Dec 4th 2008

When the going gets tough, Hank Paulson heads for the People's Republic of China

by Sol W. Sanders

Sol W. Sanders, (, is an Asian specialist with more than 25 years in the region, and a former correspondent for Business Week, U.S. News & World Report and United Press International

I guess one can't fault "Hank" Paulson for trying to put the best face on things as he set off on in early December on another trip to China, his last as Secretary of Treasury. With all the problems he temporarily leaves behind in Washington, it may help to loudly proclaim that China is a "stakeholder" and that Beijing is helping the U.S. and the rest of the world weather the credit crunch, the oncoming worldwide recession, and a welter of policy dilemmas no one is quite sure where to begin solving.

Paulson told a Washington audience that China is cooperating in helping to calm the waters and find solutions to the international economic downturn. But that is, to say the least, stretching it a bit.

But the truth is he goes into this fifth meeting of the Strategic Economic Dialogue [SED] with even less hope the U.S. and China will find "solutions" than earlier ones, and in a sense, he is facing the same old problems in a more aggravated form. Those are Chinese export subsidies, Beijing's mercantilist strategy toward blocking imports and their hoarding foreign exchange.

Chinese policy making is as opaque as ever, although Beijing is making noises about government policy pumping up domestic consumption to carry China through the worldwide crisis. Meanwhile, they can continue to announce phony statistics and policy decisions to bolster morale without the wherewithal to implement them.

There's no denying the fact that the Chinese have their own problems, and they are growing by the moment.

Paulson may be partly right. True enough, the Chinese haven't dumped their almost $2 trillion aggregation of U.S. securities and foreign exchange reserves held mostly in dollars. That's a catastrophic scenario sometimes dreamed up by the scaremongers. But it wouldn't be just a catastrophe for the U.S.; it would bring down the whole rickety financial structure in China as it is tumbling elsewhere. Blowing a hole in the dollar would be China's loss simply because it holds so many. It's Maynard Milord Keynes' old saw about owing the bank a small debt makes them they own you, a big debt and you own them. Beijing at this point has almost as much interest in seeing the dollar remain as sound as it can in this continuing crisis as Washington. Nor is it at all clear who would be around to buy the dollars if and when China sought to move into other currencies for its reserves. Beijing tried that some time back with a still undisclosed setting up a "trade adjusted" package in its reserves. And though that is as well kept a secret as most other transactions, it simply resulted in their loss in Euros when the dollar began to regain momentum, an obvious expression of the feeling that as bad as things were in the U.S., they were worse in Western Europe.

That's why it isn't likely to happen.

On the other hand, unlike the Japanese who promptly announced they would meet the worldwide demands for recapitalization by tossing $500 billion in loans to the International Monetary Fund, China has been quiet about lending a hand.

Paulson is correct, of course, when he says the Chinese are not as directly involved in the credit crunch which has brought on the worldwide crisis. But the repercussions of it, by the fact that the U.S. has gone into recession and may not come out of it for some time is ripping the Chinese economy apart.

Stephen Roach, chairman of the Asian branch of Paulson's old embattled firm, Morgan Stanley Asia Limited, recounted the sad news to a Hong Kong audience in early December: the bursting of the American consumer bubble, accounting last year for 72 percent of the US gross domestic product - a level unheard of in the world's economic history - is catastrophic news for China.

Almost half - 45 percent - of the Asian region's products go into export, 10 percent more than a decade ago when the East Asian Financial Crisis struck, delivering blows from which some countries, especially South Korea, have never recovered. Some estimate that fully a third of China's gross development product growth is based on exports, some three-quarters fed into the world markets by the foreign multinational corporations.

Bill Clinton, that great expert on international finance, told the same Hong Kong meeting that the world should not go back to "old-fashioned" finance, that is, it should stick with the leveraging that now has come crashing down. Maybe. But foreign investors, in fact, all investors, are not yet convinced.

And as far as China is concerned, it is for good reason. Nobuyuki Saji, chief economist for Mitsubishi UFJ Securities, estimates that the Chinese economy is currently operating at as much as 50 percent below capacity, due to the previous vast expansion in many industries and the current sharp downturn in global demand.

Saji even suggests that the culprit at the heart of the world deflation is in China.

"In the end, the only realistic way of closing this gap will be a correction brought about by prices collapsing," he said, which in turn will accelerate the plant closures and job losses already underway.

Caijing financial magazine confirmed that the "fragile expansion" in the Yangtze River Delta that accounts for nearly a quarter of China's gross domestic product and 30 percent of all private firms is in deep do-do. Caijing explained that many large firms, with the backing of local government, had raised highly leveraged loans. There was corruption, too: companies grouped to obtain loans by using each other's assets to make their collateral appear larger. As long as the economy was booming, the politically motivated banks - which have seen the government lift "nonperforming loans off their books by the billions - could continue to finance this debt-driven expansion. But once the economy started to slow, these firms collapsed.

"For many private firms... the apparent difficulties are slowing demand or tightening credit... But more fundamental causes are overcapacity created by excessive expansion," the publication said. "Rising prices for steel, real estate and chemical fibers and shortages of commodities attracted huge investment into these sectors. Now bankruptcies are spreading rapidly as firms are caught with mounting debts, amid the bursting of the property bubble, falling exports and collapsing prices."

Economists inside and outside China have been urging the government to boost domestic consumption. That's easier said than done. There is virtually no social welfare network to rescue unemployed or semiemployed workers with only an estimated 11 percent of the national budget devoted to them.

Instead of taking this advice, Premier Wen Jiabao is trying to revive the export bonanza. He announced a freeze earlier this year on any increase in minimum wages across China, after firms in the export sector demanded a cut in wages to avoid bankruptcy. Most workers had received little more than the minimum wage, and that has actually declined in real terms over the past decade. In Guangdong, one of the principal centers of the export trade, the minimum wage while the highest in China was reckoned at just 880 yuan [$128] a month. With a rapidly rising cost of living - food during the summer rising at as much as 8 percent - that doesn't buy much, even in China.

Meanwhile, the Chinese central bank is continuing to pour tens of billions of dollars into U.S. treasury bonds and other investments, in order to keep the yuan relatively low against the dollar and in an attempt to maintain the competitive edge for Chinese exports against other low wage areas around the world.

Although Paulson pointed to a 20 percent appreciation of the RMB of over 20 percent against the dollar since 2005, the fact is that it has frozen since midsummer even with the dollar appreciating against the Euro and many other currencies. There is a suspicion that a big chunk of the $1.6 trillion that Beijing says it has committed to a "stimulus" package, is, in reality, a new stoking of the subsidies for exports. In any case, much of the announced funds were already those committed to longterm infrastructure projects, another half trillion or so to be spent by regions and municipalities, largely unprepared to do so.

And the worst part of it may be, as far as Beijing is concerned, as with Keynes' string, with American and European demand dropping so precipitously, price may not be an effective stimulus for the exports.

Of course, Chinese continued purchases of U.S. debt are keeping the price of funding the growing American debt at a record low interest rate, the best in 30 years. That is perhaps why Paulson will speak quietly about the long cherished American hope and complaint that a rapidly rising yuan against the dollar would begin to right the trade and payments imbalance with China, and slow the draining away of American manufacturing and jobs.

But there is a greater threat hovering over this merry-go-round. There is a growing fear in Beijing that job losses will lead to social unrest. Yin Weimin, the minister of human resources and social security, in early November uncharacteristically for Communists officials, talked about the employment problem in stark terms:

"Our judgment is that in the first quarter of next year there will be even greater difficulties [for employment]," he said. Bejhing's official statistics of 4 percent unemployment is a joke; not only does it not record the millions of rural workers who are either unemployed or underemployed, but it does not count the parttime workers that now crowd the big cities' slums.

Zhang Xiaojian, vice minister of human resources and social security, recently admitted that in the third quarter, business demand for employees was down 5.5 percent from a year earlier - a sharp reversal of what had been reported earlier as the second quarter gain of 4.7 percent. In fact, Zhang confirmed net job losses for the quarter. And he made public something that the tens of thousands of Chinese students in American universities have known for some time - the growing competition for jobs and unemployment among China's millions of college graduates, many of them only marginally fitted for industrial employment..

A crunch may be coming on Chinese New Year's at the spring equinox when millions of urban workers return to their homes in the impoverished countryside. This year many may not have jobs to return to. Hubei Province officials recently estimated that over one million laid-off migrant workers will head home even before the New Year's in February. In southwestern Chongqing municipality, more than 100,000 migrant workers are already estimated to have returned home.

It's been a rule of thumb among Chinese officials and some foreign observers that the economy was like the proverbial bicycle - if it didn't keep going forward at a rapid pace, it would fall over. That minimum pace has been variously estimated at least an 8 or perhaps a 6 percent growth rate annually of the GDP. Dipping rapidly from the double decimal figure of the last few years, it has already fallen to 9 percent and seems to be dropping further.

The anticipated social protests have rocked China in recent weeks. In early November, a particularly ugly episode took place in Longnan, a city in western and poverty-stricken Gansu Province with its large Huihui [Chinese ethnic] Muslim population. Crowds were said to have swollen to more than 10,000, leading to violent clashes with police, ostensibly over government offices being moved and land being exappropriated. Chinese taxi drivers, the bellwether of discontent in many Asian cities, have staged strikes over rising fuel prices and corrupt collusion between officials and fleet owners.

Zhou Yongkang, the member of the Chinese Communist Party's powerful Politburo Standing Committee in charge of state security, called for an "all-out effort" was needed to strengthen the police especially in rural areas before a national conference November 20 in Beijing.

"By doing so, we can nip [unrest] in the bud, he said."We have to strengthen public security forces in rural areas, crack down on crimes in high places, and punish those who endanger our social stability." .

Paulson can only hope the noise outside his hotel windows in Beijing is just more of the kind of angry carping he has heard on Capitol Hill about his U.S. financial rescue program. If it is a large Chinese crowd, then the U.S. as well as Beijing's leadership may have big new troubles ahead, another part of the package he will be leaving behind for President-elect Barack Obama in January.


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