China digs in to tough it out

ON A TOUR through the factory zone of Shenyang city, the local guide reels off the latest casualties of China's new industrial revolution.

"The Number Two Machine Switch Factory went bust last year," says Sun Shangwu, pointing to his right. "The Shenyang Cable Factory on the left is on its death bed. So is the Washing Detergent Factory next door. The Number Three Machine Building Factory is in a terrible state." The 38- year-old Mr Sun was himself laid off by the Shenyang General Tractor Factory.

Along the pavement of this north-east Chinese city, groups of redundant workers attempt to sell surplus stock at heavy discounts to passers-by. "In the evening many more people come out, because the darkness hides their shame," says Mr Sun. They are the human detritus of the remnants of an inefficient centrally-planned system.

Such is the challenge of managing the next, very difficult, stage of reform of China's half-reformed economy. The policies of the new Prime Minister, Zhu Rongji, would be hard enough to implement in a booming economy, but China now finds itself trying to do so just as its own growth falters and it is surrounded by the worsening financial crisis in the rest of Asia.

The mainland's central banker, Dai Xianglong, prompted a rout on the Asian markets last week by warning that Asia's financial woes "and the sluggish Japanese economy, particularly the depreciation of the yen, have all produced a very negative impact on China's imports and exports and inflow of funds ... We hope the Japanese government will adopt effective measures to stabilise the yen".

The markets went into a frenzy, reading this as a warning that, faced with the challenge of millions of Mr Suns in need of jobs, Peking might be forced to go back on promises not to devalue its currency, the yuan. The Japanese yen did not help, weakening even further.

New trade figures quickly confirmed Mr Dai's worries. In May, mainland China's exports fell 1.5 per cent, the first overall decline for 22 months. The impact of the Asian crisis has been evident since the beginning of the year. The Deputy Foreign Trade Minister, Sun Zhenyu, said first-quarter exports to Asean states fell 9.8 per cent, and those to South Korea were down 24.5

per cent. Exports to Japan were down 3.1 per cent in the first quarter, but 6 per cent down in April.

Wu Yi, a state councillor, said recently: "It is a political issue to boost exports. Proper export growth is critical in helping the nation reform state-owned enterprises, create jobs and promote social stability." Social stability is China's priority; in Peking, the authorities pulled the plug on the channel carrying CNN the day the rest of the world was watching Indonesia's street celebrations after President Suharto's resignation.

This is the China that awaits President Clinton's arrival on 25 June. The US President will press China to hold firm on the yuan and offer strong support for the reform initiatives of Mr Zhu, who will be celebrating his first 100 days in office.

Mr Zhu has wasted no time in getting to grips with China's problems, announcing plans to halve the number of central government civil servants, end subsidised housing, shake up the banking system, introduce pensions and healthcare insurance, as well as overhauling the state enterprise sector. But what to do with all those workers? In March, one government minister admitted that the country's state-owned enterprises would function better if half the 75 million workers were dropped from the payroll.

To have any chance of a smooth transition through these reforms, China's economy needs to keep steaming ahead. But last week Wu Bangguo, a vice-prime minister, admitted it might be "difficult" to achieve the 8 per cent GDP growth target for this year. If it is missed Mr Zhu's reform programme will inevitably slow. Last week it emerged, for instance, that in Peking the date for the housing reforms to kick in has quietly been moved from 1 July to the end of the year.

Last week's panic about the yuan nevertheless looks overdone. There is no doubt that China has enjoyed the international praise and kudos for not devaluing, and Mr Dai's comments may well have been part of the pre-Clinton manoeuvring. The message to Washington was: "You want us to hold the yuan steady, the Asian crisis is hurting us, so stop nagging us about reducing tariffs and let's have some concessions on World Trade Organisation entry."

China has convincing reasons of its own for not devaluing (the yuan is freely convertible on the current but not the capital account, so the exchange rate is set by the government):

Any devaluation would set off an immediate round of competitive devaluations in the rest of Asia, possibly leaving China relatively worse off. It could knock those neighbouring countries further into recession, hurting China's local export markets even more;

China has a more subtle tool to hand to help exports. Since the Asian economic crisis took hold, Peking has been quietly increasing the tax rebates paid on certain exports - in effect a direct subsidy for those exports. This approach can target the products whose exports are ailing the worst - thus the rebate on coal exports has jumped from 3 per cent to 9 per cent in recent weeks;

The weakness of the Japanese yen is certainly a problem, but most Chinese exports to Japan are labour-intensive goods such as textiles, toys and electronics, and the bulk of these exports should hold up;

Direct foreign investment from Japan has fallen sharply, but other countries are still rolling up. Overall, foreign investment this year should still reach $30bn (pounds 18.5bn), down 25 per cent on 1997 but still substantial. And China cannot blame the Asian crisis entirely for the decline. Pledged foreign investment started to show a big drop last year before the regional collapse, mostly due to foreign investors getting fed up with the difficulties and expense of trying to do business in China; and

q If China devalued the yuan substantially, economists say the Hong Kong dollar peg could well have to be abandoned - something Peking has repeatedly said it does not want to see.

Against this background, the biggest reason for not devaluing is probably China's wish to bolster domestic confidence and stability. After the very public commitments, ordinary Chinese people would be shocked by a sudden devaluation and might well be prompted to withdraw their substantial yuan savings from the ailing banks. A run on domestic banks is probably what Mr Zhu fears most.

China also has more to insulate itself than other Asian countries. Foreign reserves stand at around $140bn, and the mainland's trade surplus reached $18.5bn during the first five months of this year. A massive infrastructure spending programme has been launched this year to try to boost the economy, with Mr Dai forecasting fixed asset investment growth of 15 per cent, 5 percentage points above 1997.