VIEWPOINT: David Roche says Zhu is what China needs COVER: The People's Republic has never had greater need for the economic wizardry of Zhu Rongji. But the incoming Premier's radical plans and even more radical personality may be more than the status quo can handle POWER SHIFT: The infamous Li Peng moves on	ASIA	March 16, 1998 VOL. 151 NO. 10
	Bullish Technocrat in a China Shop Beijing faces a rough road ahead, but it's lucky to have Zhu at the helm By DAVID ROCHE here are dramatic changes under way in china. Once the National People's Congress officially names Zhu Rongji as Prime Minister, look for him to start radically shrinking the government and pursuing deep structural economic reforms. He will be the best thing to hit China for a long time. China is blessed with a corps of realistic, talented people at the top, many of whom I met during a recent visit to Beijing. None disguises the difficulties the country faces, although some couch them in elliptical prose. To achieve the next stage of economic development, China has to clear away the twin deadweights of unproductive state-owned enterprises and bad debts in the official banks. China needs to make capital and labor more productive. That cannot be achieved simply by pumping additional investments into the economy. China is already suffering from declining marginal returns on investment, mainly from the money poured into state-owned enterprises, which account for only 34% of industrial output, but which gobble up 50% of investment, 65% of the urban labor force and 70% of bank credit. China's leaders, led by Zhu, are aware of this. To get the economy moving they need to find a new accelerator, in the form of enhanced productivity. But to make it work, they have to remove the drag from state enterprises, the bureaucracy and bankrupt banks. Success will mean higher growth. But in the short term, things will slow down. Reforming state enterprises and shrinking both the government and state banks will mean as many as 50 million additional jobless consumers and a decline in investment for a few years. The crisis in Asia, where nearly half China's exports go, couldn't have come at a worse time. Beijing's regional trading partners will be importing little from China or elsewhere over the next couple of years. And they will be competing with China's exports in other markets with currencies that have fallen 30% to 50% in value against China's renminbi. That alone could slash China's growth rate by one-third. The growth equation for the next few years doesn't add up. At the npc, delegates are chanting the mantra that 8% growth (adjusted for inflation) is needed to create sufficient employment to cope with state enterprise job losses and the labor force expansion. I believe they need much more than that but will actually get far less. Authorities hope that higher levels of fixed investment (currently equal to 34% of gdp) will save the day. Fixed investment is supposed to grow this year by 15%, after a 10% rise in 1997. In fact, it's likely to fall. That's because nearly all Chinese products are in balance with domestic demand-or in oversupply-so there aren't likely to be spare profits for investment. Township and communal enterprise investment is growing at only 8%, and state sector investment (which is still expanding by about 14%) will have to decline if reform is to work. Foreign injections, which account for about 10% of all investment, will probably drop 25% or so over the next two years. As unemployment rises, meanwhile, consumption is likely to be weak. The result is that China won't grow, and it won't create the jobs needed for economic stability. Beijing's leaders realize that the next few years are going to be tough-and that's good news. Unlike the Japanese, they are not deluding themselves. My guess is that, in the end, China will emerge as the region's economic powerhouse. But it's going to be a bumpy ride to get there. Beijing will surely print money and boost infrastructure spending, by $20 billion to $30 billion. The difficulty is getting that money to work in an inefficient and corrupt system. At best, this endeavor could add 3 percentage points to gdp growth. That would leave China short of its 8% target and well below the double-digit rate it needs. Furthermore, such a stimulus would bring market pressures on the renminbi, because it would suck in more imports just as exports are falling. Beijing officials are committed to avoiding a devaluation, even though it would restore the competitiveness China has lost amid the recent slide in its neighbors' currencies. By not devaluing, China is winning brownie points from the U.S. and the rest of Asia for not adding to regional woes. Its restraint is also boosting China's bid for membership in the World Trade Organization. Moreover, a devaluation would create inflationary dangers and political risks for Hong Kong. But if deflationary domestic trends necessitate a devaluation, China's authorities would no doubt accept it. And that's likely within the next 18 months. When the renminbi does fall, by 20% to 30%, it will put extreme pressure on Hong Kong's dollar. The cost to Hong Kong will be huge, in the short term. To preserve the currency's peg to the U.S. dollar, Hong Kong will have to raise interest rates and watch the economy slide. If it breaks the peg, that too would mean higher interest rates, as investors factor in the devaluation risk. The silver lining would be a dynamic Chinese economy and a cheaper renminbi-big long-term pluses for Hong Kong. Tough times lie ahead for Hong Kong and China, but it's fortunate that Zhu, a skilled technocrat, is about to start running things in Beijing. David Roche heads Independent Strategy, a London investment firm
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