regressions explaining the imputed and reported proªtability and two
linear regressions explaining the imputed and reported return on total assets. The
explanatory variables for the four regressions are the same: log(capital/labor ratio);
ratio of liability to total assets; log(employees); market share; industry concentration;
and dummy variables for ownership, year, industry, and region. The
coefªcients and their standard errors indicate the size and the statistical signiªcance
of the impact of the explanatory variables on proªtability.
Some common patterns emerge in all four regressions:
• The ratio of liability to total assets has a signiªcantly negative impact on
proªtability, implying that the more the enterprise borrows, the less the proªts or
the lower the returns on assets.
• Market share has a positive impact on proªtability.
• State ownership has a negative impact on proªtability.
• Proªtability improves signiªcantly during 2000–2002.
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Table 21. Summary statistics for key variables in profitability regressions, 1995–2002
1995 1996 1997 1998 1999 2000 2001 2002 Total
Number of observations for
Return on total assets with reported profit 22,543 22,974 22,957 22,293 21,463 20,738 21,898 22,220 177,086
Return on total assets with imputed profit 22,393 22,815 22,813 22,129 21,296 20,555 21,730 21,999 175,730
Capital/labor ratio (RMB thousand per person) 22,295 22,724 22,708 22,046 21,240 20,505 21,641 21,972 175,131
Asset/liability ratio 22,479 22,904 22,848 22,187 21,354 20,633 21,792 22,069 176,266
Employment 22,543 22,974 22,957 22,293 21,463 20,738 21,898 22,220 177,086
Market share (percentage of three-digit industry sales total) 22,543 22,974 22,957 22,293 21,463 20,738 21,898 22,220 177,086
Industry concentration (percentage by top four enterprises in two-digit industry sales total)
22,543 22,974 22,957 22,293 21,463 20,738 21,898 22,220 177,086
Median for
Return on total assets with reported profit (percent) 0.27 0.14 0.09 0.04 0.18 0.38 0.53 0.82 0.23
Return on total assets with imputed profit (percent) 3.42 3.56 3.40 3.22 4.51 5.38 6.59 7.31 4.58
Capital/labor ratio (RMB thousand per person) 27.4 36.5 41.6 49.4 57.9 63.6 70.0 75.5 49.2
Asset/liability ratio 0.713 0.711 0.711 0.711 0.690 0.682 0.651 0.635 0.690
Employment 877 823 793 715 654 620 560 520 701
Market share (percentage of three-digit industry sales total) 0.207 0.192 0.182 0.185 0.199 0.201 0.192 0.185 0.193
Industry concentration (percentage by top four enterprises
in two-digit industry sales total)
10.4 11.1 11.6 12.1 12.4 13.1 11.7 12.3 11.6
Mean for
Return on total assets with reported profit (percent) 0.16 0.54 0.64 0.89 0.34 1.29 1.69 2.03 0.41
Return on total assets with imputed profit (percent) 5.04 6.07 5.74 5.58 7.72 8.91 10.65 11.61 7.63
Capital/labor ratio (RMB thousand per person) 51.4 65.9 74.1 95.0 118.3 130.0 152.4 165.6 105.8
Asset/liability ratio 0.706 0.709 0.711 0.714 0.694 0.687 0.657 0.642 0.690
Employment 1,696 1,633 1,593 1,502 1,428 1,361 1,237 1,189 1,458
Market share (percentage of three-digit industry sales total) 0.838 0.831 0.823 0.839 0.867 0.907 0.881 0.869 0.856
Industry concentration (percentage by top four enterprises
in two-digit industry sales total)
11.4 12.0 13.0 13.4 13.5 13.8 13.9 14.1 13.1
Standard deviation for
Return on total assets with reported profit (percent) 8.30 9.24 8.36 8.53 8.42 8.46 9.99 8.97 8.86
Return on total assets with imputed profit (percent) 13.73 16.25 15.16 14.27 15.27 16.06 17.99 19.51 16.29
Capital/labor ratio (RMB thousand per person) 123.6 162.6 154.9 242.8 358.3 346.6 430.6 447.8 308.4
Asset/liability ratio 0.23828 0.25137 0.26388 0.28025 0.27605 0.28080 0.28693 0.28883 0.27218
Employment 5,215 4,908 4,719 4,482 4,401 3,947 3,599 3,560 4,404
Market share (percentage of three-digit industry sales total) 3.2 3.2 3.2 3.1 3.1 3.4 3.4 3.4 3.3
Industry concentration (percentage by top four enterprises
in two-digit industry sales total)
7.5 7.5 7.6 7.1 6.9 7.1 6.2 6.1 7.1
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Table 22. Median of key variables for profitability regressions by ownership, 1995–2002
1995 1996 1997 1998 1999 2000 2001 2002 Total
Percentage return on total assets
with reported profit for
Private 1.78 4.84 0.36 0.03 1.00 1.03 1.38 1.72 1.34
Collective 0.69 0.50 0.34 0.28 0.51 0.67 0.72 0.91 0.52
Mixed 2.07 1.46 0.89 0.52 0.88 1.10 1.24 1.33 1.11
Foreign 1.70 0.83 0.77 0.54 1.65 2.93 2.99 3.61 2.08
Hong Kong, Macau, and Taiwan 1.31 1.01 0.89 0.43 0.87 1.35 1.55 1.95 1.26
State-owned 0.14 0.05 0.02 0.00 0.03 0.09 0.06 0.09 0.05
Total 0.27 0.14 0.09 0.04 0.18 0.38 0.53 0.82 0.23
Percentage return on total assets
with imputed profit for
Private 11.25 17.44 9.65 7.39 12.01 11.34 12.93 13.98 12.67
Collective 7.44 8.24 7.17 7.52 8.60 9.46 10.57 10.97 8.41
Mixed 7.13 6.78 6.36 6.06 7.11 7.83 8.83 9.43 7.85
Foreign 5.80 6.31 6.09 5.49 8.15 9.93 11.01 11.24 8.66
Hong Kong, Macau, and Taiwan 6.57 6.75 6.23 5.41 6.99 8.19 8.86 9.69 7.61
State-owned 2.14 2.01 1.86 1.34 2.18 2.53 2.80 2.87 2.14
Total 3.42 3.56 3.40 3.22 4.51 5.38 6.59 7.31 4.58
Capital/labor ratio (RMB thousand
per person) for
Private 26 54 49 48 52 51 52 56 52
Collective 25 30 33 40 44 45 49 52 37
Mixed 33 39 42 46 52 57 62 67 54
Foreign 71 91 114 134 144 145 149 145 129
Hong Kong, Macau, and Taiwan 63 79 82 98 109 108 107 103 96
State-owned 26 35 40 47 55 62 68 74 44
Total 27 36 42 49 58 64 70 75 49
Liability/total assets ratio for
Private 0.531 0.653 0.722 0.724 0.686 0.693 0.667 0.654 0.671
Collective 0.708 0.718 0.723 0.717 0.707 0.712 0.690 0.686 0.711
Mixed 0.646 0.636 0.650 0.672 0.664 0.660 0.653 0.644 0.654
Foreign 0.574 0.553 0.554 0.538 0.534 0.516 0.479 0.472 0.517
Hong Kong, Macau, and Taiwan 0.638 0.622 0.625 0.614 0.603 0.589 0.544 0.520 0.583
State-owned 0.731 0.733 0.737 0.747 0.732 0.732 0.718 0.704 0.732
Total 0.713 0.711 0.711 0.711 0.690 0.682 0.651 0.635 0.690
Median employment per firm for
Private 500 453 718 429 391 394 383 367 384
Collective 643 599 565 511 490 461 437 408 528
Mixed 1,010 972 897 820 748 711 645 606 725
Foreign 408 387 376 350 321 332 320 320 341
Hong Kong, Macau, and Taiwan 446 390 387 360 364 360 343 340 363
State-owned 1,014 975 946 873 829 793 753 729 894
Total 877 823 793 715 654 620 560 520 701
Market share (percentage of threedigit
industry sales total) for
Private 0.159 0.285 0.283 0.118 0.147 0.148 0.148 0.141 0.146
Collective 0.206 0.190 0.175 0.193 0.192 0.185 0.161 0.146 0.185
Mixed 0.361 0.310 0.253 0.212 0.221 0.213 0.198 0.183 0.214
Foreign 0.450 0.402 0.399 0.419 0.406 0.396 0.355 0.318 0.381
Hong Kong, Macau, and Taiwan 0.339 0.331 0.341 0.341 0.329 0.343 0.312 0.277 0.318
State-owned 0.185 0.169 0.156 0.149 0.158 0.155 0.145 0.143 0.160
Total 0.207 0.192 0.182 0.185 0.199 0.201 0.192 0.185 0.193
Industry concentration (percentage
by top four enterprises in twodigit
industry sales total) for
Private 12.6 9.5 8.6 10.8 11.7 11.0 11.6 11.1 11.6
Collective 9.9 8.5 9.7 10.8 10.6 11.3 11.6 11.1 10.5
Mixed 10.5 11.3 11.6 11.7 12.4 12.9 11.7 12.3 11.8
Foreign 10.5 11.3 13.3 12.5 13.8 13.1 14.0 12.3 12.4
Hong Kong, Macau, and Taiwan 9.9 10.6 11.6 12.1 12.4 12.1 13.1 12.3 11.7
State-owned 10.4 11.1 11.6 12.1 12.4 13.4 13.1 12.5 11.7
Total 10.4 11.1 11.6 12.1 12.4 13.1 11.7 12.3 11.6
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Table 23. Profitability regressions
Return on total
assets by reported
profitability
Return on total
assets by imputed
proªtability
Reported proªtability
(1 proªt, 0 loss)
Imputed profitability
(1 profit, 0 loss)
Dependent variable B SE Exp(B) B SE Exp(B) B SE B SE
Constant 2.174*** 0.120 8.797 2.430*** 0.118 11.353 0.142*** 0.008 0.014*** 0.004
Log(capital/labor ratio) 0.005 0.007 1.005 0.063*** 0.007 0.939 0.012*** 0.000 0.001*** 0.000
Liability/assets ratio 1.730*** 0.023 0.177 3.156*** 0.026 0.043 0.116*** 0.001 0.115*** 0.001
Log(employees) 0.029*** 0.007 1.029 0.080*** 0.007 1.084 0.003*** 0.000 0.003*** 0.000
Market share 0.109*** 0.005 1.115 0.175*** 0.006 1.191 0.004*** 0.000 0.002*** 0.000
Industry concentration 0.001 0.003 0.999 0.005 0.003 1.005 0.001*** 0.000 0.000*** 0.000
Private 0.106*** 0.003 0.029*** 0.001
Collective 0.450*** 0.059 0.637 0.215*** 0.049 0.806 0.070*** 0.001 0.022*** 0.001
Mixed 0.534*** 0.059 0.586 0.094*** 0.048 0.910 0.047*** 0.001 0.017*** 0.001
Foreign 0.763*** 0.061 0.466 0.940*** 0.051 0.391 0.065*** 0.002 0.017*** 0.001
0.757*** 0.061 0.469 0.658*** 0.051 0.518 0.053*** 0.002 0.015*** 0.001
Hong Kong, Macau, and
Taiwan
State-owned 1.235*** 0.057 0.291 0.585*** 0.047 0.557 0 . 0 .
1995 0.390*** 0.025 0.677 0.061*** 0.025 1.062 0.049*** 0.002 0.005*** 0.001
1996 0.397*** 0.024 0.673 0.118*** 0.024 0.889 0.038*** 0.001 0.012*** 0.001
1997 0.394*** 0.024 0.674 0.236*** 0.024 0.790 0.040*** 0.001 0.014*** 0.001
1998 0.412*** 0.024 0.662 0.393*** 0.023 0.675 0.041*** 0.001 0.016*** 0.001
1999 0.231*** 0.024 0.794 0.111*** 0.024 0.895 0.027*** 0.001 0.008*** 0.001
2000 0.093*** 0.025 0.911 0.225*** 0.025 1.252 0.018*** 0.001 0.001*** 0.001
2001 0.016 0.025 1.016 0.005 0.024 0.995 0.007*** 0.001 0.001*** 0.001
2002 0 0 .
Logistic Logistic General linear model General linear model
Regression method
Nagelkerke R 2 0.189 0.251
Adjusted R 2 0.181 0.218
Number of observations 177,086 177,086 172,985 174,317
Note: Coefficients for industry and region dummies are omitted in this table but are used to calculate pure industry and region profitability index in next table.
***Estimated coefficient is significant at level of 1 percent.
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Table 24. Industry-specific profitability indexes for large and medium-sized industrial enterprises, by ISPI5, 1995–2002
ISPI6
([ISPI3 ISPI4]/2)
ISPI5
([ISPI1 ISPI2]/2)
ISPI4
(estimated from
imputed return
on total assets)
ISPI3
(estimated from
reported return
on total assets)
ISPI2
(estimated from
imputed profitability)
ISPI1
(estimated from
reported profitability)
Industry
[16] Tobacco 3.196 8.018 1.030 1.301 5.607 1.166
[07] Petroleum extract 1.314 3.714 1.060 1.142 2.514 1.101
[44] Electric power 2.451 1.764 1.019 1.021 2.107 1.020
[15] Beverage 1.548 2.654 1.006 1.065 2.101 1.036
[27] Medical 1.903 2.064 1.021 1.039 1.984 1.030
[22] Papermaking 1.353 1.508 1.007 1.008 1.431 1.008
[26] Raw chemicals 1.510 1.333 1.007 1.001 1.422 1.004
[25] Petroleum processing 0.833 1.783 0.999 1.052 1.308 1.026
[23] Printing 1.628 0.942 1.003 0.974 1.285 0.989
[33] Pressing nonferrous 1.230 1.174 1.002 1.001 1.202 1.002
[13] Food processing 1.095 1.277 0.999 1.039 1.186 1.019
[40] Electric equipment 1.283 1.021 1.004 0.996 1.152 1.000
[41] Electronic and telecommunications 1.396 0.851 1.008 0.986 1.124 0.997
[18] Garments 1.173 0.960 0.999 1.006 1.066 1.003
[31] Nonmetal products 1.007 1.122 0.993 0.971 1.065 0.982
[12] Timber logging 1.034 1.048 1.005 0.974 1.041 0.990
[37] Transport equipment 1.119 0.943 1.001 0.985 1.031 0.993
[17] Textile 1.044 1.016 0.992 0.978 1.030 0.985
[19] Leather 1.061 0.897 0.995 1.004 0.979 0.999
[14] Food production 0.935 1.007 0.995 1.005 0.971 1.000
[32] Pressing ferrous 0.858 1.061 0.994 0.998 0.960 0.996
[35] Ordinary machinery 1.088 0.832 0.997 0.961 0.960 0.979
[29] Rubber 0.780 0.984 0.992 0.990 0.882 0.991
[43] Other manufacturing 0.927 0.838 0.996 0.999 0.882 0.998
[30] Plastic 0.913 0.812 0.995 0.967 0.862 0.981
[24] Cultural 0.937 0.777 0.998 0.974 0.857 0.986
[10] Nonmetal mining 0.882 0.829 0.995 0.968 0.856 0.982
[28] Chemical fiber 0.856 0.852 0.996 0.996 0.854 0.996
[34] Metal products 0.883 0.748 0.993 0.972 0.816 0.982
[20] Timber 0.827 0.793 0.992 0.990 0.810 0.991
[36] Special equipment 0.853 0.651 0.995 0.960 0.752 0.978
[09] Nonferrous mining 0.898 0.602 1.010 0.964 0.750 0.987
[21] Furniture 0.768 0.688 0.990 0.977 0.728 0.984
[06] Coal mining 0.797 0.551 0.996 0.953 0.674 0.974
[42] Instruments 0.748 0.554 0.997 0.957 0.651 0.977
[08] Ferrous mining 0.430 0.676 0.991 0.973 0.553 0.982
[46] Tap water 0.454 0.571 0.966 0.942 0.513 0.954
[45] Gas production 0.159 0.132 0.962 0.907 0.146 0.935
Note: ISPI industry-specific profitability index. The indexes in this table are derived from the coefficients of industry dummies in the profitability regressions reported in table 23. For easy comparison, each profitability
index is normalized by the sample average. An index value that is greater than one indicates profitability that is better than the sample average. See appendix 2 for full industry names corresponding to industry
codes.
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It should be noted that the above are independent impacts by each explanatory variable
after the impacts of other explanatory variables, including the impact of industry
and region variables, are controlled for.
The impacts of ownership on proªtability revealed by each of the four regressions
are the following:
• The logistic regression on imputed proªtability implies that, compared to private
enterprises, the odds that collective, mixed, foreign, HK-M-Taiwan, and SOEs will
be proªtable are 0.637, 0.586, 0.466, 0.469, and 0.291, respectively. In other words,
the SOEs have the lowest probability of making proªts compared with the other
groups.
• The logistic regression on reported proªtability shows similar results but with less
dramatic quantitative impacts except for the foreign-invested and HK-M-Taiwan–
invested enterprises. As compared to private enterprises, the odds that collective,
mixed, foreign, HK-M-Taiwan, and SOEs will be proªtable are 0.806, 0.910, 0.391,
0.518, and 0.557, respectively. The foreign-invested and HK-M-Taiwan–invested
enterprises seem less proªtable than the SOEs when measured by reported
proªts. This is likely attributable to the different tax and accounting system for the
externally invested enterprises. For example, the multinational corporations are
likely to use various accounting practices to transfer proªts to their overseas entities.
The imputed proªts would be more useful when comparing enterprise performance
across ownership in China because they are derived from the consistent
framework of calculating value-added and would not be affected by differences in
tax and accounting systems across ownership sectors.
• The linear regression on imputed proªtability shows that the return on total assets
for private, collective, mixed, foreign, and HK-M-Taiwan enterprises will be 10.6,
7, 4.7, 6.5, and 5.3 percentage points higher, respectively, than that for SOEs.
• The linear regression on reported proªtability shows that the return on total
assets for private, collective, mixed, foreign, and HK-M-Taiwan enterprises will
be 2.9, 2.2, 1.7, 1.7, and 1.5 percentage points higher, respectively, than that for
SOEs.
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Tables 24 and 25 use the industry and region dummies in the four proªtability regressions
to construct industry- and region-speciªc proªtability indexes (ISPI and
RSPI, respectively). These tables can be used as benchmarks for assessing the pure
industry-speciªc or region-speciªc risks of enterprise debts in China. They summarize
the independent impacts of industry and location on the quality of industrial
enterprise debts averaged over 1995–2002.
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Table 25. Region-specific profitability indexes for large and medium-sized industrial enterprises, by RSPI5, 1996–2002
RSPI6
(RSPI3 RSPI4]/2)
RSPI5
([RSPI1 RSPI2]/2)
RSPI4
(estimated from
imputed return
on total assets)
RSPI3
(estimated from
reported return
on total assets)
RSPI2
(estimated from
imputed profits)
RSPI1
(estimated from
reported profits)
Region
[37] Shandong 2.829 2.105 1.023 1.047 2.467 1.035
[32] Jiangsu 1.532 1.799 1.009 1.040 1.666 1.024
[13] Hebei 1.746 1.445 1.014 1.030 1.595 1.022
[33] Zhejiang 1.622 1.496 1.014 1.005 1.559 1.010
[41] Henan 1.346 1.700 1.009 1.032 1.523 1.021
[34] Anhui 1.035 1.623 1.001 1.030 1.329 1.016
[15] Inner Mongolia 1.103 1.316 1.002 1.014 1.210 1.008
[31] Shanghai 1.432 0.858 1.007 0.989 1.145 0.998
[35] Fujian 1.253 1.011 1.007 1.015 1.132 1.011
[14] Shanxi 1.082 1.028 1.002 1.001 1.055 1.002
[42] Hubei 0.827 1.279 1.004 1.032 1.053 1.018
[45] Guangxi 0.764 1.327 0.996 1.009 1.045 1.003
[36] Jiangxi 0.901 1.140 1.000 1.003 1.021 1.001
[44] Guangdong 0.913 0.969 0.998 1.006 0.941 1.002
[23] Heilongjiang 0.905 0.939 0.998 0.997 0.922 0.997
[50] Sichuan Chongqing 0.908 0.886 0.993 0.994 0.897 0.993
[11] Beijing 1.341 0.445 0.996 0.961 0.893 0.979
[54] Tibet Qinghai Ningxia 0.825 0.833 0.990 0.983 0.829 0.987
[53] Yunnan 0.885 0.764 0.997 0.978 0.824 0.988
[22] Jilin 0.809 0.816 0.994 0.994 0.812 0.994
[12] Tianjin 0.815 0.738 1.004 0.970 0.776 0.987
[46] Hainan 0.721 0.812 0.996 0.975 0.766 0.985
[61] Shaanxi 0.766 0.760 0.992 0.990 0.763 0.991
[43] Hunan 0.660 0.857 0.989 0.989 0.758 0.989
[62] Gansu 0.686 0.794 0.984 0.982 0.740 0.983
[52] Guizhou 0.727 0.735 0.994 0.986 0.731 0.990
[21] Liaoning 0.774 0.662 0.993 0.974 0.718 0.983
[65] Xinjiang 0.705 0.695 0.992 0.973 0.700 0.983
Note: RSPI region-specific profitability index. The indexes in this table are derived from the coefficients of region dummies in the profitability regressions reported in table 23. For easy comparison, each
profitability index is normalized by the sample average. An index value that is greater than one indicates profitability better than the sample average.
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ISPI1, ISPI2, ISPI5, RSPI1, RSPI2, and RSPI5 (see tables 24 and 25) are derived from
the industry or region dummies in the logistic regressions but are normalized by the
sample average. Compared with the sample average, the odds that a speciªc industry
or region will be proªtable can be calculated by multiplying the sample average
by the index value. For example, the index value of ISPI5 given in table 24 for the tobacco
industry is 5.607. Thus the odds that the tobacco industry will be proªtable,
are 5.607 times those that the average industry will be proªtable, when other factors
inºuencing proªtability are held constant.
ISPI3, ISPI4, ISPI6, RSPI3, RSPI4, and RSPI6 are derived from the industry or region
dummies in the linear regressions but are also normalized by ªrst subtracting the
average return of all industries or regions and then adding one. This makes the index
value equal to one for the average of all industries or regions. The index value
minus one is the additional return a speciªc industry or region has over the average
return on total assets. For example, the index value of ISPI6 in table 24 is 1.166 for
the tobacco industry. This means that the tobacco industry’s return on total assets is
likely to be higher than the average return on total assets for all industries by a ratio
of 0.166 (1.166 1), or 16.6 percent.
Hence, tables 24 and 25 help us determine which industries and regions are more
proªtable for the large and medium-sized industrial enterprises when the inºuences
of other factors such as types of ownership and capital intensity are removed. The
two tables are sorted by ISPI5 and RSPI5 from high to low proªtability. The top ªve
industries by industry-speciªc proªtability are tobacco processing; petroleum and
natural gas extraction; electric power, steam, and hot water; beverage production;
and medical and pharmaceutical products. The top ªve regions by region-speciªc
proªtability are Shandong, Jiangsu, Hebei, Zhejiang, and Henan.
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The proªtability regressions in table 23 can also be used to assess the proªtability or
debt quality of a particular enterprise if we know the value for that enterprise of the
explanatory variable. The predicted value from the logistic regressions is the probability
of making proªts. Of course, the prediction using the regression equation
only helps to assess non-enterprise-speciªc risks that are summarized by the explanatory
variables in the regressions. In the real world and for a speciªc enterprise, the
enterprise-speciªc risks are clearly most important and cannot be analyzed using
the statistical results presented here. It is usually the case, however, that practitioners
know the ªrm-speciªc risks very well but ªnd it difªcult to assess non-ªrmspeciªc
risks. Our study helps reveal non-ªrm-speciªc information and thus can
contribute to better policy and more effective business strategy.
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6. Exit of poor-performing enterprises and its impact on the NPD ratio
The analysis in the previous sections is affected by a sample selection bias that results
from the way the National Bureau of Statistics in China deªnes the sample of
large and medium-sized industrial enterprises. As pointed out earlier, about 20 percent
of ªrms enter and exit this sample every year, and the enterprises in the sample
make up a very dynamic group that accurately reºects the current state of China’s
large industrial enterprise sector. Such change in the sample, however, creates a
problem for measuring the NPD ratio: it is possible that the exiting enterprises have
higher NPD ratios than the new entries.
Table 26 shows the number of enterprises by proªtability and entry-exit status for
the 1995–2002 period. The entry-exit status of a sample enterprise for a particular
period t is deªned as one of the following four exclusive groups: 1
• “exit” group: the enterprise was in the sample at t 1 and t, but not at t 1
• “new” group: the enterprise was in the sample at t and t 1, but not at t 1
• “stay” group: the enterprise was in the sample at t 1, t, and t 1
• “once” group: the enterprise was in the sample at t, but not at t 1 and t 1
As shown in table 26, among the proªt-making enterprises in 1996, 1,177 enterprises
appeared in the sample of 1995 and 1996 but did not show up in the sample of 1997,
and hence they belong to the “exit” group; 2,802 enterprises did not appear in the
sample of 1995 but appeared in the sample of 1996 and 1997, and hence they fall into
the “new” group; 10,540 enterprises appeared in the sample of 1995, 1996, and 1997,
and hence they are in the “stay” group; 516 enterprises did not appear in 1995 and
1997 but showed up in 1996, and hence they are put into the “once” group.
Table 26 tells us that both proªt-making and loss-making enterprises are actively entering
and exiting the sample every year. The dynamics of this life-death process
reºect how lively China’s enterprise reform and restructuring has been. But we
would expect that the “exit” group would have more loss-making enterprises than
the “new” or “stay” group. The bottom part of table 26 presents information to al-
1 Because we do not have data for 1995 and 2003, the entry-exit status for 1995 and 2003 may
differ slightly from the deªnition here. For 1995, we have information on ªrms that exited or
stayed in 1996, but we do not have information on ªrms that were new in 1995 or appeared
only in 1995. For 2002, we have information on ªrms that were new or stayed in 2002, but we
have no information on ªrms that exited or appear only in 2002. The unavailable information
is indicated by blank entries in the table.
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Table 26. Number of enterprises by profitability and entry-exit status, 1995–2002
1995 1996 1997 1998 1999 2000 2001 2002
Number of profit-making enterprises
Exit 2,485 1,177 2,434 1,648 1,335 2,608 1,258
New 2,802 1,533 2,408 2,523 1,160 3,890 2,300
Stay 12,229 10,540 10,493 9,849 11,017 11,235 11,221 14,968
Once 516 599 710 368 378 565
Whole sample 14,714 15,035 15,059 14,615 15,243 15,381 16,934 17,268
Number of loss-making enterprises
Exit 1,651 1,048 1,745 1,722 943 1,182 649
New 981 574 838 642 360 864 687
Stay 6,178 5,642 5,293 4,674 4,474 3,631 3,258 4,265
Once 268 286 444 161 184 193
Whole sample 7,829 7,939 7,898 7,678 6,220 5,357 4,964 4,952
Number of enterprises
Exit 4,136 2,225 4,179 3,370 2,278 3,790 1,907
New 3,783 2,107 3,246 3,165 1,520 4,754 2,987
Stay 18,407 16,182 15,786 14,523 15,491 14,866 14,479 19,233
Once 784 885 1,154 529 562 758
Whole sample 22,543 22,974 22,957 22,293 21,463 20,738 21,898 22,220
Share of loss-making enterprises (percent)
Exit 39.9 47.1 41.8 51.1 41.4 31.2 34.0
New 25.9 27.2 25.8 20.3 23.7 18.2 23.0
Stay 33.6 34.9 33.5 32.2 28.9 24.4 22.5 22.2
Once 34.2 32.3 38.5 30.4 32.7 25.5
Whole sample 34.7 34.6 34.4 34.4 29.0 25.8 22.7 22.3
Note: “Exit” group enterprise was in sample at t 1 and t but not at t 1; “new” group enterprise was in sample at t and t 1
but not at t 1; “stay” group enterprise was in sample at t 1, t, and t 1; “once” group enterprise was in sample at t, but not
at t 1 or t 1.
low us to assess this expectation. The share of loss-making enterprises in the “exit”
group is much higher than their share in the other groups, particularly during 1998–
99. In 1998, the share of loss-making ªrms is 51.1 percent for the “exit” group, 25.8
percent for the “new” group, 32.2 percent for the “stay” group, and 38.5 percent for
the “once” group. Clearly the group that is exiting the sample has a much higher
share of poor-performing ªrms than the group that is entering the sample. This is a
good trend for the economy, but it creates biased estimates of NPD ratios, because
the NPDs of the exiting enterprises are entirely ignored in the analysis of the previous
sections.
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Unlike table 26, which shows the distribution in the number of enterprises by entryexit
status, table 27 shows the distribution of the amounts of performing and
nonperforming debts by entry-exit status. For example, table 27 shows that the
amount of NPDs that exited the sample with the exit of enterprises rose from
RMB157 billion in 1995 to RMB200 billion in 1998, and then fell to RMB92 billion in
2001. On the other hand, the amount of performing debt that entered the sample
with the entry of new enterprises rose steadily from RMB311 billion in 1996 to
RMB400–800 billion after 1997. The exit of bad ªrms and the entry of good ªrms are
clearly driving forces in improving the debt quality of the Chinese enterprise sector.
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Table 27. Liabilities/debts by profitability and entry-exit status, 1995–2002
1995 1996 1997 1998 1999 2000 2001 2002
Amount of performing debt based on
imputed profits (RMB billion)
Exit 327 204 384 272 396 512 298
New 311 248 503 429 418 780 483
Stay 2,043 2,044 2,295 2,335 2,587 2,812 3,088 4,190
Once 52 70 129 78 92 71
Whole sample 2,370 2,611 2,997 3,239 3,490 3,834 4,237 4,673
Amount of nonperforming debt based
on imputed profits (RMB billion)
Exit 157 116 193 200 154 174 92
New 130 96 145 151 81 168 115
Stay 757 826 881 971 990 848 803 936
Once 23 34 54 20 25 27
Whole sample 914 1,095 1,204 1,370 1,315 1,128 1,090 1,051
Total liabilities (RMB billion)
Exit 484 320 577 472 550 686 390
New 441 344 648 580 499 948 598
Stay 2,800 2,870 3,176 3,306 3,577 3,660 3,891 5,126
Once 75 104 183 98 117 98
Whole sample 3,284 3,706 4,201 4,609 4,805 4,962 5,327 5,724
Nonperforming debt ratio based on
imputed profits (percent)
Exit 32.4 36.3 33.4 42.4 28.0 25.4 23.6
New 29.5 27.9 22.4 26.0 16.2 17.7 19.2
Stay 27.0 28.8 27.7 29.4 27.7 23.2 20.6 18.3
Once 30.7 32.7 29.5 20.4 21.4 27.6
Whole sample 27.8 29.5 28.7 29.7 27.4 22.7 20.5 18.4
Note: “Exit” group enterprise was in sample at t 1 and t but not at t 1; “new” group enterprise was in sample at t and t 1
but not at t 1; “stay” group enterprise was in sample at t 1, t, and t 1; “once” group enterprise was in sample at t, but not
at t 1 or t 1.
From table 27 it is clear that the NPD ratio for the “exit” group is much higher than
that for the “new,” “stay,” and “once” groups. For example, in 1998 the NPD ratio
for the “exit” group was 42.4 percent, close to twice the NPD ratio for the “new”
group (22.4 percent) and much higher than that for the “stay” group (29.4 percent).
The implication of the above evidence is that the dynamics of entry and exit is contributing
signiªcantly to the fall in the NPD ratio for the sample. Clearly, the analysis
in the previous sections underestimated the level of the NPD ratios. The number
of bad ªrms exiting the sample, however, is more than the number of bad ªrms entering
the sample for every one of the eight years. This means that the trend of declining
NPD, as revealed in the previous sections, is still valid, although some bias
and distortions exist in the level of estimated NPD. The rest of this section attempts
to identify the size of the NPD ratio bias that resulted from the entry-exit dynamics
of the sample enterprises.
If the “exit” group of enterprises had remained in the sample while the same NPD
ratio and the same amount of total debts were maintained, then the NPD ratio of the
enlarged hypothetical sample would certainly have been pushed higher. Table 28 at-
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tempts to estimate how much higher the NPD ratio of the enlarged hypothetical
sample would have been if the “exit” group had stayed in the sample for one, two,
or three years. The variables in table 28 are deªned as follows:
R(t) NPD ratio for the original sample for period t, from row 4 of table 6.
L(t) total liabilities or debts of the original sample for period t, from row 7 of table
1.
Rx(t) NPD ratio for the “exit” group for period t, from row 16 of table 27.
Lx(t) total liabilities/debts for the “exit” group for period t, from row 11 of table
27.
R(t, T) NPD ratio for the hypothetically enlarged sample, with the original “exit”
group remaining in the sample for T periods:
R(t, T) [R(t) * L(t) Σ j Rx(t j) * Lx(t j)]/[L(t) Σ j Lx(t j)],
where j 1, 2, . . . , T. dR(t, T) R(t, T) R(t), the difference, in percentage points,
in the estimated NPD ratios between the enlarged hypothetic sample and the original
sample.
In table 28, rows 1–4 simply replicate results we have from previous tables, as noted
above. Rows 5–10 construct the NPD ratio and the total debts of the “exit” group for
the periods t 1, t 2, and t 3. These 10 rows of data are used to calculate the
NPD ratio for the enlarged hypothetical sample in which the “exit” group of enterprises
are retained for one, two, or three periods. The results of these calculations
are shown in rows 11–13. The longer the “exit” group is retained in the enlarged
sample, the higher the NPD ratio for the enlarged sample. Rows 14–16 show the
percentage-point difference in the NPD ratio between the enlarged hypothetical
sample (i.e., including the “exit” group) and the original sample. This is the estimated
sample selection bias. As shown in table 28, on average, over 1998–2002, the
NPD ratio would have increased about two percentage points if the “exit” group of
enterprises had remained in the sample for three more years.
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As shown in row 16 of table 28, the increase in the NPD ratio in this counterfactual
experiment is particularly signiªcant for the years 1999 to 2001, largely as a result of
more active restructuring of SOEs during this period. We know that during the period
from 1999 to 2000, Chinese authorities transferred RMB1.4 trillion in bad loans
from the four big state-owned banks to four asset management companies to facilitate
the bankruptcies and restructuring of SOEs. The exit of poor-performing enterprises
and their debts from our sample was also very signiªcant around 1998. In
fact, as shown in row 6 of table 27, from 1995 to 2000, RMB0.994 trillion in NPDs
(based on the imputed-proªts method of this paper) exited from our sample,
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Table 28. Reduction of nonperforming debt ratio resulting from exit of poor-performing
enterprises, 1995–2002
Row Variable Definition of variable 1995 1996 1997 1998 1999 2000 2001 2002
Average
during
1998–2002
1 R(t) Nonperforming debt ratio for 27.8% 29.5% 28.7% 29.7% 27.4% 22.7% 20.5% 18.4% 23.7%
original sample in t
2 L(t) Total debts for original sample 3,286 3,707 4,201 4,610 4,805 4,963 5,329 5,722
3 Rx(t) Nonperforming debt ratio for 32.4% 36.3% 33.4% 42.4% 28.0% 25.4% 23.6%
“exit” group in t
4 Lx(t) Total liabilities/debts for 484 320 577 472 550 686 390
“exit” group in t
5 Rx(t 1) Nonperforming debt ratio for 32.4% 36.3% 33.4% 42.4% 28.0% 25.4% 23.6% 30.6%
“exit” group in t 1
6 Lx(t 1) Total debts for “exit” group in
484 320 577 472 550 686 390
t 1
7 Rx(t 2) Nonperforming debt ratio for
32.4% 36.3% 33.4% 42.4% 28.0% 25.4% 33.1%
“exit” group in t 2
8 Lx(t 2) Total debts for “exit” group in
484 320 577 472 550 686
t 2
9 Rx(t 3) Nonperforming debt ratio for
32.4% 36.3% 33.4% 42.4% 28.0% 34.5%
“exit” group in t 3
10 Lx(t 3) Total debts for “exit” group in
484 320 577 472 550
t 3
11 R(t, 1) Nonperforming debt ratio of
29.9% 29.2% 30.1% 28.7% 23.3% 21.0% 18.7% 24.4%
enlarged sample with “exit”
group staying hypothetically
for one period
12 R(t, 2) Nonperforming debt ratio of
29.5% 30.5% 29.2% 24.8% 21.6% 19.4% 25.1%
enlarged sample with “exit”
group staying hypothetically
for two periods
13 R(t, 3) Nonperforming debt ratio of
30.7% 29.5% 25.5% 23.0% 20.0% 25.7%
enlarged sample with “exit”
group staying hypothetically
for three periods
14 dR(t, 1) dR(t, 1) R(t) 0.3% 0.5% 0.4% 1.3% 0.5% 0.6% 0.3% 0.6%
15 dR(t, 2) dR(t, 2) R(t) 0.9% 0.8% 1.8% 2.0% 1.1% 1.0% 1.4%
16 dR(t, 3) dR(t, 3) R(t) 0.9% 2.2% 2.8% 2.5% 1.7% 2.0%
Note: Exit group enterprise was in sample at t 1 and t but not at t 1.
amounting to about 70 percent of the bad loans carved out by the four asset management
companies. The declining trend of NPD ratios observed in the sample during
1995–2002 is clearly helped by the exit of these poor-performing enterprises and
their NPDs. But as shown in row 13 of table 28, even if the “exit” group of enterprises
had been included in the sample, the estimated NPD ratio for the hypothetically
enlarged sample would still have declined very signiªcantly, from 30.7 percent
in 1998 to 20.0 percent in 2002, consistent with the trend we discovered in the previous
sections.
The NPDs of “exiting” enterprises will continue to burden China’s banks unless the
banks can transfer the NPLs to China’s asset management companies (which have
been established to manage NPLs). So it is important to examine the impact of exiting
poor-performing ªrms on estimated NPD ratios. It is also important, however,
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to keep in mind that past NPDs are sunk costs, and what matters the most for economic
growth in China is the future trend of NPD ratios. Our NPD estimation
method is more meaningful for projecting the future NPD trend because our sample
consists of a truly dynamic group of the more active Chinese industrial enterprises,
and these ªrms more accurately represent the current state of the Chinese industrial
sector.
7. Implications for banking reform
This paper investigates empirically the quality of debts in the most dynamic group
of enterprises in China. We uncover a large amount of independent, consistent, and
statistically signiªcant micro-level evidence that shows that the quality of enterprise
debts in China improved during 1995–2002, especially after 1998. Because of the
transparency and scientiªc methods used in this research, the evidence looks much
more convincing than the macroeconomic statistics announced by China’s ªnancial
authorities.
The fall in NPD ratios for our sample enterprises is brought about by the shift of
ªnancial resources from SOEs to NSEs, improvement in the proªtability of SOEs
and NSEs, and the exit of poor-performing enterprises from the sample of the large
and medium-sized industrial enterprises. Both enterprise restructuring and the timing
of business cycles have contributed to the recent improvement in enterprise
proªtability in China and the fall in NPD ratios. But the beneªts of reform dividends
and business cycle timing could be uncertain in the future.
China can continue, however, to beneªt from the shift of ªnancial resources from
SOEs to better-performing NSEs, because the gaps in performance between the two
are still very large. The gaps in proªtability across industries and regions in China
are also large, showing the need for better risk management and more efªcient allocation
of ªnancial resources. The analysis in this paper could contribute to better assessment
of various risks relating to ownership, industry, and region.
The rising share of ªnancial resources allocated to NSEs and the declining NPD ratios
for all types of enterprises provide excellent opportunities for pushing banking
reforms in China now. If China’s banks can establish good corporate governance
and risk management, there seem to be enough good NSEs to lend to.
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Most of the major banks in China, however, are still state-owned. In light of the
strong evidence that SOEs are performing much worse than NSEs, priorities for
banking reform would seem to be the development of good private banks, the pri-
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vatization of state-owned banks, and the encouragement of more foreign or jointventure
banks to establish themselves in China. If China fails to develop non-state
banks, there is a high risk that it will continue to have high NPL ratios, even when
its NPD ratio is falling as a result of the privatization of enterprises. This is because
SOEs could create NPLs in spite of the good performance of China’s enterprise
sector.
Appendix 1. Data cleaning
The NBS survey covers more than 20,000 large and medium-sized industrial enterprises
in China. It contains some observations that are unusable because of incomplete
data reporting or the classiªcation of small enterprises that were considered
large and medium-sized historically on the basis of their design production capacity.
The classiªcation standard for the size of industrial enterprises was ªrst issued in
April 1988 by several government agencies, including the State Planning Commission,
National Bureau of Statistics, Ministry of Finance, Ministry of Labor, and State
Economic Commission. The standard includes detailed speciªcations based on measurements
of output quantity or capacity in technical-quantity terms instead of
value terms. The standard is clearly a legacy of the centrally planned economy and
is being phased out at present. It now only applies to state-owned industrial enterprises.
For private enterprises, the National Bureau of Statistics is using sales as the
sole variable in determining enterprise size.
In this study, observations that satisfy one or more of the following screening conditions
for industrial enterprises are regarded as unusable, and consequently such enterprises
are deleted from the usable sample:
1. Net value of ªxed assets RMB100,000
2. Intermediate inputs RMB100,000
3. Number of employees 30
4. Gross value of industrial inputs at current price RMB100,000
5. Sales RMB100,000
6. Total assets RMB100,000
7. Total assets liquid assets 0
8. Total assets gross ªxed assets 0
9. Total assets net value of ªxed assets 0
10.Accumulated depreciation current depreciation 0
11. Missing data for total assets, number of employees, gross value of industrial output
at current price, net value of ªxed assets, or sales
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After the unusable observations are deleted, only about 5 percent or less of the sample
enterprises have sales values less than RMB5 million. Tables A.1, A.2, and A.3
show the distribution of usable and unusable observations in the sample by ownership,
industry, and region, respectively. Because the unusable observations are
evenly distributed across ownership, industry, and region, we believe that excluding
them from the usable sample does not create much bias in our analysis.
Table A.4 shows summary statistics for key size variables (i.e., sales, output, assets,
liabilities, labor, and value-added) for the sample with the unusable observations removed.
Table A.5 shows the same set of size variables at selected percentiles. Table
A.6 examines the weight of the sample within the context of the Chinese economy.
Clearly, the sample represents an important part of the Chinese economy, and this
makes statistical analysis of the sample important and valuable for both
policymakers and practitioners.
Appendix 2. List of industry codes and the full industry names
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[06] Coal mining and dressing
[07] Petroleum and natural gas extraction
[08] Ferrous metals mining and dressing
[09] Nonferrous metals mining and dressing
[10] Nonmetal minerals mining and dressing
[12] Logging and transport of timber and bamboo
[13] Food processing
[14] Food production
[15] Beverage production
[16] Tobacco processing
[17] Textile industry
[18] Garments and other ªber products
[19] Leather, furs, down, and related products
[20] Timber, bamboo, cane, palm ªber and straw
[21] Furniture manufacturing
[22] Papermaking and paper products
[23] Printing and record medium reproduction
[24] Cultural, educational, and sports goods
[25] Petroleum processing and coking
[26] Raw chemical materials and chemicals
[27] Medical and pharmaceutical products
[28] Chemical ªber
[29] Rubber products
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[30] Plastic products
[31] Nonmetal mineral products
[32] Smelting and pressing of ferrous metals
[33] Smelting and pressing of nonferrous metals
[34] Metal products
[35] Ordinary machinery manufacturing
[36] Special purposes equipment manufacturing
[37] Transport equipment manufacturing
[40] Electric equipment and machinery
[41] Electronic and telecom equipment
[42] Instruments, cultural, and ofªce machinery
[43] Other manufacturing
[44] Electric power, steam, and hot water
[45] Gas production and supply
[46] Tap water production and supply
Table A.1 Distribution of usable and unusable observations by ownership, 1995–2002
1995 1996 1997 1998 1999 2000 2001 2002
Data quality
Poor
Private 2 1 2 3 9 14 26 54
Collective 60 72 93 66 58 77 86 89
Mixed 23 24 39 73 82 145 178 158
Foreign 41 67 64 43 42 65 65 98
Hong Kong, Macau, and Taiwan 31 36 34 28 43 59 60 89
State-owned 307 525 583 901 538 626 674 615
Total 464 725 815 1,114 772 986 1,089 1,103
Poor (percent)
Private 28.6 6.7 5.6 1.7 2.8 2.7 2.6 4.0
Collective 1.5 1.7 2.2 1.8 1.7 2.6 3.5 4.0
Mixed 1.8 1.7 1.9 2.4 2.2 3.2 3.1 2.5
Foreign 3.9 4.9 4.0 2.7 2.1 3.1 2.4 3.2
Hong Kong, Macau, and Taiwan 3.2 3.1 2.7 1.9 2.7 3.7 2.6 3.4
State-owned 2.0 3.4 3.9 6.7 4.8 6.3 7.7 7.9
Total 2.0 3.1 3.4 4.8 3.5 4.5 4.7 4.7
Good
Private 5 14 34 176 307 498 958 1,302
Collective 4,008 4,199 4,116 3,577 3,350 2,899 2,394 2,138
Mixed 1,233 1,406 2,064 2,934 3,592 4,381 5,619 6,135
Foreign 1,000 1,305 1,525 1,579 1,924 2,048 2,610 2,935
Hong Kong, Macau, and Taiwan 936 1,115 1,222 1,454 1,524 1,552 2,211 2,495
State-owned 15,361 14,935 14,350 12,573 10,766 9,360 8,106 7,215
Total 22,543 22,974 23,311 22,293 21,463 20,738 21,898 22,220
Total
Private 7 15 36 179 316 512 984 1,356
Collective 4,068 4,271 4,209 3,643 3,408 2,976 2,480 2,227
Mixed 1,256 1,430 2,103 3,007 3,674 4,526 5,797 6,293
Foreign 1,041 1,372 1,589 1,622 1,966 2,113 2,675 3,033
HK-M-Taiwan 967 1,151 1,256 1,482 1,567 1,611 2,271 2,584
State-owned 15,668 15,460 14,933 13,474 11,304 9,986 8,780 7,830
Total 23,007 23,699 24,126 23,407 22,235 21,724 22,987 23,323
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Table A.2 Distribution of unusable observations by industry, 1995–2002 (percent)
1995 1996 1997 1998 1999 2000 2001 2002
[06] Coal mining 0.4 0.3 1.0 1.0 0.7 3.2 1.8 3.7
[07] Petroleum extract 0.0 0.0 4.0 7.1 3.0 2.6 2.6 0.0
[08] Ferrous mining 0.0 0.0 0.0 0.0 0.0 2.2 7.1 0.0
[09] Nonferrous mining 3.0 2.5 2.5 3.7 2.3 2.9 3.7 3.3
[10] Nonmetal mining 1.4 0.9 2.8 3.4 0.0 2.8 5.1 5.4
[12] Timber logging 0.0 0.0 0.0 0.0 1.0 4.0 4.3 5.4
[13] Food processing 2.3 2.7 3.7 5.0 3.6 5.4 6.9 6.5
[14] Food production 3.6 6.6 7.3 5.9 3.9 5.8 5.4 5.7
[15] Beverage 1.6 3.1 3.2 3.6 2.5 3.6 3.4 4.5
[16] Tobacco 0.7 4.2 0.0 0.0 0.0 1.4 1.4 1.4
[17] Textile 2.5 3.0 3.8 6.0 3.8 3.8 4.4 4.8
[18] Garments 2.8 1.5 1.8 1.6 1.3 2.0 2.0 3.1
[19] Leather 2.6 4.5 2.8 6.3 5.0 6.5 4.9 4.3
[20] Timber 7.4 1.5 1.3 5.2 5.3 4.9 4.1 5.4
[21] Furniture 3.1 5.6 1.3 3.1 2.7 1.4 2.3 2.3
[22] Papermaking 2.6 3.3 3.0 6.7 4.4 6.1 5.1 4.6
[23] Printing 1.1 1.3 2.5 1.3 2.3 1.6 2.3 1.6
[24] Cultural 9.4 8.9 0.9 2.7 2.7 7.1 3.7 3.2
[25] Petroleum processing 0.0 2.6 2.6 0.8 0.0 2.5 3.8 5.6
[26] Raw chemicals 2.4 2.7 2.2 4.2 2.5 4.3 4.9 5.1
[27] Medical 1.6 2.4 1.8 3.9 3.4 3.8 4.1 2.9
[28] Chemical fiber 2.4 1.1 4.7 3.7 2.4 4.6 3.4 5.3
[29] Rubber 4.7 3.4 3.4 4.4 3.2 3.1 4.2 6.1
[30] Plastic 2.6 3.6 2.9 2.1 2.8 4.4 4.6 5.1
[31] Nonmetal products 2.0 3.2 3.2 5.2 3.0 4.0 4.7 4.2
[32] Pressing ferrous 0.4 3.5 3.2 8.5 2.6 5.4 6.8 5.7
[33] Pressing nonferrous 1.1 2.3 1.4 2.2 3.2 1.9 3.0 2.8
[34] Metal products 0.9 1.9 3.1 4.2 2.0 4.4 3.8 4.4
[35] Ordinary machinery 0.5 1.0 1.9 2.2 1.8 2.6 2.4 2.6
[36] Special equipment 0.9 1.7 1.3 1.9 2.1 2.8 3.2 3.8
[37] Transport equipment 1.6 2.5 2.2 3.6 2.9 3.3 3.3 2.6
[40] Electric equipment 1.8 2.6 1.9 3.1 1.7 3.4 2.5 3.8
[41] Electronic and telecommunications 1.8 2.4 3.0 3.0 2.1 2.9 4.3 2.8
[42] Instruments 0.6 1.6 1.3 4.4 2.1 2.8 3.9 5.1
[43] Other manufacturing 3.0 4.2 3.8 2.8 2.1 3.7 3.8 5.9
[44] Electric power 4.7 14.2 18.6 22.8 19.5 20.3 18.4 16.8
[45] Gas production 2.9 2.9 7.6 4.7 7.1 6.2 9.8 4.8
[46] Tap water 1.1 1.5 1.0 1.9 1.9 1.4 2.6 1.7
Total 2.0 3.1 3.4 4.8 3.5 4.5 4.7 4.7
Note: See appendix 2 for full industry names corresponding to industry codes.
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Table A.3 Distribution of unusable observations by region, 1995–2002 (percent)
1995 1996 1997 1998 1999 2000 2001 2002
[11] Beijing 4.6 3.0 2.6 4.4 5.9 9.5 3.9 4.1
[12] Tianjin 4.4 5.9 13.9 13.1 9.3 18.2 18.5 22.3
[13] Hebei 1.5 2.1 2.1 4.2 3.4 4.7 7.9 8.9
[14] Shanxi 1.6 1.9 3.1 5.1 2.5 4.4 8.1 8.6
[15] Inner Mongolia 1.1 5.1 7.1 7.6 7.7 9.1 9.1 9.6
[21] Liaoning 2.3 3.2 2.9 8.1 2.0 2.6 4.4 4.3
[22] Jilin 2.2 6.1 7.8 11.2 12.5 10.6 11.3 10.2
[23] Heilongjiang 2.7 4.3 5.5 10.2 7.9 8.2 11.4 9.0
[31] Shanghai 5.4 5.5 5.4 3.6 1.1 1.2 0.4 1.2
[32] Jiangsu 0.6 0.6 1.3 0.9 0.8 1.0 0.8 1.0
[33] Zhejiang 0.5 1.7 1.5 1.9 4.3 4.7 4.5 3.1
[34] Anhui 0.8 1.2 0.4 3.7 1.8 2.7 3.5 3.6
[35] Fujian 2.1 1.7 2.5 4.2 1.9 3.3 2.5 2.5
[36] Jiangxi 1.6 1.9 1.7 5.6 4.8 8.2 4.4 5.3
[37] Shandong 1.5 2.3 2.7 2.6 2.1 2.4 2.6 2.6
[41] Henan 1.1 7.5 7.7 8.2 5.3 8.1 10.4 12.2
[42] Hubei 2.6 3.3 3.6 5.7 3.2 4.0 6.1 5.0
[43] Hunan 2.2 4.2 2.3 5.1 1.3 2.0 2.0 2.4
[44] Guangdong 2.8 2.5 2.2 2.7 2.7 2.9 2.5 3.2
[45] Guangxi 0.7 5.6 1.6 2.8 0.7 2.2 1.5 2.8
[46] Hainan 18.1 10.7 3.5 8.1 5.8 7.6 10.9 7.8
[50] Sichuan Chongqing 1.7 2.7 1.8 5.1 4.9 6.4 5.8 3.6
[52] Guizhou 0.8 6.9 11.0 10.0 14.2 15.3 16.0 8.9
[53] Yunnan 0.9 0.0 1.2 2.9 1.1 2.6 1.5 2.3
[54] Tibet Qinghai Ningxia 0.0 0.6 2.7 6.2 2.4 0.6 4.4 2.8
[61] Shaanxi 1.5 1.3 0.6 4.7 2.1 2.5 2.3 1.4
[62] Gansu 1.4 1.0 6.9 7.4 8.7 9.2 8.8 10.3
[65] Xinjiang 1.5 1.6 1.4 3.7 0.6 4.0 2.2 1.8
Total 2.0 3.1 3.4 4.8 3.5 4.5 4.7 4.7
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Table A.4 Summary statistics for sales, output, assets, liabilities, labor, and value-added for
the cleaned sample (RMB million)
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Number of
enterprises
Mean
Standard
deviation
Median
Minimum
Maximum
Sales
1995 22,543 136 630 45 0.109 39,930 3,071,530
1996 22,974 144 681 44 0.100 43,738 3,308,847
1997 22,957 155 761 44 0.103 50,760 3,560,393
1998 22,293 163 772 44 0.101 50,611 3,629,511
1999 21,463 188 871 50 0.107 61,211 4,032,923
2000 20,738 234 1,219 57 0.112 92,279 4,843,396
2001 21,898 257 1,213 63 0.109 78,984 5,624,020
2002 22,220 292 1,329 69 0.101 72,843 6,495,292
Total 177,086 195 966 51 0.100 92,279 34,565,913
Gross value of
industrial output
1995 22,543 136 616 46 0.101 40,214 3,073,253
1996 22,974 147 685 48 0.130 44,349 3,378,619
1997 22,957 157 762 48 0.113 51,693 3,607,608
1998 22,293 165 767 48 0.100 51,646 3,681,858
1999 21,463 190 874 54 0.106 63,918 4,068,673
2000 20,738 230 1,171 61 0.150 92,617 4,775,290
2001 21,898 255 1,177 67 0.140 79,422 5,573,291
2002 22,220 288 1,275 71 0.100 73,633 6,388,539
Total 177,086 195 943 54 0.100 92,617 34,547,132
Total assets
1995 22,543 229 1,047 79 0.829 65,931 5,161,722
1996 22,974 256 1,199 85 0.831 75,366 5,872,942
1997 22,957 291 1,388 92 0.701 83,704 6,690,180
1998 22,293 329 1,522 99 0.701 90,322 7,323,630
1999 21,463 369 1,684 105 1.350 91,485 7,918,937
2000 20,738 397 1,763 111 1.770 85,791 8,239,931
2001 21,898 420 1,846 113 0.741 86,018 9,196,855
2002 22,220 446 1,882 115 0.835 85,809 9,909,926
Total 177,086 341 1,564 98 0.701 91,485 60,314,123
Total liabilities
1995 22,543 146 595 56 0.028 29,785 3,285,112
1996 22,974 161 658 60 0.016 27,652 3,706,920
1997 22,957 183 788 64 0.016 31,269 4,201,084
1998 22,293 207 859 69 0.098 33,133 4,609,115
1999 21,463 224 895 71 0.022 32,958 4,804,740
2000 20,738 239 957 74 0.010 46,409 4,962,981
2001 21,898 243 908 72 0.001 33,647 5,328,350
2002 22,220 258 990 71 0.016 43,050 5,723,794
Total 177,086 207 840 66 0.001 46,409 36,622,096
Number of employees
1995 22,543 1,696 5,215 877 30 254,078 38,223,099
1996 22,974 1,633 4,908 823 30 197,048 37,513,117
1997 22,957 1,593 4,719 793 30 193,076 36,581,069
1998 22,293 1,502 4,482 715 30 193,110 33,490,764
1999 21,463 1,428 4,401 654 30 194,410 30,656,548
2000 20,738 1,361 3,947 620 30 161,654 28,225,561
2001 21,898 1,237 3,599 560 30 147,722 27,079,491
2002 22,220 1,189 3,560 520 30 137,962 26,426,284
Total 177,086 1,458 4,404 701 30 254,078 258,195,933
Reported value-added
1995 22,543 43 332 11 424 32,912 958,256
1996 22,974 44 348 11 3,241 34,809 1,016,728
1997 22,957 47 382 12 6,738 39,565 1,080,121
1998 22,293 51 398 12 5,939 41,525 1,131,106
1999 21,463 60 479 14 1,954 53,645 1,288,589
2000 20,738 73 690 16 12,140 79,063 1,520,978
2001 21,898 80 660 18 1,796 78,355 1,741,547
2002 22,220 91 652 20 2,339 72,057 2,012,908
Total 177,086 61 510 14 12,140 79,063 10,750,232
Sum
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Table A.5 Size of sales, output, assets, liabilities, labor, and value-added at selected
percentiles for the cleaned sample (RMB million)
Percentiles
5 10 25 50 75 90 95
Sales
1995 6 10 20 45 101 233 418
1996 5 9 19 44 102 245 438
1997 4 8 19 44 105 264 488
1998 4 7 18 44 107 286 530
1999 6 9 21 50 125 325 614
2000 6 10 23 57 146 387 739
2001 6 11 25 63 162 444 838
2002 6 11 27 69 181 505 983
Gross value of industrial output
1995 7 10 22 46 104 236 403
1996 6 10 21 48 110 250 440
1997 5 9 21 48 112 266 489
1998 5 9 20 48 115 288 536
1999 7 11 24 54 131 333 606
2000 6 11 25 61 151 388 730
2001 7 12 27 67 169 444 836
2002 7 12 29 71 186 505 956
Total assets
1995 22 28 44 79 167 378 676
1996 23 29 46 85 180 414 745
1997 22 29 48 92 198 474 888
1998 23 30 50 99 218 538 1,007
1999 24 32 54 105 239 603 1,144
2000 23 31 54 111 259 672 1,304
2001 22 31 54 113 271 725 1,445
2002 21 30 54 115 282 775 1,589
Total liabilities
1995 12 17 29 56 115 245 424
1996 12 18 31 60 125 268 471
1997 12 18 33 64 137 301 542
1998 12 19 34 69 151 345 641
1999 12 18 35 71 160 381 709
2000 11 18 35 74 169 412 784
2001 9 16 32 72 170 429 848
2002 9 15 31 71 176 459 910
Number of employees
1995 211 306 520 877 1,515 2,858 4,631
1996 186 271 475 823 1,457 2,806 4,584
1997 168 248 445 793 1,429 2,767 4,595
1998 141 208 388 715 1,340 2,656 4,429
1999 126 187 348 654 1,257 2,566 4,258
2000 116 173 323 620 1,208 2,497 4,143
2001 103 150 288 560 1,129 2,332 3,815
2002 92 134 260 520 1,079 2,257 3,778
Reported value-added
1995 2 1 4 11 26 64 121
1996 2 0 4 11 29 69 131
1997 2 0 4 12 30 74 141
1998 2 1 4 12 31 80 159
1999 0 2 5 14 37 95 183
2000 0 2 6 16 43 115 215
2001 1 2 7 18 49 131 247
2002 0 2 7 20 54 147 289
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Table A.6 Weights of sample enterprises in Chinese economy
1995 1996 1997 1998 1999 2000 2001 2002
(1) Number of enterprises in sample 22,543 22,974 23,311 22,293 21,463 20,738 21,898 22,220
165,080 162,033 162,885 171,256 181,557
(2) Number of all industrial state-owned enterprises plus non-state
industrial enterprises with annual sales above RMB5 million
(3) Reported value added for all enterprises in sample (RMB billion) 958 1,017 1,080 1,131 1,289 1,521 1,742 2,013
(4) Total industrial value added in China (RMB billion) 2,472 2,908 3,241 3,339 3,509 3,905 4,238 4,654
(3)/(4) Sample value added/China’s industrial value added 38.8% 35.0% 33.3% 33.9% 36.7% 39.0% 41.1% 43.3%
(5) China’s GDP (RMB billion) 5,848 6,789 7,446 7,835 8,207 8,947 9,731 10,479
(3)/(5) Sample value added/China’s GDP 16.4% 15.0% 14.5% 14.4% 15.7% 17.0% 17.9% 19.2%
(6) Number of employees for all enterprises in the sample (million) 38 38 37 34 31 28 27 26
(7) Number of employees in all industrial enterprises (million) 157 162 166 166 164 162 163 158
(6)/(7) Sample employment/China’s industrial employment 24.4% 23.1% 22.1% 20.2% 18.7% 17.4% 16.6% 16.7%
(8) Urban employees in China (million) 191 198 202 216 224 232 239 248
(6)/(8) Sample employment/China’s urban employment 20.0% 18.9% 18.1% 15.5% 13.7% 12.2% 11.3% 10.7%
(9) Total employment in China (million) 679 689 696 706 714 721 730 737
(6)/(9) Sample employment/China’s employment 5.6% 5.4% 5.3% 4.7% 4.3% 3.9% 3.7% 3.6%
(7)/(9) China’s industrial employment/China’s employment 23.0% 23.5% 23.8% 23.5% 23.0% 22.5% 22.3% 21.4%
(10) Total liabilities for all enterprises in sample (RMB billion) 3,286 3,707 4,201 4,610 4,805 4,963 5,329 5,722
(11) Total loans in China (RMB billion) 5,054 6,116 7,491 8,652 9,373 9,937 11,231 13,129
(10)/(11) Sample total liabilities/Total loans in China (%) 65.0% 60.6% 56.1% 53.3% 51.3% 49.9% 47.4% 43.6%
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References
Anderson, Jonathan. 2005. How to Think about China (Part 3): Which Way Out for the Banking
System? Asian Economic Perspectives, 9 May. UBS Investment Research.
Cai, Hongbin, Qiao Liu, and Geng Xiao. 2005. Does Competition Encourage Unethical Behavior?
The Case of Corporate Proªt Hiding in China. Hong Kong Institute of Economics and
Business Strategy Working Paper no. 1126. Hong Kong: The University of Hong Kong.
China Banking Regulatory Commission (CBRC). Statistics. Available at http://www.cbrc
.gov.cn
Liu, Qiao, and Geng Xiao. 2004. Look Who Are Disguising Proªts: An Application to Chinese
Industrial Firms. Hong Kong Institute of Economics and Business Strategy Working Paper no.
1095. Hong Kong: The University of Hong Kong.
Xiao, Geng. 2005. What Is Special about Enterprise Performance in North-East People’s Republic
of China? Dynamics of Privatization, Proªtability and Productivity during the Reform Era.
Hong Kong Institute of Economics and Business Strategy Working Paper no. 1133. Hong Kong:
The University of Hong Kong.
Xiao, Geng, and Zhengge Tu. 2005. China’s Industrial Productivity Revolution: A Stochastic
Frontier Production Function Analysis of China’s Large and Medium-Sized Industrial Enterprises
during 1995–2002. Paper presented at the Western Economic Association International
and Hong Kong Economic Association conference, 15 January, Hong Kong.
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The economic challenges ahead for China
By Xiao Geng, China Daily, September 8, 2010
China's key macroeconomic challenge over the next two decades is to determine how to manage
its exchange, interest and inflation rates to facilitate sustainable, stable and efficient economic
growth as the Western economies shrink in size relative to emerging market economies.
To appreciate the magnitude of this challenge, one must realize that China's high economic growth
rate in the past 30 years has largely been a story of rapid productivity growth and catching up.
This is likely to continue for the next two decades as it continues to implement market-oriented
reform alongside rapid industrialization and urbanization.
In this context, the price of China's non-tradable goods - such as wages for unskilled labor and
property prices - is likely to continue to rise compared with the prices of tradable goods, which are
set by global markets. In the next two decades, China's price levels will gradually but steadily
converge toward those in the United States through structural inflation or structural revaluation of
the yuan - or both.
Since the inflation rate and currency revaluation, necessarily associated with productivity catch-up,
can cause distortions, shocks and income redistribution, the critical challenge for Chinese
policymakers is to mitigate any potential dislocation created in the adjustment process.
There are two key policies that China can pursue.
First, when structural inflation emerges, it would be critical for China to raise nominal interest
rates. This will avoid the asset bubbles caused by negative real interest rates, and will protect the
value of bank deposits held by low-income households which cannot afford to hedge against
structural inflation by investing or speculating in property markets.
By way of example, China's urban residential real estate prices have risen on average by about 9
percent a year since 1991, but the mortgage rate is only about 5 percent and the one-year
fixed-deposit rate is only about 2 percent. Such structural inflation in property and low mortgage
and deposit rates imply a very serious problem of negative real interest rates in terms of property
investment. These negative real interest rates are at the root of China's property bubbles and
associated huge income redistribution from depositors (usually poor) to mortgage holders (usually
the rich).
If China cannot maintain a positive real interest rate, the boom and bust cycles in its property
sector are likely to continue, leading to serious inefficiency in investment and social instability.
Conversely, if China does raise interest rates to a level higher than its structural inflation, it will
need adequate capital control mechanisms to deal with speculative capital inflows.
But this problem is solvable, and brings us to the second policy point; China must permit

easonable structural inflation.
Specifically, China need not rely solely on nominal exchange rate flexibility to facilitate its rising
price levels. Instead, it can tolerate higher structural inflation and the associated real revaluation of
the yuan.
In fact, by allowing for reasonable structural inflation, China can implement a flexible exchange
rate regime more easily. With inflation, there will be potential for the currency to devalue when
inflation runs beyond productivity growth.
Furthermore, a mixture of inflation and nominal appreciation would create a regime in which the
market exchange rates could go up or down. This would reduce the incentive for massive
speculative holdings of the yuan. Such speculative holdings have become a key driver of China's
foreign exchange reserve bubble.
Since the yuan's peg to a currency or basket of currencies has a stabilizing function, when China
pegs the yuan to the US dollar, it need not worry much about runaway inflation. If the inflation
rate goes beyond China's underlying productivity growth, the market will expect the yuan to
depreciate, which will lead to capital outflows and the tightening of money supply.
There is one final point to be made.
While the debate over the yuan's exchange rate is often framed in terms of global trade imbalances,
the exchange rate is a price not just for trade but for assets. In fact, asset markets are much larger
than trade markets. Thus, maintaining stable exchange rates to facilitate stable and efficient capital
flows between the US and China is more important than using the exchange rate to correct global
trade imbalances. In any case, using trade policies may be a more productive way of correcting
China's trade imbalances.
In sum, given China's huge foreign exchange reserves, it will be easy for it to defend the yuan's
peg and avoid runaway inflation. And, as soon as China starts tolerating reasonable structural
inflation and the associated increase in its real exchange rate, the pressure for nominal
reevaluation of the yuan will be reduced.
The author is director of Columbia University Global Center for East Asia based in Beijing and a
non-resident senior fellow at the John L. Thornton China Center of Brookings Institution.

Alternatives to revaluating the yuan
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Op-Ed Contributors
Alternatives to revaluating the yuan
By Xiao Geng (China Daily)
Updated: 2010-03-25 07:48
Editor's note: According to the author, it’s not the appropriate time to revaluate yuan in
consideration of national interests of both US and China. But he suggests some
structural and institutional reforms as alternative options.
The debate on how to correct the trade imbalance between the United States and China is
focused on increase: How to increase US exports and savings and how to increase Chinese
imports and consumption.
A big part of the debate, especially in the US, is focused on China's currency, which US leaders
allege is undervalued. The Americans want China to revalue the yuan considerably in the hope
that it would lead to an increase in US exports and employment.
Chinese leaders differ. They regard the US pressure to revaluate the yuan and Washington's
protectionist measures as unfair and detrimental to China's development. They place emphasis
upon structural and institutional reform to increase Chinese consumption and make domestic
investment more efficient.
Related readings:
Tagging the yuan as a scapegoat is
unfair
Yuan revaluation talk heats up
Raise yuan at the right time
industrialization, low national debt and low fiscal deficits.
Why is there such a considerable gap between
Chinese and US views?
The US demand for the revaluation of the yuan is
based upon its short-term concern over China's large
current account surplus and long-term worry over
China's high growth, rapid urbanization and
China, on its part, is worried that a revaluated yuan or a premature end to its link with the US
dollar would cause financial instability through speculative capital inflow, asset bubbles and
nominal shocks to employment and business in its exports sector. China fears that a currency
revaluation could destabilize capital inflows and discourage private Chinese firms and financial
institutions from buying dollar assets, especially if their values could continually to fall in yuan
terms.
Beijing has not forgotten how the large increase in the value of the Japanese yen brought about
by the 1985 Plaza Accord created massive asset bubbles, which burst in 1989 and led to a two
decade-long deflation without eliminating Japan's trade surplus.
But a nominal exchange rate adjustment is not China's only tool for correcting trade imbalances.
If China pegs the yuan to the dollar, it can still use inflation to achieve a rapid increase in its price
level relative to that in the US, or a real revaluation of the yuan against the dollar. Relative price
levels between economies tend to take into account the nominal exchange rate and adjust price
levels for the gap in inflation rates between two economies.
Because of these two factors the Chinese approach to exchange rate stability thus far has
focused on inflation first and appreciation second. This puts priority on creating employment,
increasing wages and productivity, and price liberalization rather than addressing trade
imbalances through adjustments of the nominal exchange rate.
Given that the Chinese approach is likely to remain constant, it is important to consider some
alternative policy options, particularly certain structural and institutional reforms.
First, to reduce savings and inefficient investment, China needs to privatize and deregulate large
State-owned enterprises (SOEs). China's savings rate reached the high of about 55 percent of
GDP in 2007-2008, with a current account surplus of about 10 percent of GDP. Corporate
savings amount to about half of the national savings, and a major contributing factor is the
savings of China's SOEs.

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The SOEs are not allowed to pay high salaries to their employees and do not distribute
dividends, and they do not generate purchasing power when the prices of their shares increase.
This has created huge capital gains with no wealth effects on consumption. In addition, the highsavings
of SOEs are often invested in overcapacity sectors.
Household income still accounts for only 35 percent of China's national income, and the country
will not be able to significantly raise the wages and productivity of its workforce in the near
future. To improve domestic consumption, therefore, China must create an investment
environment conducive to investment in sectors with large domestic consumption potential. In
sum, investment at present is the most important variable for eliminating China's current account
surplus, and for absorbing its savings internally.
Especially now, it is important that investments be made more efficiently. In the past few years
cheap money, or a low interest rate, has often led to inefficient investment in China's exports
manufacturing sector, driving down prices of "made in China" products. Since the US' current
zero interest rate policy is likely to bring capital flows into China in the hope of higher investment
return, the current availability of cheap money is likely to continue. Because of this it is important
that China improve its capital control mechanisms to allow orderly cross-border capital flows for
more efficient investments with higher returns both domestically and internationally, while limiting
the speculative flow of capital and inefficient investments.
Another overlooked problem contributing to the global imbalance is factor price distortion in the
Chinese economy. This must be addressed if the global economy is to be righted. Price
distortions are caused by a number of factors, including local governments' offering of cheap
land as part of efforts to attract foreign invested enterprises, weak property rights, rudimentary
carbon-emission standards, weak enforcement of environmental protection laws, and a lack of a
social safety net, which makes the cost of labor low now, but has hidden social liabilities for the
future.
Given the huge potential of cross-border investment and debt financing between the US and
China, a stable yuan-dollar exchange rate suits both countries' long-term national interests. And
in the long-term, certainly after 2020 and perhaps between 2025 and 2035, the yuan is likely to
become a fully convertible currency. But for that to happen, the Chinese economy must first
complete its structural and institutional transformation into a fully modernized market economy
with a more democratic political system. Until then, the US and China should look for long-term
policy options that are realistic and beneficial to both countries.
The author is director of the Brookings-Tsinghua Center for Public Policy in Beijing and senior
fellow of the Brookings Institution in Washington DC.

Wall Street Journal Asia February 9, 2010
Geng Xiao: Beijing's Property-Price Dilemma
Bolder action—including increasing the interest rate on deposits—is needed to keep a bubble
from forming.
By GENG XIAO
Average prices for urban residential property in China have increased to $523 per square meter
($48.59 per square foot) in 2008 from $111 in 1991, or about 9% annually. Throughout this
period, there have been warnings that sustained investment and speculation could lead to a
boom and bust—especially given uncertain government policy. But before policy makers can fix
the problem, they have to understand what has gone wrong.
In the long run, China's economic growth will inevitably drive prices higher. A property's value is
the present discounted value of the rents it can generate in the future. Since rents are impossible
to predict with certainty, markets guess based on assumptions about future economic
development. The urbanization rate—one proxy for China's level of productivity since industrial
activity is concentrated in cities—is only around 46% now, so productivity growth will likely
continue for another decade or more.
Inflation expectations are another factor pushing prices higher. Investors view property as a
hedge against rising prices, so the worse inflation expectations are, the more investors will pay
for "insurance." However, this demand drives property prices beyond the inflation trend if supply
cannot keep pace with demand. Policy makers have contributed to that excess demand by
keeping bank deposit rates near zero, which has made property a better outlet for household
savings for the past two decades. The situation will worsen if the central bank fails to raise
deposit interest rates fast enough if inflation picks up.
Finally, actual and expected currency appreciation has encouraged overseas Chinese to bet on
property in major mainland cities. Not only do these properties seem to be on an upward trend,
but yuan appreciation further boosts returns in dollar terms. Real estate-related investment
accounted for 10% to 15% of China's foreign direct investment between 2006 and 2009. The
ownership of high-end residential real estate by foreigners and overseas Chinese in big cities was
around 20%, by some estimates.
Preventing a property bubble will be difficult in the face of these trends. When the government
tried to control the real-estate boom around 2005, it restricted both high-end property supply
and demand. The State Council asked all new residential development projects in May 2006 to
allocate 70% of their floor space to flats smaller than 90 square meters to reduce the number of
luxury flats. In July 2006, it also restricted the investment on residential property by foreign
investors and overseas Chinese, allowing them to buy only one property to live in themselves.

But total demand remained strong and pushed up prices. Reducing supply is easier than cutting
market demand.
Efforts to boost supply at the lower end of the property spectrum might help. High-end property
is concentrated only in major cities such as Shenzhen, Shanghai and Beijing. These cities have
relatively high per-capita income, rapidly modernizing city infrastructure and particularly large
concentrations of non-local and cash-rich residents and enterprises. The price for luxury property
in these cities is high compared to the incomes of local residents, but is still 30% to 50% below
those in cities such as Hong Kong, Tokyo, London and New York. The convergence of prices for
high-end residential and commercial property among these cities means local residents with
much lower wages can no longer afford to buy a decent home.
Few developers, however, are enthusiastic about building low-price housing without heavy
subsidies. So central and local governments have subsidized lending rates, rolled out
administrative controls and tax rules and lowered down-payment requirements while increasing
taxes on luxury development. The goal is to shift construction away from bubble-prone, high-end
projects. Though these policies create some cases of inefficiency, corruption and uncertainty
about future property prices, recently they have started to cool down property markets.
Yet that alone will not be enough to prevent a serious bubble. Investors and speculators are still
betting on an upward trend in property prices. They know neither the central nor local
governments want a collapse of property markets; about one-third of local government revenues
come from land sales, and property development is regarded as a pillar of the economy. Recent
macro statistics also reflect a high probability that consumer-price inflation will be as high as 5%
in coming years. Moreover, given the Federal Reserve's zero interest rate policy, Chinese
authorities are likely to be cautious in raising their interest rate or the value of yuan, to avoid
attracting speculative inflows of overseas money. This means China is likely to experience a low
or even negative real interest rate for the next few years, reinforcing property's appeal as an
investment.
Policy makers can't put off dealing with the drivers for property demand and the low interest rate.
Authorities need to balance strong domestic demand-driven growth fueled by cheaper credit and
potential property, and stock market bubbles if credit becomes too cheap. The key is to raise the
interest rate to deter domestic speculative forces while managing cross-border capital flows so
they are invested in more efficient projects outside property speculation and stock markets.
Mr. Xiao is Senior Fellow at the Brookings Institution and Director of the Brookings-Tsinghua
Center in Beijing.

Inflation First, Appreciation Second:
China’s Practical Choice
Xiao Geng Brookings Website July 30, 2007
Starting in July 2005, the RMB was de-linked from the dollar and has since been under a
managed float with reference to a basket of currencies. However, from July 2005 to March
2007, the RMB appreciated only about 7%. In particular, China’s global current account
surplus in 2006 jumped to a record high of $184 billion, or about 9% of GDP. As a result,
China’s foreign exchange reserves have reached $1.07 trillion, the largest in the world. China
has also become the second-largest holder of U.S. bonds.
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The rapid rise in China’s global current account surplus and the slow appreciation of the RMB
has led to a strong Washington consensus: China should be pressed hard to raise the value of
its currency so as to reduce its global current account surplus as well as its current account
surplus with the United States. In Congressional hearings on 28 March 2007, Institute for
International Economics scholar Morris Goldstein held that China’s currency is now grossly
under-valued on the order of 40 percent against the US dollar, saying that, “China should
deliver right away a meaningful‘down payment’of a 10-15 percent appreciation of the RMB
from its current level.”
In my view, the current single-minded focus on the RMB exchange rate by Washington elites is
unlikely to be helpful in addressing the imbalances of China’s trading patterns.
Barriers to China’s Fixable Rate Adjustment
On the issues of China’s rate and global imbalance, China, the U.S., and the world can reach a
win-win approach to resolve the issues, but that is built on the basis of a mutual understanding
of difficulties the other party faces and mutual assistance. China currently faces
unprecedented challenges and opportunities not entirely dissimilar to those of post-war
reconstruction in Europe. Without the help and cooperation of the U.S. and other developed
nations, China is unlikely to be able to handle this crucial step in its economic, social and
political modernization.
The special phenomenon, the coexistence of surplus labor and surplus capital, appears in
China and other Asia countries. China’s main challenge today is to develop
smoothly-functioning financial, planning, and regulatory systems that can employ the
remaining rural surplus labor and surplus capital. These surpluses now show up now as
China’s sustained current account surplus and rising foreign exchange reserves, and instead
should be utilized in an efficient, harmonious, and environmentally-friendly way.

In China, hidden transaction cost has been the single most important barrier to national growth,
development and prosperity before and after the advent of market-oriented reforms. Low
wage is neither the single factor nor even the most important factor pushing the
advance of China’s export competitiveness. No countries in the world worried about
China’s export competitiveness before 1979, even though at that time the average wage for
factory workers was only 24 dollars a month (under the official exchange rate of 1.5
yuan/dollar), as compared with the current monthly wages of about $120/month for migrant
workers (under the exchange rate of 8 yuan/dollar in 2006). The declining transaction costs of
exporting and the expanding market play more important roles in China’s export
competitiveness.
In fact, international supply chain management has largely decreased China’s export costs
and has had significant effects on this sector and also that of foreign investment. However,
exports from China involve only labor-intensive processing and manufacturing. At the same
time, the international supply chain faces tremendous obstacles when importing goods into
China, so these transaction costs are very high. The supply chain has to start by ascertaining
consumer demand and then find the lowest-cost producer. Consumer demand in China,
however, is affected by many factors outside of the international supply chain’s control,
including China’s lack of efficient consumer financing, the absence of a functioning social
safety net, a shortage of medical insurance, the weaknesses of the pension system, an
absence of basic urban and rural infrastructures for individual consumption, a lack of basic
regulations and enforcement of environmental protection, shortfalls in the effective regulation
of product quality, and a near-total breakdown in the effective protection of intellectual property
rights. Clearly, many of the domestic challenges involved in economic structures and
institutions that China faces have hindered the growth of China’s imports but not
exports and are at the root of China’s sustained global current account surplus.
While the relative cost of labor can be affected directly by a change in the exchange rate,
transaction costs cannot be affected very much by such a change. In my view, thanks to
China’s continued reform and opening, including the benefits from the accession to the World
Trade Organization, China’s export competitiveness is likely to grow greater in the future
because of the declining transaction costs of exporting, even if labor costs rise from RMB
appreciation, inflation and other events.
In order for China to balance its trade, it has to work hard on reducing the transaction costs for
imports. Since the barriers to imports are primarily in the realm of hidden transactions
costs, not in price, an emphasis on exchange rate adjustment would not be as effective
as a focus on reducing the barriers and constraints facing imports into China.
Only Adjusting Rates Is Not Enough
Unfortunately, in the public policy debate, rates, especially the nominal rate, are thought to be
the most important factors affecting competitiveness and trade imbalances, which is a
misunderstanding in both theory and practice.

The implication is that as long as China maintains free trade, China’s nominal exchange rate
will always be consistent with the PPP exchange rate based on tradable goods because of the
possibility of market arbitrage. In other words, claims that China’s nominal exchange rate is
undervalued are nonsensical unless they are based on a PPP exchange rate derived from
buying a bundle of goods that also includes non-tradable goods.
Japan allowed its currency to appreciate steadily and significantly for many years during the
1990s with little effect on reducing or eliminating Japan’s current account surplus. What Japan
got from the appreciation of the yen was little more than a decade of deflation. If Japan had
held its nominal exchange rate constant throughout the 1990s, it most likely would have faced
inflation during that period. But too great an appreciation of the yen eliminated the necessity
for inflation and even required some deflation to compensate the excessive appreciation of
yen. Clearly the argument that changes in the nominal exchange rate will have a lasting
effect on current account balances is misleading. If a country can gain real
competitiveness through nominal devaluation of its currency, economic growth and
development would be easy and should have been accomplished a long time ago for
many developing countries. What we know from basic economic principle and real world
experiences is that the nominal exchange rate is only a benchmark for domestic price levels.
Changes in the nominal exchange rate will have lasting effects only on the domestic price level,
not on competitiveness. Lasting improvements in competitiveness are determined by factor
costs, transaction costs, technological progress, infrastructure, human capital and other real
variables, but not the nominal exchange rate. Moreover, we should realize that sustained
current account imbalances have very little to do with the level of the nominal exchange rate.
Current account imbalances are fundamentally about surpluses or deficits of capital, about
savings and investment gaps, and about consumption and saving behaviors.
China Should Adopt an Inflation-First and Appreciation-Second Strategy
Inflation and currency appreciation are substitutes that are equivalent in terms of facilitating
the rise of a country’s domestic price level. To an American consumer, the effects of China’s
suffering 15% inflation or an appreciation in the RMB-dollar exchange rate by 15% are the
same. The U.S. consumer faced with a 15% increase in his costs of buying goods made from
China would not really care where the increased costs come from: inflation in China or an
appreciation of the RMB.
Those who are pushing China to revalue the RMB by 15% or 40% are really asking
China to adjust upwards its domestic price level by 15% or 40%. But why not just
recommend to Chinese policy-makers 15% or 40% inflation? We can see immediately
the difficulties in engineering inflation as high as 15% to 40% in China.
Although inflation and currency appreciation play the same function in raising the domestic
price level, they work through very different economic mechanisms. Structural inflation, which
accommodates domestic price level changes, works through individual markets with much
less shock to the society than sudden and large exchange rate changes.

To speed up the growth of China’s domestic price levels, China can of course use inflation,
currency appreciation, or even both at the same time. In my view, China should be
encouraged to run a stable but low rate of inflation first, say about 5% a year, so as to match
the steady growth of its domestic price levels with those in more developed economies. When
structural inflation, which is different from pure monetary inflation, is expected to reach beyond
5%, China should also add currency appreciation as an additional instrument to further absorb
the pressure for increases in domestic price levels. The extent of currency appreciation should
be determined by the market in the sense that appreciation would not be so excessive as to
push inflation down below 3%.
This inflation-first and appreciation-second strategy would avoid the risks of both
deflation and excessive inflation. It will also be able to deter currency speculation as
speculators would need to worry about inflation in China whenever they bet on the
appreciation of RMB. Speculators and investors can still bet on real estate, which will rise in
value with both inflation and appreciation, but the catch-up of prices in property should be
viewed as a leading indicator for the catch-up of overall price levels in China and should not
concern the Chinese authorities too much as long as investors are required to make sizable
down-payments for their properties.
Overall, price levels in China are far low than those in the US, but some luxuries and costly
services are exceptions. The gap in price levels between China and the U.S. can be
measured by the difference between China’s nominal exchange rate (8 yuan/dollar in
2006) and the PPP exchange for GDP as calculated by the World Bank (2.6 yuan/dollar
in 2006). This gap is as much as 67.5%.
In my view, it is not possible for China’s domestic price level to reach that of the U.S. within 15
years. If this common-sense judgment holds true, then China’s average annual currency
appreciation plus its extra inflation could not possibly exceed 8%. Hence, 4% per year extra
inflation and 4% per year currency appreciation would probably be the best we can
hope for in China.
The actual pace of inflation and RMB appreciation in China at the present is far from this “limit.”
In 2006, China’s inflation rate was only 1.5%, much lower than the inflation rate in the U.S. of
2.5%. In fact, relative to the U.S., China had deflation in 2006! The average rate of RMB
appreciation in 2006 was around 3%. So in 2006 China’s domestic price level increased only
about 2% (1.5% - 2.5% + 3% = 2%) relative to that in the U.S. At this pace, it will take China 57
years to catch up to the U.S. price level. No wonder so many in Washington are getting
impatient about China’s currency policy! However, while it is easy to complain about China’s
slow adjustment, it is difficult to find a solution to speed up China’s price level catch-up.
The International Community Should Encourage China to Adopt a Loose Monetary
Policy
The structural constraint of the large pool and surplus of unskilled labor is the main reason for
price increases and the RMB’s slow appreciation. According to the Asian Development Bank,

in 2006, inflation reached 2.2% in Korea, 5.5% in India, 7.9% in Pakistan, 13.1% in Indonesia,
7.5% in Vietnam, and 6.2% in the Philippines. It seems fair to say that in the global context
China experienced deflationary pressure in 2006 even though China’s growth rate was 10.7%.
Surprisingly both the Chinese government and international organizations like the ADB, World
Bank and International Monetary Fund have urged China to tighten monetary policy so as to
restrain investment when China actually recorded one of the lowest inflation rates in the world
in 2006. On the other hand, the ADB, among others, recommended that other Asian
economies, many of which have much higher inflation rates than China in 2006, raise
investment, especially in infrastructure. The typical answer is that “China is special,” that China
has over-capacity, and that therefore China should reduce investment and increase
consumption.
The advice on increasing consumption cannot be wrong. However, consumption in China
today is largely under the control of individual families and firms. They have probably already
tried their best to optimize their consumption given all the constraints they face, and are
unlikely to welcome the government telling them how to spend their money. Since the health
insurance and social security networks in China are in their infancy, many Chinese people
choose to save a great deal of money as a hedge against severe illness. In the absence of
student-loan programs, families also choose to save a great deal for their children’s education.
As roads, subways and schools for many newly developed residential communities are
underdeveloped, many middle class Chinese families are deciding to buy property, betting on
the capital gains but refraining from moving into the new property until the road and/or subway
networks are completed.
In the context of the above examples, the answers are quite straight forward: build an
integrated health insurance system; create student-loan or scholarship programs; and build
more roads, subways, and schools. All these solutions, not surprisingly, require investment.
But these are productive investments, and productive public investments are fundamentally
different from the investment that generates unproductive over-capacity, since these
investments will free up the consumption power of Chinese households, which are currently
held back as a hedge against potential negative future eventualities.
Because of the difficulties in distinguishing productive investment from unproductive
investment, the central bank of China faces a dilemma: if it adopts a loose monetary policy, it
will have to deal with over-capacity as unproductive investment expands out of control; if it
adopts a tighter monetary policy, it will have to deal with a current account surplus when
imports and productive investment cannot grow fast enough to keep up with the expansion of
exports.
To speed up China’s catch-up in domestic price level the international community should
encourage China to adopt a loose monetary policy, which means less sterilization of its rising
foreign exchange reserves. This move would accommodate steady structural inflation, and a
low and stable inflation rate is a necessary condition for facilitating an orderly RMB
appreciation that would not risk deflation. But to convince China to adopt a loose monetary

policy, it is necessary to help China to develop a robust financial planning and regulatory
system that can distinguish productive from unproductive investments.
The strength of the financial sector in the U.S. contrasts sharply with the weakness of that of
China. With a strong financial sector, the average American can afford to maintain a low
savings rate since they can secure capital gains on their investments in property and capital
markets. With a weak financial sector, the Chinese consumer has to maintain a high saving
rates, lower consumption (and hence a lower standard of living), and thus China cannot use its
surplus capital to utilize productively all its people.
Americans today worry about competition from China just as Hong Kong people did a decade
ago. But today, people in Hong Kong realize that as China’s economy grows, more work
opportunities come than all of Hong Kong’s labor pool can handle. I have no doubt that if
America helps China fix its financial sector, China will create an enormous demand for
American goods and services, consequently giving similar benefits and employment
opportunities for the American people. The U.S. and the international community should make
efforts for that solution instead of a narrow-minded focus on simple RMB exchange rate
revaluation.

Sustainable Growth
By Xiao Geng
Far Eastern Economic Review, page 54-55, Vol. 168
The year will be one of little significance for China’s macro economy, which means 8% growth
with few shocks.
Given the many challenges facing China, why such strong confidence? The answer may be
obvious to business executives in China, but it has taken economists a lot of research effort to
understand. The country's most important firms are in the middle of a quiet productivity
revolution that is going to transform not just Chinese enterprises and cities, but also eventually
the global economic landscape.
In the past few years, too much attention has been paid to China's macro-economy, largely due
to exciting business cycles. However, hidden behind the headlines are deep structural and
institution al changes: ever intensifying market competition, on-going inflows of FDI, rapid
expansion of both exports and imports, quiet but steady privatization, chaotic but breathtaking
improvement in the regulatory environment, and finally the transformation of urban
infrastructure in many leading cities.
A key question linking the macro- and microeconomics of China's development is the effects of
these changes on productivity. If there is no productivity improvement, china's high growth is
simply borrowed prosperity, driven by the expansion of investment in the past and the rise of
non-performing loans in the future. Many observers have rightly pointed out that China's
statistics so far show no impressive productivity growth. But China is too big and too diverse for
the data to show what is really happening.
Working closely with researchers at the National Bureau of Statistics of China, my colleagues and
I discovered that the average annual growth of total factor productivity in China's large and
medium-sized industrial enterprises sector is as high as 6.8%, with a steep rising trend during
1996-2002. This productivity revolution is driven mainly by frontier technological catching up. In
another words, the high growth in China is sustainable if the productivity gaps between the best
and the average are narrowed in the future through intensifying competition, privatization and
improvements in the regulatory environment.
We also found that the debt quality of the large and medium-sized industrial enterprises
improved sharply after 1998 due to improving profitability as well as a shift of debt capital from
less profitable to more profitable firms. While the over all improvement in enterprise profitability
is likely to be associated with business cycles, the better allocation of debt capital observed in our
study is clearly linked to better performance of banking and debt markets.
In a separate study on China's FDI inflows, we also found that the round tripping FDI (e.g. FDI
suspected to be domestic capital or unverifiable to be foreign origin) accounts on average for

about 40% of China's total FDI inflows during the last decade. During the same period, China's
total capital flight, including that due to misinvoicing of imports and exports, was actually larger
than China's total FDI inflows. These findings indicate that FDI in China, although important in
bringing advanced technology, is not important quantitatively as a capital input in supporting
China's growth. Because China's high growth is not dependent on net inflows of foreign capital, it
is more sustainable.
The huge technological gaps between China and the advanced economies, between the best and
worst firms within the country, and between the coastal and inland regions are all driving forces
for rapid productivity growth. Competition in each industry will be as fierce as ever and the race
between ever-rising volumes of market transactions and slowly improving market and regulatory
infrastructure will intensify. In the middle of this productivity revolution, it is wise for the
government to minimize macro shocks so as to allow the market forces to play out in spreading
frontier technology, allocating inputs and finding equilibrium prices. The government on the
other hand should focus on the Ionger-term objective, improving the market and regulatory
infrastructure so property rights can be delineated clearly, exchanged efficiently and enforced
fairly.