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Directo te of IntelBleRce

This paper was prepared by the Central Intelligence Aaency for submission to the SUbcommittee on Technology and National

security Of the JOint nomic committee,

congress Of the united States.

Revers« Bltlnk

£A 89-10023 All , 1989

..... . _ .

'I .... _

. _ _... _ _ . ~ __ I.... _ ..... _ r - • •

Tbe Chinese Economy in 1988 nd 1989: Reforms on Hold, Economic Problems Mount

Preface

Irafor",DI;on available as at 1 A IIZ'lS I ! 989 was used in this report.

China's leaders experienced the greatest challenge to the authority of the Communist Party in 40 years of rule when massive demonstrations swept China this spring. The protests were symptomatic of public dissatisfaction with the leadership because of its unwillingness to make the political

system more responsive to public concerns and inability to control growing official corruption, nepotism, and inflation which approached 30 percent in China 's cities last year, the highest level since the Communists came to power.

The demonstrations sparked leadership maneuvering that toppled Zhao Ziyang, one of China's most ardent market-oriented reformers, from the party's top post. An expanded meeting of the Communist Part)' Central Committee in June elevated leaders who believe greater political, ideological, and social control is necessary and who generally advoca te economic reform strategies that emphasize improved central planning rather than experiments with market measures.

The unrest has weakened Beijing's ability to solve the country's economic problems. The preoccupation of China '5 leaders with consolidating power, restoring ideological orthodox}', and maintaining social order will proba bI)' prevent them from formulating new solutions to the country's economic problems. Consequently, China's reform program is likely to be bogged down for the next few years. Indeed, key market reforms like price decontrol and bankruptcy which Beijing put on hold in the fall of 1988 when it began implementing an austerity program will be postponed indefinitely .

-II

Inflation is likely to remain a problem. With economic reforms on hold, industrial efficiency and labor productivity Will lag, and Beijing Will have difficulty stimulating production Of grain and industrial raw materials, items chronically in Short SUPPlY. At the same time, pressures to increase governmem expenditures Will probably grow in the aftermath Of the demonstrations, fueling inflation. Beijing may attempt to increase food subsidies and loans to state enterprises to minimize the impact Of rising prices on its restive urban labor force. TO head Off growing unhappiness among peasants WhO are being pressed to grow more grain bUt are having

increasing difficulty Obtaining inputs and are being paid in IOUs China 's

..

central bank may have to loosen credit restraints in the countryside,

Defense expenditures also may rise because military leaders are exerting

•••

III

EA 89_/0023 AuguSt /989

areater influence in Beijing following their suppression of the demonstrations. Persistent inflation will fuel social unrest by eroding standards of living, but rigorous enforcement of the austerity policies would probably swell the ranks of unemployed, embitter workers whose income subsidies do not keep pace with price rises, and anger farmers paid with IOUs for their crops.

Finally, Beijing's ability to draw on foreign resources to alleviate domestic shortages, promote exports, and fund infrastructure and industrial projects has been diminished by the reluctance of foreign businessmen and

governments to sign new investment and loan agreements. Although China can probably weather the expected decline in tourism revenues and slower export arowth this year, the downturn in China's international economic relations may dim China's long-term economic prospects. For example, industrial and export growth would probably slow if to forestall a steep decline in its foreign exchange reserves Beijing broadens its restrictions on imports to include capital equipment and raw materials. Moreover, if foreign businessmen choose alternative Asian sites for new technologyintensive investment projects, China will have greater difficulty competing with Asian exporters like Thailand, Malaysia. and the Philippines in the

1990s.

IV

Contents

Page

Preface

•••

111

Problems of an Overheated Economr

I

Economic Reforms Stall as Beijing Attempts To Reassert Control

..-.....-.......-----.......,...._..-..---------.....__....--~~..........._...~......--...-- ............... _._~__..-__......_...._,_~...........,___...........----_._........,._.........-----------~-. - - ,- . -------

Problems Persist in 1989

2

3

,......_.__........-.-..._____.. ............... ...........-... ............. -.-.-----'--~-.....-..........._~----~----- - -- ............... _.,.__.._.........._-..--.....-----------~~-~....,._.._~-----..........- ._........,.__._.__.......,..._.

5

~ ............... ----~..........,-."......__......_....,--.-......,----.- - 'IIIIi&&&

6

Turnloil Worsens Economic Difficulties Near-Term Economic Problems Mount

~............._--~ ............... ~-.-._....__..........--...._._..............-----......._....__..............,.............._~~ ............... - - - ~ _........_---.......,.__.,__..~..-..- -.......,__.-..--.......__._,,~~ ............... --.......----.-..............,_.- - -

Damage to China's Foreign Economic Relations 6

.-................._~.......--.--....._.........-.-.__....-------......._._..------.--..-............._..----~ ............... ~-_...........~~ ............... .......___,,,.~....-.....-.-----~_.......,.....-..-..- ............... ..._............._._....------.......-...--~----.,..,___...-.

Outlook for Reform 9

.. ..

Appendixes

-

A. Economic Performance in 1988 and 1989 by Sector 11

..._...........------~___._...._.~ ........ .._~.........._~ .............. ~~~~.......__..~---~.........._-------~......--....------- ....,_............_.._. ... .- ------_.._...__...........-. ............... ...._.........~..........__-------..-_.-

B. How Reliable are Chinese Statistics? 19

Stllde", PrOltSIS: 15 AII,il-3 JIl"~ 1989

15 April

Hu Yaobang dies.

First student demonstration in Tiananmen Square.

20 April

Demonstrations spread 10 Nanjing. Shanghai. and Chengdu; Beijing students declare Q threeday strike.

22 April

Hu Yaobanz's official memorial service is held. Demonstrations occur in Tiananmen, Shanghai, Chengdu, Guanzzhou, Xian, and Harbin.

23 April

General Secretary Zhao Ziyang leaves for North Korea.

2·' April

Students in Beijing form a citywide coordinating committee and declare a class boycott.

26 April

Renmin Ribao editorial criticizes the students.

27 April

150,000 students and activists protest in Tiananmen in one of the largest demonstrations 10 date.

29 April

Party officials hold a televised dialogue with representatives of officially recognized student groups, later disclaimed by student leaders on Tiananmen.

30 April

Zhao Ziyang returns from North Korea.

2 MIIY

Students threaten to march in two days if the government refuses to begin negotiations.

., ~VIIY

.J4n estimated 50,000 students are joined by 250,000 other citizens in a march to protest the government s refusal to negotiate. Zhao Ziyang delivers a conciliatory speech at a conference of representatives of the Asian Development Bank.

13 MIIY

An estimated 1.000 students begin a hunger strike in Tiananmen.

16 MIIY

Gorbachev arrives in Beijing. Crowds in Tiananmen swell to over J million.

18 MIIY

Li Peng participates in a televised discussion With student leaders: Gorbachev leaves China.

20 MIIY

Martial la ... v is declared in Beijing. Troops surround the City but remain behind barricades set UP bj' protesters. Li Peng states that Tiananmen Will be Cleared in two days, by force if necessary.

23 MII1

Troops remain behind barricades; I million march in Beijing to demand Li Ptng.s resisnation.

30 Mil,

"Goddess of Democracy" is unveiled in Tiananmen.

Troops begin to Shoot demonstrators as PeL., of tht crackdown in B~iji"g.

The Chinese Economy in ] 988 and J989: Reforms on Hold, Economic Problems Mount

ProbieDIS of an Cherbeated EcODOm)'

The acute shortages of raw materials gave rise to increased speculation and profiteering by local officials who acquired scarce &oods at low in-plan prices and resold them on the market. Profits from such activities can be substantial; market prices for steel, fertilizer, and grain are two to three times the in-plan price. The increase in profiteering diverted industrial materials earmarked for use by state-owned enterprises to the collective and private sectors .. where enterprises were willing to pay higher prices. In rural areas, officials frequently charged peasants high rna rket prices for fertilizer and other scarce agricultural inputs that Beijing had promised to make available at low, state-set rates. Consequently, peasants reduced applications of fertilizer on fields, which hurt yields.

China's economic problems continued to mount in

1988 as the leadership failed to check overly rapid erowth, soaring inflation. increasing official corruption, and a deteriorating trade balance. According to Chinese statistics. GNP erew b~' more than 11 percent in real terms and industrial output surged 2] percent, nearly three times the target rate. This intensified China's chronic energy and raw materials shortages and transportation bottlenecks and. in turn, pushed inflation to its highest level in nearly 40 years,

19 percent overall and almost 30 percent in China's cities. (See appendix A for a detailed review by sector of economic performance in 1988.)

The overheating occurred partly because Beijing relaxed credit controls in early 1988, apparently to "prime the pump" for industrial and export growth (see figure 1). China's currency in circulation increased 47 percent last year, adding to demand pressures that had been building since 1984~ when

Beijing sharply expanded the au tonomy that ind ustrial enterprises could exercise over investment, wages, and spendini for their workers' social welfare. Urban enterprises financed these expenditures from retained earnings and by borrowing from China 's central bank and from a erowin& number of nonbank financial institutions. In rural areas, local govemments and informal credit cooperatives funded a dramatic expansion in rural industries and such commercial activities as marketing and transportation.

Inflation also ca used income disparities to widen. Rural entrepreneurs and urban street vendors were able to cash in on surgina demand f O~· goods beca use they sell their merchandise at market prices. Wages of teachers and government bureaucrats are generally fixed. however. so their incomes failed to keep up with inflation. Overall, real urban incomes rose only I percent, according to Chinese sta tistics.

Trade Balance Worsens

Imports surged in the second half of 1988 as China turned to foreign suppliers for many of the industrial and agricultural products it could not supply domestically. In particular, China's imports of fertilizer. sugar, and cotton rose sharply. China also imported

15 million metric tons Of grain.

Infla tionary pressures were intensified use Of

:aiiina asncultural production. The value Of overall farm output inched UP only 3 percent. Grain produc-

tion actually rell 2 percent use Of adverse weath-

er, lOW state-set procurement Prices, and Tisine costs Of asrieulteral inputs like fertilizer and PlastiC sheetiDat which is Used as mulch. SiUllish prcduetion Of industrial crops like sUiar. ramie, and cotton caused

uetion costs to rise in food prQ.~sinl and textile industries.

A Sharp increase in exports. a result Of incentives to state trading companies introduced in earl}. 1988~

was a mixed blessing. Rapid export erowth worsened domestic shortages Of eneriY and raw materials and bid UP domestic prices. Because China's skewed do-

mestic Price structure severelY underprices raw mate. rials and cp.:rIY, tradinl companies f.lshed to export these commociitics When Bejjina eased control over the rorei,n trade sector. ExSJOns or PiE iron. steel.

J

Fiprel auna: ~

toran~

ted

.1988

Perceru

pushin ... ~ prices to a post .. /949 hIgh.

The money supply surged ...

fueling rapid Industrial growth ...

50

10

30

strainmg supplies and transportation ....

40

20

o

Currencv Cash and

til

.

In savines

.....

circula lion deposi is

TOlal

State- Collecuve Private

owned sector sector

sector

Energy

Steel

Cargo

Retail pnce index

M.Jr~c:t pru .. "e Index

Source: Official Chinese statistics

. ~ .. . . . ..

32X>lJ ~89

coal, nonferrous metals, raw silk, and cotton all jumped even thouah dom estic factories were reporting shortages of the same ioods. Trade corporations

rea large profits bY buyina these &oods at lOW,

state-set prices and exporting them at higher international prices,

interior areas, unhappy about the erowina regional

income disparities last year t ted interprovincial

trade barriers to protect their supplies and prevent the wealthier coastal provinces from bidding UP prices Of their industrial SUPPlies, coal, grain, and pork.

Rapid export erowth also Widened regional income disparities. which have been a source Of debate Within the leadership, coastal provinces, With relatively mod. ern factories, a fairly Skilled work force, and access to POrts and rail lines that link China to the OUtside world. have provided more than 70 percent Of China .5

exports in r nt years. This has liven them lieater

a to eredit anc rorcilD exchange, more raPid

,aiDs in income, and treater independence from BeijinK tban the inland provinces have enjOYed. The

EconomiC RerorlllS Smn as BeUiDl Attempts TO

R contrOl

spurred bY these mountina problems, Chin leaders

announced at a party Plenum in tember 1988 that

theY WOUld postpone key market reforms for several years and implement an austerity proeram to COOl the economy. In particular, Beijine shelved a Plan to PUSh

., ..

ahead witb price d ntrol, currency devaluation. and

reduced state intervention in raw materials distribution. which apparently was sponsored by former party chief Zhao Ziyan&. Leaders were concerned because rumors of impendine price reforms. proposed b)· Dene

Xiaopina in ~fay 1988. prompted bank runs and panic buying sprees in July and August 1988. Continuing bank runs could have caused serious dislocations; consumers' bank accounts total 380 billion yuan (S 1 03 billion) equivalent to 27 percen t of GNP.

• To stimulate laSlin& agricultural production. Beiiina announced an increase in the state procurement prices paid to peasants for their arain. sugar, and oil-bearing crops. Beijin& also hiked the state procurement price of coal.

As part of its retrenchment plan. Beijin& has issued a series of directives since September 1988 designed to 5)0'" capital construction. restrict spending, and control price hikes:

Since September 1988. Beijin& has also reasserted central control over foreign trade. To curb exports of scarce commodities, Beijin& expanded the number of products subject to export licenses. quotas. and outright bans. It also tightened control over imports b~' restricting the number of corporations authorized to import several products, by banning purchases of selected consumer aoods and industrial inputs. and b~ tiehtenina control over the use of foreign exchange retained by exporters in Bank of China accounts. In addition. Beijing reduced the share of foreign exchange tha t China's five Special Economic Zones (SEZs) were permitted to retain from their exports.

• Beijin& announced it would cut state investment spending by 20 percent in 1989. The burden is to fallon nonproductive projects such as worker housing and recreational facilities.

• To discourage bank-financed investment outside the state plan, Beijing tightened credit ceilings for its domestic banks and raised interest rates on bank loans. Chinese authorities have also called for a halt in loans to private and rural enterprises.

Problems Persist in 1989

• Beijin& reduced the number of government entities authorized to borrow funds abroad from 1 00 to only 1 0 to Slow the ftow of credit acquired throuzh fOreign channels,

Chinese statistics for the first half of 1989 indicate that these efforts have been only partially effective, China 's industrial growth rate fell b~· almost one-half to about 11 percent, but inflation continued at a more than 25-perccnt annual clip. Although Beijing was able to sharply slow growth in capital construction spending during early 1989, the impact seems to have hurt state enterprises more than collective or rural industries. According to Chinese statistics. rural enterprises grew three times faster than key statedominated sectors such as energy during the first quarter. Thus, slower overall growth did not ease inflationary pressures.

• China '5 central bank hiked interest rates on household deposits, indexing those with maturities of three years or longer to the retail price index. and imposed limits on the amounts individuals could withdraw from savings accounts.

• The state Council recentralized control over the production and marketing Of certain steel products and nonferrous metals, The central lovemment also reestablished its monOPOlY over the distribution Of fertilizer, pesticides, and plastic sbeetine to control

S lation in farm inputs.

Demand pressures have apparently also been sus-

tained use Of weaknesses in the enforcement Of

Beijing 's retrenchment program. For example, Beijing apparently loosened credit restraints in March 1989

~ use or concern about a Sharp decline in produc .. lion Of state-owned enterpri . Meanwhile, factories were circumventing the credit controls by drawing on the resources Of Widespread nODaovemment financial institutions. Access to financine from Hone Kon&

ella bled many ent · r-nicularl). in the SOUthern

• Beijine reimposed price controls for steel. copper, aluminum, and other production materials.

3

- -

til ..,.

. .-

ChiMSt officials hQ\1~ acknowledged that Beijing

plans no Iurther p,ogr~ss on fo,eign trad« reform Ior

the next few years. Thus, extensive state cortrols will continue to guide China s trade. Beijing still restricts the number 01 entities thaI are authorized to conduct trade: export and import prices remain largely slatedetermined: and the government continues 10 provide

financial sz '~fJ'" 10 unprofitable factories and trade corporatic.is. Moreover, the value of China's nonconvertible currency is still fixed by central authorities.

Export 11,,4 Import Pric;II,. Export prices on finished goods are generall}' set on the basis of international prices, rather than domestic CO.flS of production. In a

dozen product lines, cartel-like export associations regulate pricing to ensure that exporters do not cut prices to compete for Ioreig« sales. Imports are generally sold in China's domestic marker at stateset prices.

S"bsidies. The Slate provides grants to state trade corporations thai Jose money on export OT import transactions because of the gaps between China's domestic prices and prices in international markets. Export subsidies probably amounted 10 $6-8 billion in 1988. equivalent to up to 15 percent of China's export earnings.

rrue Sllbj,ect to PI_lIS. Roughly 70 percent of China's trade both exports and imports remain subject 10 either "mandatory ,It plans set b_}' Beijing or

"guidance" plans negotiated by central and local officials.

Restrictions 011 Authori:ed Traders. Few [actories have authority 10 sign trade contracts directly with foreign firms. Beijing prohibits private enterprises and foreign-invested ventures from signing trade contracts.

Foreign Exchang« Controls. Beijing sets the official exchange rate for China s nonconvertibie currency and strictly controls the use of foreign exchange. Beijing also requires export corporations to turn Oller to higher authorities most of the foreign exchange they earn. Central or provincial authorities monitor closely how traders use the portion they are permit-

ted to retain.

Commodiry·Specijic QllotlU Gild Bans. Since Novembe' 1988. Beijing has banned imports of a variety of consumer g s. including liquor, soda.s, and color televisions. Beijing has added several minerals. alloys, chemicals, and consumer goods production lines 10 the list of prohibited exports in 1989.

Licenses. Half China's trade is subject 10 import or export licenses. Trade reforms have generally shifted issuing authority from central to provincial Ievels Without diminishing the Share Of trade covered b}' licenses.

,. .

• I .. ... .. _ •

provinces closest to the territory, to ensure they WOUld have a steady ftow Of monetary resources despite BeijiDi11s attempts to rein in credit.

production materials in Short SUPPlY domestically-> such as steel, synthetic fibers, and fertilizers led the import surge, Meanwhile, exports apparently Ian-

2uished use Of the slowdown in 'China's state.

owned industrial sector.

China 's trade balance continued to worsen early this year. Imports grew five times raster than exports in tbe first five months Of 1989; China's trade deficit Irew from less than 51 bi}lion in the first five months or ) 988 to nearb 55 billion as or May 1989t according to (Jffici21 Chin~ Customs statistics, Purchases or

..

4

Turmoil Worseas

mi( Difficulties

play a laracr role in politics and in the economy in return for their support for the crackdown in Beijing. Military leaders probably will petition civilian au-

thorities to reverse the d delona decline in the share

of the budget loina to defense.

The new leadership has endorsed a continuation of the austerity prOJram, but the social and political turmoil that has lripped China since April will make it difficult for Beijin, to solve its pressine economic problems. First, the preoccupation of Cbina's leaders with consolidating power, riddin& the bureaucracy of Zhao Ziyane·s supporters, strengthening pan)' con-

trol, and restoring ideological orthodoxy will prevent them from formulating new solutions to China '5 economic problems.

Resistance Remains

Bcjjin&'s preoccupation with social and political issues will accelerate the trend toward economic autarky at the local level in China, and increased provincial resistance to Beijina's directives will undermine the effectiveness of efforts to slow the economy. J .ocal lov~rnments will probably stronely resist implementing austerity measures in their own areas, for example, by resuming some of the construction projects that central authorities cancelled early this year. This resistance will be especially strong in wealthy southern provinces, where reform and an open door to Western business have yielded significant economic benefits. Local iovemments may also heizhten existinK barriers to trade with other parts of China to protect their own industries, making it difficult for

Beijine to implement nomic policies consistently

when authorities tum their attention back to econom-

............... nd, pressures to increase aovernment expenditures and expand the money suWly have probably

erown use of the social unrest. Beijin& may

attempt to increase income subsidies and loans to state enterprises enough to ensure that wages of most urban workers keep pace with inflation.

I

Beijin& rna)' also worry that peasants might become restive use they are being pressed to grow more grain but are havin& increasing difficulty obtaining

inputs and payment from a financially strap gov-

ernment. In ash in June, Li Peng called for greater efforts to solve rural credit shortages that have forced state procurement agents to pay peasants with IOUs instead of cash. Beijin2 began issuing IOUs in the fall of 1988 when retrenchment-related credit restrictions and bank runs caused a shortage of funds in rural banks. Chinese press reports have claimed tbat an additional10 billion yuan will have to be provided to local grain procurement stations to solve the problem. Officials fear that, if peasants are forced to take IOUs aaain, they miaht simply refuse

to hand their &rain and other commodities over to the state. Beijine apparently hopes to taP local funds for

most Of the money, but th are funds that migh;

otherwise have lone for more profitable undertakings like investment in rural industry. More likely, however, liven BeijiDa's diffiCUlty implementing central

dir rives at the local level. the funds Will come from short-term leans from the central baDk9 which Will

add to inflatjon. Chieese press indicate that,

as Of mid-June, tbe central bank bad already made more than 4 billion yuan available for this purpose.

For Similar reasons, Beijine may have to back investment commitments made before the crackdown that it milht Otherwise have postponed. China 's southern coastal provinces apparelltJy signed Ifia ny contracts in the first few months or 19891 bGPinl to let funds

either from Hons KODI sou or from the central

lovernment for the Chil!ese !'Ortion Of tbe prOjects

• •

rc Issues.

Other Pressures To Relax Austerity

The reluctance of foreign businessmen and governments to proceed with investment, trade, and technoloaica) exchanges following the crackdown in Beijing has also weakened the authorities' ability to implement the austerity program. For example, since the start of the retrenchment program, foreign investors have complained that credit shortages have eroded their profit marlins by cutting their sales within China. BeijiD2 may now be forced to expand credit to fcreian-funded ventures as part Of its effort to convince foreijn traders and investors tha t the business environment is stable and that they can make money in China.

ure ror mer r .. meD! 5PCDdiDa may also CO!71e ffOiD China .5 military. After a decade Of dcc~in ·

inK inftuencet Cbi!Ja '5 military leaders prob.\bJY Will

s

before the retrenchment program really took hold.

Beijiol will now have to provide the money itself or ease controls on foreign borrowing to keep foreign investment levels up to lend credence to its claims that

busin is back to normal.

Near-Term EcoDOmic Problems Mount

The retrenchment prOlram bad begun to take its toll on exports and foreiln investment even before the demonstrations; both had been projected to slow in

1989 and 1990. The downturn is now likely to be much sharper because of the damage to China's economic relations with foreign businesses caused by the crackdown. Because BeijinK started 1989 with about S 17 billion in foreian exchange reserves, it can probably ride out the downturn this year. but the problems will increasingly take a toll in the early

1990s.

.

• t

t ,

~

Competina pr ures to increase spendin& will probably prevent the retrenchment program from brinaina infta lion under control. In urban areas, inflation will probably remain above 20 percent through the end of

1990; nationwide, inftation is also likely to remain in double digits for at least the next 18 months. Blanket controls on prices could reduce the inflation rate, but would fail to reduce imbalances between demand and supply and would lead to widespread reimposition of

rationing. Persistent inftation will fuel urban unrest by eroding the living standards of a large segment of China's workers. Chinese statistics for the first half of

1989 indicate that the real incomes of state workers declined despite a nearly 19-percent increase in nominal wages and subsidies. Beiiina's recent decision to force factory workers to purchase government bonds has heightened their resentment: many believe they are bearing the brunt of the austerity program.

Tourism WiD Plummet

Tourism will probably remain depressed through at least the end of the year and possibly into the early

1990s. Tourism last year earned Beijing 52.2 billion in foreign exchange and had been expected to generate about 52.5 billion in 1989. Despite robust tourist travel in the first half of this year, China will probably take in only SI.5 billion from tourism in 1989.

The retrenchment policies and midyear work disruptions will slow the overheated economy somewhat. but will enlarge China's pool of unemployed. Senior Chinese officials have admitted that the slower economy will be a ble to absorb only half of the 1 0 million workers entering the urban labor force this year.

New Foreign Investment Contracts WiD Slow

Many investors seeking low-cost Asian production sites are now looking to other countries, such as Thailand .. the Philippines, and Malaysia. Moreover, investors already operating in China have. by and large, shelved expansion plans indefinitely. Hong Kong businessmen, who have provided two-thirds of China's foreign investment. will probably react especially sharply; many of the territory's wealthiest magnates are scrambling to extricate themselves from existing mainland projects while also intensifying efforts to get out of projects in Hong Kong before the territory reverts to Beijini's control in 199i. Those investors that proceed With China projects Will probably fOCUS on Short-term investments that involve small capital commitments and little investment in rnachinery and infrastructure.

"

.

t

.

Increased spendin2 Will prObablY cause China's gOVernrnent budget deficit to grow this year. Beijing Will probabb have to bailout growing numbers Of unprof-

itable state enterprises as Wider price controls on finished i prevent factory managers from recoupina losses caused bY work slowdowns, enersy and transportation disruptions, and h~gher wages and bonuses for workers. Expenditures en consumer subsidies, infrastructure development, and I -most likely~ defense Will also Irow. Meanwhile, Slower overall arowth and declining enterprise profits wil~ cause government revenues to stagnate,

For all Of 1989, new investment contracts Will. probably fall Short Of tbe 55.2 billion in new contracts signed last year (see table 1). Before the crackdown,

Beijing might have ex ed a record 58 billion in new

contract silniDIS on the basis or the surge in new contract siinines in the first five months or 1989.

6

T ble I

New F oreip Intestment Contracts, 1988

1 S'Hstors RelUs~ss ,"~ Risks •• d Rewards 0/ Clti"G Proieets

Beiji.ng is attempting 10 salvage its economic relations with the West in the ahermatb of the crackdown. Li Peng has ordered China S "[oreign investment leading ,roup ,. to' assure foreign investors that China remains

open to the outside world. Coastal provinces and

cities in southern China that have come 10 relv on the

irjusion oIfo,eignfunds, technology, and managerial

and marketing expertise have also stepped up efforts 10 lure investors back. Along with the inducements. Beijing has made veiled threats that China will penalize foreign businessmen that pullout of existing

ventures 0' halt negotiations on future projects.

Number of Value

Projects tmillion ('S $)

,--...-------------------------~-.......-.,__,_.- -___.._,~---- - ... -- . .-..-.....-.......-..-......~~

Totll 5.890 5.180

..-........-.._._--------------~~...---.-._.......,........_.......,_..... --~ ..

Hone Kone 4.56~

3.400

United States 269

370

Japan 2~5

275-

Netherlands 5

) 50

\\. est Germans

23

4i

United Kingdom

21

41

France

12

23

Other

763

874

Source: Official Chinese statistics.

Some foreign businessmen will no doubt be attracted b}' the lower taxes or greater access 10 China's domestic market that Beijing may offer as sweeteners. BUI many foreign firms had been operating on thin profit margins and ellen accepting losses in the hope that continued evolution 01 China 's economy

10 a iegalJ}' based, markel-orienlea system would ensure large profits in the long run. Beijing's crackdown and subsequent show trials of arrested workers and students, however, have probably convinced man}' foreign businessmen that China's political SJ'Stem is not stable enough to allow any leaders to implement economic reforms consistently or 10 strenzt hen legal processes.

Paid-in investment, which reflects contracts signed in ] 988 and in early 1989, may exceed 1985·s level of

$2.6 billion.

Foreign investment has a fairly limited impact on the country's economic gro~,th in the short run; annual inflows are equivalent to roughly 2 percent of domestic investment, and forei&n-invested projects last year genera ted onl)' 2 percent of China '5 industrial output and 5 percent of its export earnings. But foreign

investment has brought in crucial technical and managerial expertise and helped to improve prod uction efficiency and quality control, especially in coastal provinces, which have drawn 90 percent of China's

foreign investment.

These doubts have probably been reinforced b)' the replacement 0/ Zhao Ziyang and man): of his allies in the leadership with conservative economic planners.

Uncertainty about the stability 0/ the current leadership coalition after Deng Xiaopinz passes from the scene probably a/so adds 10 caution by foreign investors. In addition, although profitable niches Will remain, some potential investors rna}, be deterred by Q prazmatic assessment 0/ their ability to earn profits, riven China s economic problems and the leadersbio's public commitment 10 austerity ..

Low-Iaterest ForeilD Lo Have Been Postponed

finitelY

At the request Of many Of the countries tha t dona te

funds to international financial institutions like the world Bank and the Asian Development Bank, billions Of dollars worth Of eoncessional financing has been Placed on hold. In addition, Japan and most west European countries have delayed promised lowinterest development loans to China pendina the restoration or social and economic stability. Most Of these loaDS WOUld have lone to the energy, transportation, and tcJccoollDuniC8tions sectors. Rates on for.

eip columcrcialloans Will probabJy be raised as

..

7

-

.. ' .... ...'" .. ~

• I P •• • _.... ..

N~cr· Taw", ChltlDOI for Cia; ~ £ct] omit Rdor", Pro""",

Reform

se

Outlook

..

Price

To make the price structure more accurately ,d/eel relative scarcities by allowing selected prices to move to market levels.

On hold as Beijing tries to control i1lliation.

To link productivity and wages more closely.

Likely to continue as Beijing seeks to maintain output, but may be watered down by the need 10 continue subsidies and worker bonuses regardless of

productivity.

...

Enterpris« Bankruptcy

To Iorce management to employ resources more efficiently.

Not likely to rigorously enforce bankruptcy law because increased business failures would add unemployed workers to the already volatile urban population.

Stock ownership

To cut firms Iree from central funding by allowing up to 50 percent 01 stock to be owned privately.

Backed mainly by Zhao, likely to remain on hold because conservatives have ideological objections to private ownership of large enterprises.

Contract system

To increase managers' responsibility

lor profits and losses by requiring them to adhere to financial quotas negotiated between factories and their supervisory bureaus.

Likely to be retained because it ensures the central controllavored b}t conservatives; may be adjusted to reduce focus on negotiated quotas, faulted for favoring certain enterprises.

F 'oreign trae

To encourage exports b}' allowing exporters to retain a share of their foreign exchange earnings; preferential policies lor coastal export-prOdUCing regions.

Recentralized state control over key ex-

ports and imports in late 1988 and curtailed regional incentives. Could place more products Under central control, limit the number Of trade corporations.

A,';ClIllllre

TO encourage diversified farm outout bY Offering farmers contracts lor staples like grain in exchange lor SUbSidized inDUIS, or the option of grOWing crops not Under state control.

Beijing wfll probablv try to steer agricultural production back to basics and limit expansion oj nonstaple farm production.

R"rlll ellterprise

TO invigorate rural economy bY absorbing excess Iarm labor. producing consume, , s. and generating lax revenues 10, local government p,oiects.

Beijing has already begun squeezing this profitable sectors access 10 credit and hiking its taxes and COUld also OPt 10 channel Taw materials to ne~dy state-run fi,.ms instead of rural enterprises.

.. .. ... .

"

,

banks reevaluate China's creditworthiness eivcn the expected drop in foreign currency inflows from tourism, foreign investment, and exports,

..

Export Growth May Slac en

Recently released Chinese statistics suggest that China lost up to S] 00 million in export revenues daily during the height of the crisis. Lost earnings proba bly amounted to S] billion in the first two weeks of June, and exports for the latter half of June were slightly lower than usual, 5ue&estin& tha t these losses may not be made up even though rail lines, ports. and Chinese trade offices arc back to norma) operations. Foreign purchasers of Chinese manufactured eoods may wonder if additional worker strikes or slowdowns will prevent China from meeting its commitments in the future; many are reported to be investiga ting other sources for the textiles, toys, and other la bot-intensive ligh; industrial aoods they buy from China. Shortages of credit and raw materials in China as well as risine input costs will also slow export growth to single digits for the next few years. Exports had been growing at nearly a 20-percent annual clip for the last four years,

More Controls on Imports Are Likely

Beijing's concern that China's foreign exchange reserves may drop quickly as a result of the deteriorating trade balance and sharp declines ir; tourism and foreign investment inflows could lead to additional controls on the use of foreign exchange for imports. Although grain and agricultural inputs will very likely remain exempt, Beijing will almost certainly tighten

controls over iterns like consumer g that are not in

the annual import plan. Beijing might also curtail purchases or industrial equipment and scarce raw materials to conserve foreign exchange, even though reduced purchases or these items WOUld probably SlOW industrial and export Irowth in the early 19905. If China experiences a foreign exchange crunch, it may increase barter trade With the Soviet union and Eastern Europe. In particular, Beijine migh; increase purchases Of raw materials it imports from the Soviet Union, like fertilizer, iron and steel. and nonferrous mctals--some Of WhiCh it now uses hard currency to purChase Irom WestCiD SUPPliers. It milht also in-

crease purchases Of · et heavy industria) and POW.

er-generating equipDlcnt9 WhiCh some Chinese leaders censider more Suited to Chinese conditions than that available from western SUPPliers.

9

Outlook for Reform

In speeches since the crackdown Deng Xiaoping has reiterated his commitment to pursue economic reform. The main elements of Beijing's market-oriented reform program, however, have been stalled for almost a year. Such key refoi ms as price decontrol and bankruptcy are likely to be postponed indefinitely

~ use Beijin& does not want to add to its problems by implementing measures that would raise prices or swell the ranks of the urban unemployed. Experiments with stock ownership in state enterprises=implemented by Zhao Ziyang over the strong ideological objections of hardline leaders are certain to fall by the wayside.

Under the guise of austerity, the hardliners rna}: try to chip away at market reforms, clamping down on previously decontrolled prices and exerting closer central control over some collective and private enterprises tha t compete with sta te factories for ra w materials. They may even restrict the ability of state enterprises to sell overquota production at market prices. Hardliners. however, can turn back the clock

only so far. I officials would strongly resist efforts

by Beijing to reclaim financial and planning authority. In addition, efforts to roll back reform would be strongly resisted by Deng Xiaoping, who views rapid reform-driven erowth in the last decade as one of his major accomplishments.

Without further reform, however. China will be unable to alleviate the imbalances in its economy. Without price reform, for example, Beijing will con-

tinue to have problems ling grain production,

encouraging development Of energy and raw material resources. and stimulating exports Of labor-intensive

manufactured g rather than scarce resources.

Without additional enterprise reforms, industrial efficiency and labor productlvity will lag, and Beijing Will experience difficulty encouraging enterprises to make responsible decisions reaardiD& capital investments and salary and bonus increases. Continuinz economic problems Will stoke social and POlitical unrest in the

19905. ·

t

1

Apre2

strial Output

J ... ..,. 1988-May 1989

P~C~1U growth

25

25

IS

20

IS

20

10

s

Stan of retrench men t

program --.............

10

5

o

1980 81 82 83 84 85 86 87 88

o

Jan

Apr

JuJ

Oct

Jan

Apr

t Output by Sector, 1

Private Foreign-funded enterprises

1.2% 1.7%

- .... .., ..

ToIaJ _1.8/0 billion )&UlII

10

..

,

,

.

Appendix A

Economic Performance in 1988

nd 1989 by tor

/ • t

..

Industrial PerfO.lllance .

Industrial production rose a t a breakneck pace of almost 2) percent in 1988 (see figure 2). State-sector industria] production rose about ] 3 percent; the collective and private sectors grew 29 percent and 46 percent, respectively. Forei&n-funded enterprises doubled their industrial output .

Alriculture d the Rural Economy

The value of China's agricultural output increased about 3 percent in rea) terms in 1988. Most of the increase was accounted for by expansion of sideline industries, like poultry and fishery operations, and a sharp increase in the prod uction of cash crops such as tobacco and silk. Grain production fell 2 percent last year to 394 million metric tons, 16 million short of target (see fiiure 3). As a result, China imported 15 million metric tons of grain primarily from Canada and the United States (see figure 4).

t

I

This rapid erowth intensified China's enerey deficit. Overall eneriY production climbed about 4 percent in

1988. Although production of electric power grew 9 percent last year, electric power shortages idled factories for several days each 'Neck. Output of coal and crude oil increased only 4.5 percent and 2 percent, respectively. Transportation bottlenecks compounded the enerey shortage by delaying deliveries of coal-> which accounts for more than 70 percent of China 's ener&y supply from mines in the northeast to power plants in southern and eastern China. Rapid growth also intensified shortages of key raw materials. Steel production, for example, increased only 5 percent in

1988.

After last year's fourth consecutive disappointing harvest, a broad spectrum of China 's leadership agreed that, without redressing lone-term problems, the stagnant far III sector could prove a major stumblingblock to overall economic development, Premier

Li Peng called agriculture the "weak link" of China's ____ nomy in his keynote address to the National People's Congress this spring, underscoring agriculture's fall from grace as a symbol of reform success. To address the problem, this year Beijing has:

Rural industry and commerce are among the most dynamic segments of the Chinese economy and since

1987 have accounted for more than half the value of rural output (see figure 5). They currently employ more than 85 million people, about 15 percent of China's labor force.

..

t

" •

,

Although industrial output grew at an l l-percent annual rate through June about half last year's rate sharp increases in input prices at the end of

1988 caused the profits earned by China's state-run factories to decline 12 percent. Moreover, imbalances between overall industriallrowth and the production of enerlY and raw materials persisted. EneriY production grew at a 5-percent annual rate in the first four months Of 1989, and output or raw materials actually rei).

• Raised producer prices for eovcrnment.contracted train. cotton, sugar, and oil .. bearing crops and agreed to purchase over-quota commodities at market, rather than lower, state-set prices.

China's Energy Minister called this year for easing the enerlY crunch bY increasing state investment in bydroclectric and nuclear power and in crude Oil and natural las extraction. Even if China's financially strapped lovemmeDt can came UP With the funds for

these Ploj , however, it WOUld take years for in-

enerlY production to come on line.

• Recentralized the distribution Of fertilizer, pesticides, and plastic soeetina Used as. mulch and azreed to SUPPlY more Of these inputs at favorable prices to nts Who erow Irain.

..

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-iii

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• Da~ DOt far 1911 aad 1982.

on- aciaI Oiaese

• •

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1980

81

82

83

84

85

86

87

88

r I.

men I

• III "II ••

• I • .. .. •

-'1- •

I'"

..

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• ••

IOVerllDleDt mvestment m aan·

In 1988

tradiDl ere

CbiDa 9S third-

, .... I

~ .

• ..... 'I •

.... ,

wu the United States' 13th-laraest United States. in tUIII, was

tradinl pa) tDet, behind

HODI KOD, aDd ahead Of West Geimany

· ct UDioD. A · I to US Commerce

-- t statistics, US arew a robust 44

t over 1987 levels. and ror the til5t tilDC

cd 5S · n. 1m Crool C'biDa ; bY

tbaD ODe third to S9.3 .on. aDd the US deficit

a fourth to 54.2 billiOD (sec filUrc 6).

CD

the

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01 Growth

T 0IaI Over 1917

) ~(~"')

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decentralization of China's trade sector .. Newly empowered exporters in ChiDa·s interior rusbed to earn foreian exchaDle by scUina raw cotton, silk. and

wool thereby curtailina supplies available to Chinese aarment manufacturers. At the same time, cutthroat priciDI tactics by Chinese exponers meant that increases in tbe volume of exports were Dot always

matched by incr in Coman exehanse earnings,

US Commerce rtlDeDt statistics tbro May

1989· ieate that tralizatioD of trade has en-

abled ChiDa to t aro in its eaminp from

textiles and apparel sales to the United States baCk to dOUble dilits; the most raPidlY &rOwinl export proa.

uClS · hOld electrical appliances, radios,

and rootwear. UCDtly, the US trade deficit is

likelY to &roW alaiD this year t 1Dd Will ProbablY exceed 55 billion bY yearend.

..

~-

~ ...... of ,raiD were triple the 1987

s rertile, pesticides also

y IliDS. US to CbiDa will proba-

to show fairly arowth in 1989;

CYCII if P1l ofilldustriallDlchinery and

• bel' dcrJiDe IS a t of the curbs im on

-tal COIIItluctioo. dcmaDd ror amiD and qricultur-

aI · ts is iikely to i· . In the first five

tbs of 1989. for US to China

30 t over the period in 1988;

of Ifain, raw COlUJD. aircraft. aDd ~

s strOlllIl'OWlb.

.... ~ f

.

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balr or 1989 ·

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of

eel

1980 81 82 83 14 IS 86 87

Tbe of Sino- · et o:onomic relations broad-

ened last year to include some new forms of

II

1

t

,

I

t 1 •

....

, • III

- f

" · i

.....

• Cbinese Ia an workina on projects in the

·et Union er com tory-trade arranse-

IDCDts that I y cxchanae ChiDese labor ser-

vices for a tqe of the aoods produced. Over

8, Chinese workers are already in the Soviet

Union with .t least S, more to follow this year

er labor 15 sipeci ill 1988.

_

.. _

~ _

· . • I

...

i.

~ . .

· ,

, ~ ..

....

~ .. .

"

Wood DClS

• Joint vent rly those combinina Soviet

nw IDa aDd equipment wid! Chinese labor~

actively beina pursued; the first arc likely to

uens year.

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- "

Edible oils

• Both sides aareed to swap braDch offices of their

foreip excballlC aDd Moscow provided more

thaD million iD trade-related credits in the

rOIDI or lOW-interest lOY ment loans payable in

aDd · . For the first time, the Bank or

China paniciPllted in a IYDdic&tcd loan valued at

SSO iDillio or a · et

j - .

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CODliauc'to favor ChiDeSC ua· (ODlpanics

tput in the Wat for bard

of such as timber

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• continue to &row over the

• Union bJy is reluctant to

bave too Ia within its borders.

live projects. partia.larly in tbe enerlY and

beavy industry , hold tbe &realest potential for

expanded eeuaomic relations, es · Ily if forcil11

investment rrom' HODe Konl the West slows, as

anticipated .

-2

-4

. ... .

-8

.. .

des

China', IOVeflUneat budaet deficit Irew almost SO percent ill 1988 ,to reach $9.2 billion (see filure 8). Rapid arowtb in .subsidies was ,laracly r nsible for

the sharp in Indecd9 risinl raw materials pri

caused losses of state enterprises to climb almost 27 nt last year.

-10

87

85

86

88

1980 81 82 83 84

"I dollar· 3. 72 yuan

~ rce; CIA esu tes based on

• •

stausncs

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. • I" .... ...1 ~ I I • .

..

the economy, however. growth in tax revenues is likely to slow also. Meanwhile. since inftation has not yet abated, budlet subsidies will continue to skyrocket. Thus. China's deficit this year willarow. probably exceedina S 10 billion.

~ ,

,

BeijiDI the deficit by issuinl domestic bonds,

latina on ter Coreip de~ and printina money. In

1988 tbe tat 38 percent of its

deficit by seUiDl bonds domestically and

fina aD equal amount tbroulb (oreian loans. J t

Jnade up the I cst , with central bank overdrafts the

equivalent or printina money.

e.eS China releases statistics on national defense spcndinl as a line item in the annual state budlct but provides neither a definition or the catclones or expenditure included in the filure nor a breakdown or the total. Our estimates or Chinese defense expenditures cover

spendiDI for investment .nllrilY weapon procure-

ment); operatiDI expenses (iDCludiDI maintenance and nne) costs); and research, development, testing,

and evaluation (RDT &E). Usinl a buildiDa-block

appioacb for valuiDI tbe costs Of these various components. we estimate that Chma's total defense expendi. tures for 1988 were roulhly 45 billioQ yuan, more thaD twice the announced fi,ure. ~t current exchange rates. this is equivalent to 512 billion. ~

. .

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r t .,.~. t , I ~ • t

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.

AlthO China·s deficit is loW bY international stan-

clarets it equaled a t 2.5 t or GNP in

198 ea are cOllccrned about its raPid rise

usc it is addinl to iDfiationary pressures and

use it is -i '. DI China.$ rorci,D indebtedness.

Moreover, it is a POlitical problem for reformers;

,

InaDY or China'5 -- tive leaders view any level or

lover liment deficit as an -indication or eC>OncHnic mismanalelDCDl" - · COUld use it as one additional araumeDt cor boldiDl ofr on . ref 01 ms. ,

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.~. I is trriDI to SOlve its deficit prOblem bY

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mel casiRl tax rates, wideniDI its. tax , and im •

, ploriDI COUectiOD efforts. As the austerity drive SlOWS

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IrIIIds a.,. resoa ca • .,.,·

11Jd~x 1978-/00

• • r

Investment

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30

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Share or state

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Sh of groc_s national product h

75

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oil

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1978 79

83

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87 88

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1978 79

80 81

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I.l)ite the difference in absolute values, China's

aJlDOU fipres and the CIA estilDltes both show

dec:liniDI in the defense sector's share of

China's ballact as well as in tbe size of the defense budget relative to GNP (see fiaure 9). CIA estimates iDdicate that defense expenditures accounted Cor about one-fourth or China'5 total budaet in 1978, but

tblD one-fifth of the budlet in 1988. Moreover,

we esliloate ·08t5 defense diDI dropped from

I 0 percent or GNP in 1978 to onlY 4 percent in 1988 SODJC\Vhat less tbaD the 6 percent for the

United States .. ClDtly) than the I S to 17

t for the iet UDion.

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II '

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....._. ries has declined by about one-fifth since 1978.

Bcijina has nearly completed its force reduction, but we believe that it may take several more years before demobilized men find civilian jobs and are moved from military posts. Expenditures on weapons pro-

curement declined about 1 0 percent in the last

decade lIse Beijinl has postponed major pur-

chases until more t~hDolOlically advanced weapons SY5telus are available. we estimate that RDT&E

expenditures have · about 25 percent Since

1978, althoulb this catclory continues to account for oDly about one-eilbth or. China's defense spcndine .

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<:biDS has cut military diDI by biDI nne)

bas redUced its allned forces bY about 3

aul · 1DeII. 1978. with most Of the cuts comins

its POUH forces. we believe China '5 military

· budaet Iy half or WhiCh loes for

,

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