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China: all bets are off

October 14, 2008

The economic miracle has been halted in its tracks
Michael Sheridan in Hong Kong
The Sunday Times (UK)
October 12, 2008

FROM Hong Kong to Shanghai, shuttered factories and laid-off workers
tell a tale of how the world credit crisis may end the Chinese export
miracle and pose the greatest threat to economic reforms since they
began in 1979.

Bankruptcies and unemployment are climbing, while political pressure
is mounting from the left on policymakers. Some officials are openly
challenging the export-driven model that led China to stack up
foreign reserves of $1,800 billion (£1,060 billion). There has been
little effort to cover up the distress, perhaps because of rivalries
between factions of the Communist party.

China Central Television, for example, recently broadcast a report
prepared for the cabinet saying that 67,000 companies have gone
bankrupt in the first half of the year and 20m workers have lost their jobs.

The latest phase of the crisis, in which stock markets fell sharply
across Asia, forced the authorities to reverse policy by cutting
interest rates and restoring subsidies to exporters.

However, the most important, if understated, signal of China's
response came in the currency-futures market, which now prices in a
2.5% fall in the value of the yuan against the dollar over 12 months.

That is a defeat for the strong-currency policy urged on China by US
Treasury secretary Hank Paulson, who boasts of his leadership ties
forged during 70 visits to Beijing on behalf of Goldman Sachs.

The yuan has strengthened by more than 20% against the dollar since
2005. Halting its rise is the one sure way to restore a cost
advantage to exporters, although it would infuriate China's trade
partners in Europe and America.

This crisis has already cast doubt on fundamental assumptions about
global trade, though, and presents China's leaders with another
serious domestic challenge.

Their propaganda triumph at the Olympics was overshadowed by riots
across Tibet, terrorism in the Muslim far west and an earthquake that
killed 60,000 people. There were also scandals over fake or
contaminated goods, most recently milk products tainted with melamine
that have killed and hospitalised many children.

Now their main claim to legitimacy -- a strong economy -- is under
pressure as Chinese stock markets have fallen more than 60% while
real estate in

the nation's most liberalised city, Shenzhen, is down by 40%.

Critics at home have openly challenged their policy of investing
dollar reserves in US Treasury bonds. China holds $519 billion,
second only to Japan, which has $593 billion.

These investments kept US interest rates low, funding the sub-prime
mortgage boom and the war in Iraq. For China, though, they could turn
out to be a bad deal.

Most ordinary Chinese are unaware that foreign-exchange reserves are
not free assets but represent liabilities against domestic currency
issued by the central bank to "sterilise" dollar inflows earned by
exporters. Even so, public opinion does grasp that every percentage
point fall in the value of the dollar against the yuan represents a
loss for China in its own money.

There is also angry popular debate about state-directed forays into
foreign acquisitions, such as loss-making investments in Morgan
Stanley, the US investment house, and For-tis, the recently
nationalised European bank.

A significant fall in exports, leading to more unemployment and
company failures, could intensify unrest and destroy confidence in
private enterprise.

That would strengthen the hand of Marxist intellectuals -- who,
contrary to wishful thinking in the West, have not vanished from
China. That is why economic reformers are striving to avert a sharp slow-down.

In August, production of fridges fell 14% compared with a year
earlier, said Huo Dufang, chairman of an industry association. Output
of air - conditioning units fell 7.7% and of microwave ovens by 6.5%, he said.

"As more and more developed countries run into a financial crisis,
China's exports will contract exponentially," said Wang Jie, an
economic analyst in Shanghai. "I forecast that a third of small and
medium-sized enterprises in the export sector will go bankrupt by the
second quarter of 2009," he added.

In the export-orientated provinces of Guangdong, Zhejiang and
Jiangsu, the slowdown has already cut a swathe through businesses.

Out of some 6,000 shoe factories in the Pearl River Delta, 2,331 have
gone bankrupt, according to a trade magazine.

One in five small or medium-sized enterprises in Zhejiang have also
gone under, said the Securities Daily, a business newspaper.

Scenes of angry workers and creditors besieging the premises of the
Golden Sun group were shown on local television, which reported that
its boss, Zhang Zhengjian, had fled owing almost £100m.

And last week the China Youth Daily told the story of how an
employee, Xiao Gao, showed up early for work at the biggest printing
and dyeing group in Zhejiang to find the offices stripped of
computers and strewn with documents.

Police were looking for the owner and his wife, who are reputed to
owe £85m to state-owned banks and a further £57m to the institutions
known in Chinese as "underground banks."

The latter, which levy interest at up to 40% a year, have
proliferated in a landscape of commercial desperation despite the
fact that Chinese businessmen fear their sinister figureheads and
their drastic methods of debt collection.

"At first the government thought that Chinese companies could export
more to Europe while America was in a slowdown but now the crisis has
spread," said Wu Jian, an analyst at Ping An insurance.

Optimists can argue that China is a vast country of 1.3 billion
people, which has absorbed far worse shocks in the past 50 years than
a down-turn in exports. This ignores the reality that the export
zones of south and east China have been the locomotives of economic
reform, generating prosperity and helping to create a class of
Chinese with a stake in political stability.

Not surprisingly, some officials are openly arguing that China has
got its priorities wrong. Wen Zongyu of the Ministry of Finance
research centre, said: "We need to admit that most of our exports
were low-quality, without brand value or added knowledge, which meant
that most of our exports to America and Europe were sold to poor people."

Speaking on state television, Wen said: "Poor people in America and
Europe are having a hard time, so the fall in consumption will
directly affect China's production and exports."

British businessmen visiting China last week to attend the big annual
trade fairs disagreed with this analysis. "In a recession, the top
end and bottom end of the market do well but the middle market gets
squeezed," said one. "Unfortunately for China, that's exactly where
they've been trying to shift their exports."

Yet some Chinese thinkers are already exulting, saying the crisis is
proof of the superiority of the Beijing model of state-dominated
capitalism over its free-market counterpart.

Vindication of that theory will come at a high price.

The title of a banned book by an economist, circulating to great
enthusiasm on the internet in Chinese last week, said it all: China -
The Twilight of a Miracle.
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