China Begins to Feel Economic Shock Waves

Asia's giant has been shielded by a Great Wall of isolation. Now its banks and markets are wobbling too.

China's leaders are worried. The economic chain reaction spreading crisis and confusion across much of Asia is beginning to hit home here, where it's likely to halt building projects and swell the ranks of the poor in the world's most populous nation.

After patterning China's free-market and trade reforms on policies pioneered by East Asia's emerging tigers, the leadership here is watching with concern as economic turmoil engulfs the region.

China's moves toward capitalism and increased trade have fostered a shaky banking system and an overinflated stock-market "bubble" - the same problems that are muting once-roaring tiger economies from Thailand to South Korea.

Yet in China's half-reformed economy, a great wall of isolation still surrounds its financial system, created decades ago when the communist giant was cut off from the West. This isolation so far has protected China from some of the global economic forces that are exposing weaknesses in more-open markets.

"China's banking system certainly has problems comparable to those in South Korea and Thailand," says William Overholt, a manager at Banker's Trust in Hong Kong. "If China doesn't take steps now to reform its economic system, it could end up with an even worse form of turmoil."

Ironically, China may have helped create the current crisis by sharply devaluing its currency, the yuan, nearly four years ago. The move made its exports and labor cheaper than those of most regional rivals.

That set in motion a domino effect as other export-driven economies in East Asia came under increasing pressure to devalue their currencies to stay competitive. That process, accelerated by the current crisis, has now come full cycle, making China appear more expensive to foreign investors and importers.

For the moment, laws that bar freely converting Chinese currency, block foreign banks from equal competition here, and restrict foreign investment in stocks will ward off finance problems that plague more liberal Asian economies, says a Hong Kong-based securities analyst. "Unlike [South] Korea and Thailand, which are creating relatively open and sophisticated economic systems, China is still in transition from a closed, command economy to a market-driven model," she adds.

For decades following China's 1949 communist revolution, Beijing modeled its state-planned economy on the Soviet Union. But China avoided the economic collapse that helped lead to the breakup of the Soviet empire by starting market-oriented reforms and gradual integration with the West in 1979.

Yet China's drive to replace Marxism with free markets has barely touched huge swaths of the economy. State-owned companies still employ roughly 2 out of every 3 urban workers and are managed by party apparatchiks rather than the business-savvy entrepreneurs who run the best private firms.

China's curious hybrid of socialist and capitalist economics has created some schizophrenic statistics:

The economy has been growing at about 10 percent annually for nearly two decades, but state firms are running into the red faster than ever.

While China now has 1 million millionaires, half a billion peasants still earn less than $1 per day.

The fledgling private sector is expanding, but as many as 30 million laborers laid off by the state still can't find jobs - this in a society that lacks comprehensive unemployment benefits.

Though optimists predict China could surpass the US as the world's largest economy within decades, doomsayers point out that many state-run companies and banks here could go quickly bankrupt without huge injections of cash from government coffers.

More than half of the government-run companies chalked up losses last year, and many are kept afloat with state-ordered loans from Chinese banks. "China can't really reform its banks until it reforms their major customers, the state firms," Hong Kong banker Overholt says.

Already, "up to 20 percent of the credit issued by Chinese banks consists of nonperforming loans to state companies," says Wu Jinglian, an economist at a think tank run by China's State Council, or premier's office.

"The net worth of these banks is probably negative," says a recent report issued by the World Bank.

"Bad debts in China may be larger than those in [South] Korea and Southeast Asia," adds Huang Yasheng, an expert on the Chinese economy at the Harvard Business School in Cambridge, Mass. But because Chinese banks have not used short-term foreign credit to finance risky domestic loans, as many Asian counterparts have, China will not need an international bailout, he says.

Instability has also affected the nation's nascent stock market.

State-owned trading houses often pump money into the market to reverse dips caused by poor company earnings reports, which has created a stock market bubble. While exchanges from Bangkok to Tokyo have suffered double-digit drops in recent months, Chinese shares have risen.

China's state-run press exerts little pressure on managers of state firms to release information about losses to shareholders.

China has been willing to work with international agencies like the World Bank to painstakingly reform its system and "pop economic bubbles before they explode," Mr. Overholt says.

Chinese Vice Premier "Zhu Rongji is a superb economist, and the reforms he has started are unmatched" in Asia, adds Overholt, who is author of "China: The Next Economic Superpower."

While currency drops by Asian competitors could cut into China's foreign trade, Mr Zhu said recently that Beijing will not lower the value of its currency. The yuan has been stable since 1994, and Beijing has an estimated foreign reserve of $130 billion with which to back it.

Yet the problems still are enormous: China aims to transform its top 1,000 companies into giant conglomerates that can compete on the global market while simultaneously remaking shaky banks into profitmaking enterprises.

The result, if successful, is likely to refashion China's economy into a cross between the free-market American model and the Japanese system of close government-business cooperation.

"China is still on track to become the world's next economic superpower" if it carries through with the painful economic reforms that lie ahead, Overholt says.

Opening its financial system too quickly "would expose it to the same ... currency speculators who wreaked havoc in other parts of Asia," Wu says. While China's leaders can no longer afford to stop state-run firms from sinking by providing bailouts, they also seem to fear privatization will erode their political power.