Author: Thomas Clouse
China’s efforts to cool overheated sectors seem to have paid off, and the country appears set for another banner year.


ACGA’s Jamie Allen

China entered 2005 with an unusual goal: to slow down. Its economy grew at an average annual rate of over 8.5% from 2000 to 2004, as international and domestic investment flowed into projects around the country. In the past two years fears of an overheating economy prompted new policies aimed at slowing investment and reducing market speculation. The government limited loans to overheating industries and passed new laws to better regulate property transactions and reduce market manipulation. The policies gradually began to affect industries around China. Remarkably, real estate, construction, steel and other industries have cooled without crashing.

At the same time, though, China’s GDP continued to rise, showing growth of 9.4% year-on-year for the third quarter of 2005. The Organization for Economic Cooperation and Development (OECD) recently predicted that this trend would continue, estimating that China’s gross domestic product (GDP) will grow by 9.4% in 2006 and 9.5% in 2007. While overheating continues to be a danger, China has thus far slowed investment in several overheating sectors without losing its economic momentum.

But China, like most large economies, has challenges ahead. University of Pittsburgh professor Thomas G. Rawski, a long-time China-watcher, believes China will continue to grow, despite having some difficulties along the way. He explains: “Big dynamic economies can carry a lot of baggage. But the important question is, Which weakness can seriously obstruct further growth?”

Prof. Rawski believes one such weakness could be China’s dependence on foreign trade. China’s trade surged to $80 billion in the first 10 months of 2005, compared to only $32 billion for all of 2004. The growing dependence on export markets makes China vulnerable to shifts in the global economy as well as political tension with trading partners.

China’s trading partners often point to the inflexible exchange rate of the country’s currency, the renminbi (RMB), as a primary contributor to this rising surplus. Partly as a response to external criticism, in July last year China dropped the RMB’s peg to the US dollar, choosing instead an exchange rate tied to a basket of currencies. The move had little effect on exchange rates, and in early December representatives from the world’s seven richest countries issued a joint statement calling for greater flexibility in China’s currency regime. If trade friction worsens, possible retaliatory sanctions could hurt China’s economic growth.

Chinese leaders have dismissed allegations of currency manipulation. Morgan Stanley’s Hong Kong-based chief economist, Andy Xie, agrees. He attributes the soaring trade surplus to the country’s growing savings rate. Xie explains: “Large trade surpluses in China should not be interpreted as a sign of an undervalued currency. It merely means that the domestic savings rate is too high.”

Xie has a point: China’s savings rate, according to the Asian Development Bank, stood at almost 45% in 2004. Cultural factors, an unsteady job market and weak social security and social welfare systems all contribute to China’s high savings rate. The heavy investment capability allows China to increase its production and export to the rest of the world. At the same time, this high rate of investment directs money away from consumption, lowering demand for imports and pushing the country’s trade surplus even higher. Chinese leaders have recognized that increased consumption will lower the trade surplus and promote steady, sustainable growth. To stimulate spending, the government has limited loans for fixed investment and decreased taxes for certain income groups.

Dealing With The Threats
Threats also exist on the domestic front. Jamie Allen, secretary general of the Hong Kong-based Asian Corporate Governance Association (ACGA), believes that the strong influence the government exerts over business could stall China’s growth. He explains, “Relationships exist between the government and boards of directors of many listed companies, preventing the boards from functioning in their proper roles.”

According to Allen, party officials continue to appoint company managers, and price controls remain in some of the country’s largest industries. Corporate governance is weak, and decisions are often based on administrative orders rather than sound business strategy, he says.

China has started to face this problem, focusing intensely in recent years on reducing state ownership. This focus is most apparent in the reforms of China’s four biggest state-owned banks. In 2006 China’s banking sector will open to foreign competition in line with the country’s World Trade Organization (WTO) commitments. In preparation for this opening, China has injected capital, auctioned off non-performing loans and tightened lending practices in order to make its banks more efficient and competitive. The banks have also taken on strategic foreign investors, bringing new capital and, more importantly, expertise to China’s banks.

In October 2005, China Construction Bank became the first of these four banks to publicly sell stock, choosing the Hong Kong stock exchange as its venue. The Bank of China is expected to follow in January, and further bank stock offerings may take place before the end of 2006. While it is too early to measure the success of the banking reform, foreign investors and stock exchange regulations will intensify the pressure for both transparency and good corporate governance.

Banks are not the only state-owned enterprises facing reform. While China’s economy blazed forward in 2005, the Shanghai composite index, a benchmark of the domestic stock exchange, hit eight-year lows. The drastic contrast between economic growth and stock market value highlights the problems associated with government ownership. Approximately 65% of China’s domestic shares are non-tradable state-owned shares, creating situations in which the government acts as majority shareholder, manager and regulator. Minority shareholders are generally overlooked. The government has for several years been considering methods of reducing its shares. Each time a new plan is considered, however, stock prices fall on fears that the newly tradable shares will flood the market and lower prices.

The China Securities Regulatory Commission (CSRC) instituted new guidelines in 2005 for the conversion of these non-tradable state-owned shares and has begun to implement the changes with small groups of listed companies. According to the new guidelines, the CSRC will compensate current shareholders by offering them newly tradable shares. Investors will receive two to three additional shares for every 10 shares they already own. In this way, the value remains high even if prices drop. Some companies have begun the conversion, and more are expected to follow in 2006.

Allen is skeptical about the CSRC’s plan. While he praises the reduction in government ownership, he also points out that many investors, anxious to cash in on the government’s plan, have bought shares based on companies’ participation in the reform plan rather than financial fundamentals. Once the shares become tradable, they are sold and prices drop. In some cases, it is the government that ultimately buys those shares back. Allen believes that some revisions to the plan will probably be needed.

As China’s economy pushes forward into 2006, the complicated landscape of the world’s most dynamic emerging market offers new challenges to China’s leadership. Chief among those challenges are reducing an escalating trade surplus and more clearly separating the roles of business and government. Their effectiveness will determine China’s future.

Thomas Clouse