China May Well Devalue

June 4, 1998

In a way, China led the devaluation parade, having cut the yuan 70% against the dollar in 1994 after five previous devaluations in the last 13 years. This wasn't nearly as negative for the other developing Asian countries as the fall in the yen, starting in 1995, since China's economy is less than 15% of Japan's. Still, China accounts for a third of the developing Asian country output, and if she follows them in another devaluation, they will be forced to respond in a competitive devaluation race for the bottom. She's the 500-pound gorilla. Taiwan, with huge investments in China and big trade ties, could hardly stand still for a cut in the yuan. Nor could the rest of Asia nor Latin America without unacceptable losses of global market shares to China.

We'll Never Do It!

Chinese officials deny that they will devalue, but so, too, did Mexican leaders right up to the very day they cut the peso loose in late 1994. China will probably devalue, but later. A drop in the yuan now would undoubtedly take the Hong Kong dollar with it and destroy that currency's 15-year peg to the dollar at a time that is embarrassingly close to the takeover from Britain.

It can be argued that China has such low labor costs relative to her neighbors that she has no need to catch up with their devaluations. Low labor costs, yes, but low productivity too, so unit costs aren't all that low. Besides, in the low-skilled labor area, China competes with the likes of India, and the rupee has fallen in sympathy with other Asian currencies. The Bank of China, the central bank, said the nation would face considerable competitive pressure from neighbors in Asia, especially in textiles, shoes, home appliances, and clothing. The advantage of her 1994 devaluation has now evaporated as the yuan has risen sharply against her competing neighbors' currencies. In the December 1997-February 1998 period, Chinese goods exports dropped at a 20% annual rate while imports climbed 12%, narrowing her trade surplus from both sides.

Export Dependent

Exports account for about one-fifth of Chinese GDP, but for the bulk of last year's disappointing 8.8% economic growth, and much of the rest was due to unsustainable inventory building. The domestic economy has been slowed by earlier inflation-fighting monetary and fiscal restraint, but now inflation is non-existent and deflation is setting in. Consumers, who routinely save 40% of their after-tax incomes, are subdued, perhaps waiting for even lower prices. Interest rates have been cut repeatedly to rekindle the economy, but to no avail. Reserves are piling up in banks as they cower under already huge bad loans and refuse to lend.

About $200 billion or 20% of those loans are nonperforming—five times the banks' equity capital—and 5% or 6% of them are unrecoverable, according to the Bank of China. The banks are essentially broke, but the government owns them and most of the companies they lent to (50% of which are in the red with debt to equity ratios of 200% to 400%), so there's little likelihood of foreclosures. Nevertheless, credit rating agencies are cutting their outlooks on China from stable to negative, and also reducing their ratings on Hong Kong's debt.

Still, China wants to clean up these bad loans, but at the current pace, it will take decades even if the government plan to raise $33 billion for that purpose is successful. Now, you're probably aware that the Chinese take the long-term view. Chairman Mao was once asked his opinion of the French Revolution. "Too soon to tell," he replied. Still China can't wait because of her immense employment problems.

China Needs Jobs

She has 200 million people in coastal areas who are productively employed, about 1 billion in the hinterland who would like to be, and 100 million more squatting in coastal cities looking for work. This last group is potentially socially disruptive. Note that the Tiananmen Square uprising was preceded by a similar unemployment problem, and jobless protests are up 50% in the past year. Furthermore, restructuring state-owned enterprises will make about a third of their 100 million workers surplus, as well as half of the 20 million civil servants, while 15 million people enter the work force annually.

In addition, a new government proposal calls for halving the 8 million government and party officials. The China People's Daily estimates the surplus labor at 130 million in 1996, 370 million in 2000, and 450 million in 2010. About 12 million state enterprise workers have been axed in exchange for minimum living allowances. Beijing wants to sell off most of the 100,000 state-owned businesses and merge the rest into 50 government-backed titans, but she needs employment for those who will lose their jobs.

Furthermore, China has about 40% excess capacity in manufacturing. Sure, some of it is in state-owned factories that turn out shoes that nobody wants to buy. Only the guys building warehouses to hold them benefit. Still, the nation has plenty of unutilized and economically useful productive potential. Textile industry capacity utilization is 20%. China produces 30 million TV sets a year, 35% of global production, but can sell only about half at home.

Real estate is also in abundance. Construction continued to leap and support the economy for years after inflation started to fade, but activity was flat in 1997 from 1996 and will probably fall as prices collapse. Vacancy rates in Beijing for Class A space are about 35%, and 70% in Shanghai's new Pudong Financial District. Rent at Beijing's China World Trade Center is now $65 a square meter, down from $110 in 1995. New apartments elsewhere are selling at about one-sixth the original asking price.

Growth Needed Desperately

China needs growth to employ people, to utilize excess capacity, and to restructure, but the outlook is bleak. Foreign direct investment accounts for one-third of China's total investment, or 12% of GDP, but only grew 3% last year when foreign contracts fell about 30% as international money fled Asia. Nearly two-thirds of that investment used to come from Hong Kong, but her highly-leveraged lenders are suffering their own financial problems. So, Hong Kong's direct investments in China dropped 51% in the first half of 1997 and accounted for only 38% of the total. The numbers in early 1998 are undoubtedly a lot smaller. This drying up of critical foreign investment growth occurs at a time when no government or bank funds are available to replace it. And competition from devalued countries will probably slash Chinese export growth from the 20% forecast for this year. Also, the liquidation of superfluous inventories and a falling trade surplus will be drags on growth. Furthermore, a management think tank in China recently predicted 6% real GDP growth for 1998, far below the government's earlier 9% to 10% projection. Given China's problems, 6% is painfully low, a sure ticket to regional recession and riots. The 50% fall in Chinese stocks illustrates dramatically investors' outlook.

Exports, Not Imports

Despite a faltering economy, Beijing shows little interest in domestic consumption growth, but rather favors exports to the exclusion of imports. American corporations have learned, painfully, that their investments in China better provide a big component of technology to help China develop domestic production that will then substitute for imports and achieve self-sufficiency. GM recently won the right to build a plant in Shanghai because it was the high bidder in the technology transfer game. In the import arena, capital equipment is vastly preferred over consumer goods. Many American CEOs salivate over the prospect of 1.3 billion Chinese consuming their products. Suppose each one of them drinks just one Coke a year, is the logic. I think it's more realistic to see them as 1.3 billion producers who are concentrating on exports of anything and everything they can sell abroad.

And China is taking steps to make sure consumers spend less of their money on imports or anything else. Beijing is encouraging saving in forms that will not be tucked away in mattresses, but can be channeled into export industries. Starting this year, younger workers must fund their own pensions, unlike their older colleagues. Employers and employees will be required to contribute 20% of company total wages to retirement funds. By emphasizing personal responsibility for retirement, the state, ironically, plans to raise money for state-directed investments.

If you were running China and faced this gloomy outlook, and were philosophically oriented toward self-sufficiency and export-driven growth, what would you do? I'd devalue and take away from our dear friends in Asia, and elsewhere, whatever low-labor cost export business there was available in the world. I bet they reach the same conclusion, sooner or later. Indeed, the Export-Import Bank of China is increasing lending to exporting companies by as much as 60% this year, and the export-tax rebate on textiles has been raised. China is running a $50 billion trade surplus, but even that isn't big enough to provide the necessary domestic stimulus. Watch it get much bigger—much to the consternation of Washington—especially if China devalues.

If China's the 500-pound gorilla in Asia, Japan is the whale. And so far, Japan is a beached whale, part of Asia's problem, and not a leader in its solution. Will this continue?

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The first use of gold as money occurred around 700 B.C., when Lydian merchants (western Turkey) produced the first coins