The PRC has stumbled little amidst a regional financial crisis which "sent dynamo economies of East and Southeast Asia crashing down like dominoes." To explain China's relative resilience, Dr. Shalendra Sharma points both to the "strong fundamentals" reflecting continuing reform and to the absence in China of commercial and financial practices common to "Asian Contagion" victims. Sharma warns, however, of the need to confront serious weakness in the banking and state industrial sectors before China's economic health is seriously compromised.

Shalendra D. Sharma, Ph.D. is Associate Professor and Director, MA program in Asia-Pacific Studies at the University of San Francisco. His email address is This e-mail address is being protected from spam bots, you need JavaScript enabled to view it

When the financial crisis unexpectedly hit the high-performing East and Southeast Asian economies in mid-1997, there were good reasons to believe that the People's Republic of China (PRC) would be the next domino to fall. First, China had inextricable intra-regional trade and investment linkages with the rest of Asia. Second, the Chinese economy suffered from many of the same debilitating structural problems that long plagued (and ultimately did incalculable damage) to the Republic of Korea, Thailand, Malaysia and Indonesia, including a fragile bank-dominated financial systems, poor prudential surveillance, weak central bank regulation and supervision of commercial banks, a large buildup of non-performing loans due in part to excessive lending to inefficient, over-leveraged state enterprises, and a largely state-owned financial sector that may be almost insolvent. These problems led many observers to conclude that the contagion's lethal spread to China was imminent.

However, so far the Middle Kingdom has beaten the odds. Like the Great Wall, China has not only steadfastly withstood a region-wide financial meltdown of unprecedented severity, the mighty dynamo fueling its economy missed only a few beats during the crisis and since. China's ability to sustain a strong gross domestic product (GDP) growth performance of 8.5 % in 1997 and 7.8 % in 1998 and 7.0 % in 1999, continued success in attracting foreign direct investment (FDI) and in running healthy current account surpluses (roughly 3 % in 1998-99), and maintaining the stability of its currency, the RMB (renminbi), in the face of plummeting currency devaluations and precipitous asset price deflation elsewhere in the region and beyond, is simply miraculous.

Why has China come through such a severe region-wide economic contraction relatively unscathed? What explains the astounding resilience of the Chinese economy, and can the PRC continue to remain insulated from the uncertainty that pervades the region and beyond? What lessons can be learned from China's experience? And, what measures must China implement to further insulate itself from the seemingly unpredictable (and volatile) international financial and currency markets. The following sections discuss these interrelated issues.

The Economy: Strong Fundamentals

Never in human history has an economy grown so rapidly and as extensively as in post-Mao China. Since the reform period (ushered in the late 1970s by Deng Xiaoping), the Chinese economy has grown at an average rate of 9 % per year, and the gross national product (GNP) has more than quadrupled. China's GDP further increased by 20 % on July 1, 1997 when Hong Kong became a Special Administrative Region of China. China's transformation into a veritable "dragon economy" is reflected in the fact that based on purchasing power calculations it is currently the second largest economy after the United States, a far cry from the below thirtieth rank it occupied some two decades ago.

Prudent market-friendly policies epitomized by Deng Xiaoping's strategy of "groping stones while crossing the river" have been critical to China's phenomenal economic growth. Specifically, the replacement of the decrepit, corruption-ridden agricultural collectivization system with the "household responsibility system" in the early 1980s led to an almost immediate increase in agricultural production and productivity. Over the past two decades, the agricultural sector (measured in terms of farm output) has grown consistently at the impressive rate of 6 % per year, compared to just 2.6 % a year between 1970 and 1978. This growth has led to an unprecedented 14% annual increase in rural incomes between 1978-1984 period, and a significant improvement in the living standards of China's peasants. It has also provided the surplus needed to sustain industrial growth and the resultant urban expansion.

Similarly, China's ambitious "export-led growth" strategy has paid dividends. Prior to the Deng reforms, China remained a backward and closed economy, with foreign trade amounting to a miniscule 7 % of GNP. However, the liberalization of the foreign trade and exchange rate regime, followed by further wide-ranging reforms introduced in 1988 (which included increased retention of foreign exchange and easier access to foreign exchange adjustment centers established in 1986), enabled the enterprises to buy and sell foreign exchange at a depreciated rate known as swap rate greatly helped to boost exports. Not surprisingly, by the early 1990s, foreign trade had grown to an unprecedented $200 billion or roughly 40 % of GNP.

On January 1st, 1994 China unified its exchange rate by bringing the official rate into line with the prevailing swap-market rate, resulting in the depreciation in the official rate by about 50 % (i.e. the yuan was devalued by 50 % ). China's preemptive devaluation, even as it led to a real exchange appreciation for the dollar pegged currencies in Southeast Asia (undercutting their export competitiveness), it created an export boom for China. Moreover, reform measures were carried out to increase China's competitiveness. For example, the retention quota system for foreign exchange was abolished, and the tax system was revised to allow a zero value-added tax (VAT) rating for exports by domestic firms and newly established foreign-funded enterprises. China also further relaxed its open-door policy towards foreign direct investment, including the provision of special tax incentives to foreign investment in technology-intensive industries. Finally, China provided generous tariff concessions (including lower income tax rates and tax holidays) to firms operating in the coastal special economic zones. All of these policies only served to further enhance China's international competitiveness and help it greatly expand its export markets. Between 1990-1997, Chinese exports to industrialized countries has grown at an average rate of 15.5 % per annum, and for the period 1995-1997 which saw a decline in world trade growth, China's exports to the United States grew by 8 %, while Japanese exports declined by 2.4 %. Overall, since the start of the reform period, China's share of world trade has almost quadrupled.

Although, China's exports have slowed since the Asian financial crisis, China's trade surplus continues to remain at a historically high level. In 1990 China's foreign exchange reserves was only US$40 billion compared to Japan's US$100 billion, however, by 1997 it increased to US$111 billion in comparison to Japan's US$150 billion. By the beginning of 1999, China's foreign exchange reserves had risen to US$150 billion (equivalent to twelve to fourteen months of imports), thanks to a robust trade performance and the massive inflow of foreign capital which largely has taken the form of FDI. While FDI was negligible before 1978, by early 1999, foreign direct investment in joint ventures and wholly foreign-owned companies in China exceeded one-quarter of a trillion US dollars, several times larger than cumulative FDI since World War II in Japan, South Korea and Taiwan combined. While China's large and growing reserve is matched by growing external liabilities, that the bulk of these liabilities have long-term maturities, thereby making external debt manageable. Short-term debt made up only 19.7 % of total debt in 1996. Moreover, China's foreign debt is at a low level compared with other Asian countries, with the debt/GDP ratio at 16.0 % and the debt service ratio (i.e. debt service as a percentage of exports) at 8.5 % in 1998. Not surprisingly, China is among a handful of developing economies with an investment-grade rating on its sovereign external debt. Finally, the fruits of post-reform economic development has trickled down to broad segments of the Chinese population. The rapid development of township industries has created some 130 million jobs, even as worker productivity has sharply increased at an annual rate of 3.9 % during 1979-94, compared to 1.1 % during 1953-78. Disposable income per capita has quadrupled since the early 1980s, and Chinese households are saving on average some 40 % of their income. All this has helped to dramatically improve the living conditions of the majority of China's 1.3 billion inhabitants.

By any standards, post-reform China's economic achievements are enviable. Yet, to his credit, China's amiable economic czar, Premier Zhu Rongji, and his team of able technocrats have not being lulled into complacency. It seems they have grasped the essential lesson, the so-called "paradox" of the Asian financial crisis: that strong macroeconomic fundamentals while necessary, are not always sufficient for adverting currency crises or providing immunity from virulent contagions. Acutely aware of their economy's underlying structural weaknesses, they remained deeply concerned. As the next sections shows, their concerns were not misplaced.

The Economy: Underlying Structural Weaknesses

An important lesson from the Mexican peso crisis and the Asian financial crisis is that a sound banking sector is the single most essential element of a healthy financial system. This is particularly true for transition economies like the PRC where markets for corporate securities are limited and most lending unsecuritized. In such settings, banks are the main institutions that can effectively evaluate and monitor the risks and returns on financial intermediation, including the evaluation of borrowers' creditworthiness, and to enforce financial contracts, loan recovery, and the realization of collateral. Given the banking sector's wide-ranging responsibilities and powers, it is critical that governments, including the central bank and related regulatory and supervisory agencies, establish clear legal and institutional guidelines. Governments in this financial market system must also implement adequate prudential supervision and regulation, including rules to ensure undue reliance on deposits many times larger than their capital and assets that are longer term and less liquid than liabilities do not plague the system. The government must also encourage accounting and auditing practices that are clearly defined and adhered to so that banks cannot mask problems such as high proportion of non-performing loans. Finally, a government in this situation should insure that banks which conduct business internationally have a healthy balance between assets and liabilities denominated in different currencies. The Asian financial crisis vividly demonstrated that systemic problems in the banking and financial sector are accidents just waiting to happen, or more appropriately, waiting to "explode" without warning and quickly engulfing the economy as a whole.

In his exhaustive study, Nicholas Lardy convincingly shows that China's banking sector, among the sickest in Asia, remains the Achilles heel of the entire economy. Reminiscent of the central-planning era, virtually all banks in China are state owned. Banks dominate the financial system, accounting for approximately nine-tenths of all financial intermediation between savers and investors, a ratio that exceeds that found in almost all other Asian countries. The banks' near total monopoly and the resultant lack of competition in the financial sector have stunted the development of capital markets. This feature of the financial system resulted in interest rates that are below internationally market prices, not to mention inefficient financial intermediation and diminishing rates of return for savers who have no real alternative to bank deposits.

Despite the introduction of The Central Bank Law (in March 1995), which gave sweeping powers to the People's Bank of China (PBOC) to implement monetary policy and to exercise financial supervision over the other financial institutions, the PBOC, which still operated under the watchful eye of the State Council, hardly constituted an independent entity. In reality, despite the law, not to mention Zhu Rongji's repeated exhortations that politically directed lending would end by 1998, the PBOC's supplicant managerial class, its weak supervisory and disclosure framework, as well as the pervasive meddling by recalcitrant powerful political bosses, prevented the PBOC from exercising real discretion. The PBOC was hardly in position to perform independent credit-risk analysis or to evaluate bank performance on the basis of normal commercial criteria. Lardy notes that "China's largest banks are not subject to independent audits. Three of China's four largest banks do not even report their consolidated financial results, meaning that losses can be buried in subsidiary firms. Nonperforming loans are classified by more lenient standards than the international norm, impairing the value of the data in measuring bank performance". Suffice it to note, weak central bank supervision combined with ineffective prudential regulation have made it easier for obstinate Communist party insiders, influential provincial bosses, and those with the ubiquitous guanxi connections to influence access to credit to their own advantage, besides channeling funds to themselves and their cronies through fraud, corruption, and other lending irregularities. Although China's recent high-publicity anti-corruption campaign have witnessed the arrest of several high-profile businessman and bank executives, available evidence indicates that financial criminal activities, cronyism, and favoritism continue to be rampant and may in fact have worsened.

Not surprisingly, China's leading banks are today burdened with an enormous build-up of non-performing loans conservatively estimated at US$200 billion, or approximately 25 % of the total GDP. Indeed, under growing pressure from international agencies and financial markets "for greater transparency" the usually stoic Dai Xianglong, the Governor of PBOC, recently admitted (in January 1999) with uncharacteristic candor that the share of non-performing loans in the portfolios of China's four largest state-owned banks had increased from 20 % at the year-end 1994 to 25 % at the year end 1997. Cognizant of the fact that the ratio of non-performing loans in South Korea was 17 % on the eve of the crisis, the Governor and other senior officials of the PBOC were quick to point out that only 5 to 6 % of the loans are unrecoverable. However, because problem loans in China were not clearly recognized on banks' balance sheets, the scale of uncovered losses constituted a major source of uncertainty. Most analysts, including those in the IMF, were of the view that some 50 % of the borrowers are already in default, and a similar percentage of the loans non-redeemable. It seems that a key precondition for a financial crisis -- a fragile, if not, largely insolvent banking sector-- already existed, making a domestic banking crisis the most serious threat to macroeconomic stability in China.

The rapid deterioration of the banking sector was the direct result of what Nicholas Lardy termed "China's unfinished economic revolution." Specifically, the reforms have not only failed to fundamentally restructure the economy. The country still has some 300,000 ailing state-owned enterprises (SOEs) which absorbed large (if not extravagant) doses of subsidies. These so-called concessionary indirect "soft credits" or "policy loans" from state banks to SOEs, implicitly guaranteed by the government, as well as granted under preferential terms, have over time reduced the banks to little more than conduits for cheap credit to the SOEs. It is no surprise that borrowing by the SOEs, as measured by the value of loans outstanding, have increased by 40-fold between 1978 and the end of 1997.

Yet, the SOEs' insatiable appetite for subsidized credit does not seem to affect their poor performance. Currently, SOEs account for less than 30 % of the industrial output, compared to 80 % fifteen years ago. Factory capacity utilization rates for major industrial products of SOEs have fallen below 60 %, while the industrial SOEs profits have declined precipitously from 6 % of GDP to less than 1 % in the past decade. While asset stripping (the illegal transfer of state assets to non-state ownership) and the customary practice by the central, provincial and even local governments to conveniently saddle SOEs with excessive social responsibilities (including the responsibility to provide cradle-to-grave services to the estimated 112.4 million SOEs workers ) have taken a toll on performance, Lardy notes that the underlying reason for SOEs' moribund performance is the lack of fundamental change in ownership and in corporate governance. Besides overproducing an array of unwanted goods, a growing number of SOEs have been losing money. Approximately 50 % perennially incur net losses compared to one-third just a decade ago. As of October 1997 roughly 46 % of SOEs were in the red, and losses of these enterprises made up 57 % of the total. Indeed, available data shows and a growing number of SOEs have accumulated unmanageable debt to equity ratios of between 400 to 700 %. In effect, the majority of the SOEs, unable to amortize their debt and recklessly borrowing, have zero or negative net-worth today. They have not only made themselves technically insolvent but have also left the banking sector hopelessly burdened with large portfolios of non-performing, indeed, non-redeemable loans. Asia's financial crisis illustrates that in an economic slowdown, the highly leveraged SOEs have the potential to create major liquidity problems for the banks. A domestic banking crisis could push China into a deep recession, which may eventually force the government to devalue the currency. The cost of bank bailouts under such conditions will be astronomical.

Yet, if by tomorrow the SOEs were to miraculously honor all their financial obligations, the banks' position would still remain weak. This is because, like Thailand, Malaysia, South Korea, Japan and Indonesia, Chinese banks have played a leading role in creating "asset bubbles", especially in the volatile real estate and construction sectors. During the early to mid 1990s, when "a casino mentality" gripped the country, banks and other financial institutions imprudently funded massive property developments throughout China. First-class office spaces, luxury villas, ostentatious townhouses, and apartments sprang up almost overnight, not only in major cities like Beijing, Shanghai, and Shenzhen, but also in the many smaller provincial and coastal county towns. Perhaps nowhere was the transformation as stunning as it was in Shanghai. The so-called "Shanghai bubble" transformed this once drab city into one of the world's most glamorous metropolis. By the end of 1995, Shanghai boasted over a thousand skyscrapers, some one hundred five-star hotels, about 13.5 million square feet of office space in 1997-- five times the 2.7 million square feet in 1994--, and a "hot" real estate market that was adding stock at a faster rate than New York city. However, the boom was relatively short-lived. By late 1996 the bubble had burst, in large part because of inefficient allocation of resources and overcapacity. By first-quarter 1999, some 350 million square meters of office space stood empty, and real estate prices slid to below 50 % of their peak level. For many banks and their subsidiaries such as trust and investment companies (including SOEs) with heavy exposure to real-estate construction and speculation, the bursting of the asset bubble sped up the deterioration of their balance sheets. For an increasing number, it has meant bankruptcy. The collapse of the country's second largest financial-trust company, the Guangdong International Trust and Investment Corporation (GITIC) in October 1998 constituted an ominous sign. The GITIC had to declare bankruptcy when it was revealed that its debt totaled $4.4 billion, compared to only $2.9 billion in assets.

Explaining China's Resilience

One of the bitter ironies of the Asian financial crisis is why China seemed to have survived the worst of the crisis with barely a bruise when it suffered from many (if not more) of the same structural ills that sent the dynamo economies of East and Southeast Asia crashing like hollow dominoes? In other words, what explains China's remarkable immunity to the "Asian flu"?

First, unlike the free-wheeling Southeast Asian financial markets, the PBOC required those who wanted to buy or sell foreign exchange or foreign currency denominated financial assets to enter the exchange market which operated through designated banks. This policy has inadvertently given the PBOC greater flexibility in responding to balance-of-payments problems because the foreign exchange market was not open to any purchase of foreign exchange for capital account transactions. Simply put, the renminbi (RMB) was not convertible for capital account transactions. Instead, it was only convertible on the current account, which meant that official documentation of a legitimate trade or other approved transaction was required to change money. The partial convertibility of the renminbi has not only made it extremely difficult to place large leveraged bets for or against the currency but also rendered the RMB far less vulnerable to domestic or externally driven speculative attacks.

Second, in the pre-crisis Asian economies, a mix of pegged exchange rate, heavy sterilization, and the lack of capital controls all encouraged heavy external borrowing, in particular, of ever increasing amounts of "hot money" in the form of short-term credits. Within a short period of time such practices not only created excessive exposure to foreign exchange risk in both the financial and corporate sectors (the result of growing mismatches in the structure of lending borrowing), it also had negative effects on foreign direct investment and portfolio investment, which sharply declined as a share of private capital flow. However, by mid-1997, approximately 70 % of capital flow to China was in the form of foreign direct investment. At an estimated US$200 billion, it was almost twice the level of China's officially reported foreign borrowing. FDI, with their much longer-term maturities and manageable debt-service ratios, provides far more stability and is less susceptible to sudden reversals in direction due to negative monetary shock or investor panic. It made China less vulnerable to a speculation-led liquidity crisis.

Third, unlike pre-crisis Thailand, South Korea, Indonesia, or Malaysia, approximately 90 % of China's external debt was primarily medium to long term. Thus, foreign lenders could not call in their loans every three to six months. Such relative stability greatly reduced the possibility of an immediate banking crisis. Also, China had less capitalization through the stock market and less foreign equity investment to be repatriated by nervous investors if market sentiments change. These strengths gave China a greater breathing space to make the necessary policy adjustments during the crisis. Finally, as noted earlier, China's healthy current account surpluses (some $30 billion), massive trade surpluses, and a formidable "war chest" in foreign exchange reserves (totaling some $150 billion in 1999), reduced the pressure to devalue the currency or raise interest rates.

However, as this paper has shown, China's problems, especially in the financial sectors the SOEs, are not sustainable and need to be resolved quickly and expeditiously. Most importantly, banks must be recapitalized and the state sector open to competition. It seems unlikely that most of the loans to the SOEs will ever be repaid. Ultimately, SOEs must be restructured, either through hard-budget constraints, downsizing, or outright closure. While such drastic measures have the potential to displace up to one-third of the 100 million SOE workers, failure to do so will simply compound the problem. Finally, China must develop the institutional mechanisms with which to reduce macroeconomic instability. While premier Zhu Rongji has yet again expressed serious interest in developing institutions to oversee the economy at the 15th Congress of the Communist, it is too early to discern the success or failure of his proposed reforms. If Zhu fails, who knows, in the next round of financial crises, China may be the first domino. That will result in a crisis of truly global proportions.