Testimony of Gordon Chang
Author and Attorney

Before the U.S.-China Commission
August 2, 2001
Washington, D.C.


Mr. Chairman and Members of the Commission:

Thank you for the opportunity to present my views.

I am the author of The Coming Collapse of China, which will be published by Random House next week. I have lived and worked in China and Hong Kong for most of the last two decades. I was a partner in the international law firm of Baker & McKenzie and counsel to New York law firm Paul, Weiss, Rifkind, Wharton & Garrison. During this period I specialized in major corporate finance transactions involving China's state-owned enterprises. In these transactions Chinese enterprises issued equity securities in China, the United States, and Hong Kong. My practice also included other types of transactions by which foreign parties acquired interests in businesses on the Chinese Mainland. Moreover, I have extensively participated in litigation in China's court system and in other dispute resolution forums in China. Coming Collapse is based in part on the knowledge and experience gained during my period of law practice and my travels throughout China.

These days China presents the image of success. Chinese leaders tell us that they're doing a great job, and they give us statistics that back them up. Foreign (non-Chinese) experts assure us that the People's Republic has a bright future.

We can all look at the potential of China and become giddy. We extrapolate, multiply, and then let our imaginations run wild. The consensus is that the Communist Party has found the right formula for sustained development. "China's stars have never seemed in better alignment," said one American economist in the middle of 2000. "China's time is now." Now that China has been awarded the 2008 Summer Olympics and is about to enter the World Trade Organization, who can be pessimistic about the most populous nation on earth?

Before we let our optimism overwhelm us, let's look at the facts. The facts point to one conclusion: China is a weak giant, not a strong one. I have been asked to summarize The Coming Collapse of China. That I can do in a few words: the Communist Party of China will fall from power within a decade.

Nothing in this world lasts forever, so predicting the fall of the Party and the republic it leads is not a major feat. After all, the People's Republic maintains an unsustainable economic and political system, so talking about its demise is long overdue. Coming Collapse, if it has any startling message at all, is this: the fall of the Party is near.

Why will we see great changes soon? China is not prepared for accession to the WTO. Its state-owned enterprises and banks are not ready for increased competition. The economy, in reality, is stalling, not growing fast enough. The result is worker and peasant unrest. The central government's finances are in bad shape, and one day the People's Republic could run out of money. But before that happens, the rulers of China will run out of something even more precious: time.


Accession to the WTO
In the past, the central government's deft handling of multinationals and private entrepreneurs resulted in the fastest economic growth in the world, perhaps the fastest the world has ever seen. Change was impressive, and the country is a far better place today than when Deng Xiaoping grabbed power from the hapless Hua Guofeng at the end of 1978. We shouldn't take anything away from Deng, but one point should nonetheless be mentioned. In his era, China was, as a practical matter, accountable to no one. It set the rules and administered the game. Therefore, it was able to achieve the desired results.

In the WTO era, the story will be different. Tariffs will drop and internal barriers to trade will fall, but those changes will not be the most important ones. From the day of accession China will be subject to the strict regime of WTO rules and its international mechanisms for resolving disputes. The changes in China will be dramatic. When China accedes to the global trading body, the country will no longer be the sole master of its own economy.

China, however, is not prepared for accession. In Beijing today structural reform of state-owned enterprises has been essentially deferred because there is a lack of comprehension of the seriousness of the situation. A little while ago Premier Zhu Rongji proclaimed victory in his three-year campaign to make SOEs profitable. A close analysis of the numbers indicates, however, that most of the claimed profits are the result of a fortuitous rise in the world price of oil and the availability of central government subsidies (such as the relief of interest expense). Moreover, we will never know to what extent fabrication has enhanced these statistics.

Yet we don't really need to sort the good numbers from the bad. The real issue is not the profitability of the SOEs. After all, under China's accounting rules, almost anything can be made to look profitable. In the WTO era we can forget about profitability because it will be competitiveness that counts. And despite their improved profit picture, most SOEs will not be able to compete. That's because China's state-owned enterprises have made relatively few preparations for WTO: they largely assume that Beijing's ministries will continue to protect them. The assumption is wrong, however. WTO is unforgiving, and accession will limit the ability of the central government to defer problems to the indefinite future. Therefore, some analysts believe that only a handful of China's listed companies will survive the first few years after accession. Maybe it won't be that bad, but one thing's for sure. The shakeout will be horrendous.

The story is much the same for the state-owned banks, which include among them some of the weakest financial institutions in the world. Insolvent and backward, these banks are kept afloat by the central government, which cannot afford to let them fail. The most recent recapitalization of the "Big Four" banks still left them straining under mountains of bad debts and nonperforming loans, so their rehabilitation is still beyond the horizon. Reform in this area has so far failed, and China's commercial banking institutions are still not ready for the enhanced competition of the WTO era.

In short, many of China's enterprises, and maybe even some of the banks, will fall by the wayside in the first few years after accession. So the consequences for the economy will be critical. Not everyone thinks that the impact of accession will so severe, however. There are three main arguments why WTO won't be so bad at first: China will cheat, foreign investment will swell, and GDP will rise.

Will China cheat on its commitments? Senior Chinese leaders tell us, every few days, that they will honor all the promises that they have made. Take them for their word: they won't go back on what they said. Their honesty, however, doesn't mean that compliance should be taken for granted because there is a group in China that will cheat. Every province, city, and town will protect local industry. They will employ traditional tactics as they seek to preserve the present. Powerful today, they will fail tomorrow. Multinationals will fight because, if there is one reason why WTO is significant, it is this: WTO means foreign investors don't have to listen to the bureaucrats anymore. WTO rules will be enforced after all is said and done. Local officials will fight, but foreigners will eventually prevail.

Those who say foreign investment will mushroom are ignoring the realities of China and the world at large. China is suffering deflation because, except for telecommunications, there is too much capacity. Overcapacity in China is matched by overcapacity in the world today. China managers will want to build bigger facilities in country to take advantage of the emerging national market. But executives in New York, London, or Paris will want to export to China from existing factories. WTO means that tariffs will drop and local rules against distribution will lapse so that exporting to the Mainland will not only be a feasible solution but also the compelling one. Need proof? Volkswagen, with a roughly 50 percent share of the domestic car market in China, says that it will not be able to compete with imported cars after accession due to the scheduled reduction in tariffs. The world's most efficient car plants are just two days away from China by ship. Even General Motors, which is committed to making parts and assembling vehicles on the Mainland, plans to import car parts and even whole cars into China in the future.

Bottom line is that there will be some increase in foreign investment, but the boom will be smaller than predicted and shorter than expected. So those analysts who foresee an explosion in foreign investment have misperceived the future.

When the waves of imports flood China, it's unlikely that Gross Domestic Product will continue its current pace (whatever that actually is now). Accession will knock one or two percentage points off GDP growth. That means GDP, at least in the first few years after accession, will trend downward. Maybe not by much, but enough to be felt. China is perhaps at the point where the loss of a percentage point of growth would have a disproportionate impact on the urban proletariat and the peasantry.
Technocrats in Beijing, while tinkering with reform, have been able to maintain social stability in the big cities. Yet we must remember that in the smaller urban areas workers are restless. They used to demonstrate in the tens and hundreds. Now they protest in the thousands and tens of thousands. The trend is clear. If growth slips further, the central leadership will have to struggle to maintain order. Today, the number of all the unemployed and underemployed probably exceeds the combined population of France, Germany, and the United Kingdom. No one really knows what the actual figure is, but we're talking about a social problem of large proportions. Despite what state media sometimes implies, there is no general safety net in the country for the unemployed.

Now let's talk about the 900 million peasants. We don't think about them very much because they're hidden from the view of most visitors, but in the coming years they will be a force to be reckoned with. Like many of their urban cousins, peasants, or ìfarmersî to use the term favored by official newspapers, are discontented. They also demonstrate, and their acts of disobedience have taken on a desperate tone: barehanded peasants fight the armed security forces of the state. What does that tell us?

We hear central government leaders talk about social order and think that they're obsessive, but they have good reason to be concerned about the stability of the modern Chinese state. Today, the state is keeping the economy going by massive fiscal stimulus, which means running increasing budget deficits. If there's a river, technocrats will dam it. If there's a pension, they'll increase it. And when they find a patch of land, they build a highway. They do all those things to keep their economy going.

Now the situation looks manageable. The ratio of public debt to GDP in 2000 was 22.9 percent. That figure is well under the internationally-recognized safety mark of 60 percent. Public debt is not the end of the story, however. To figure out the true capability of the central government to borrow, one must add in pension obligations and indirect loans to the state, for instance. In a recent report Merrill Lynch suggests that the figure is 120 percent, but it's more than that for sure.

I think it's just shy of 150 percent. China's pension obligations are US$850 billion (or 79.4 percent of GDP). This is not the official estimate, which is unrealistically low. This figure comes from the respected Chinese Academy of Social Sciences (and is not the highest one that can be found). Finally, include nonrecoverable loans extended by banks and other financial institutions (other than the policy banks). These loans probably amount to approximately US$490 billion. I have assumed that half the loans in the banking system are nonperforming and that 20 percent of the nonperforming loans are recoverable (assumptions that are not the most pessimistic that exist). Add pension obligations and rotten loans to the amount of public debt, and one can begin to see the dimensions of the problem.

The debt to GDP ratio would, of course, be higher if we had reliable GDP statistics and if we had a better idea of all the obligations of the central government. We can quibble over the numbers, yet all of us will eventually arrive at the same stark conclusion: Beijing is running out of money and it is running out of time. It has just a few years, perhaps only five, to put things right.

Those are the five years when the negative effects of WTO accession will impact China. The country will be a beneficiary of joining the global trading organization, but the benefits come later after structural reform has had an opportunity to take effect. In the beginning, however, there will be the layoffs and business failures that accompany change. That's inevitable--China is curing decades of economic mismanagement. Analysts who assume that the road leads straight up from here simply ignore common sense. The next few years will be rocky.

We see all the change in China and assume that progress, in one way or another, must continue. We should not take further development for granted. The concern is not that China is doing the wrong things. Today one will find evidence of solutions that, with time and political will, could work. If China had decades, everything might come out right. But whether China is on the right road is not the critical question.

When the People's Republic falls, historians will say that there wasn't enough time. China's cautious--sometimes glacial--approach to reform is not suited to the severe problems it faces or, for that matter, a world where the pace of change is accelerating.

While the world speeds up, China crawls to the ìtipping point,î to borrow the phrase popularized by Malcolm Gladwell. Gladwell likens social change to epidemics, which begin with the smallest of events. ìThings can happen all at once, and little changes can make a huge difference,î he writes. So change does not occur gradually; it takes place in one critical moment. China, on the eve of membership in the WTO, will tip when something, and probably just an inconsequential event, goes wrong. In some small village or large town, events will get out of control. Mao Zedong said all it takes is a single spark to start a prairie fire. Now it is just a matter of time.


Politics Still Rule


The People's Republic could survive the upcoming transition if WTO accession were just a question of economics. After all, drastic situations usually breed drastic solutions. Yet one cannot discuss China's economy in isolation. To understand economic development in the People's Republic, we need to look at politics. There is one essential truth about the People's Republic: ideology still reigns in China, despite all the progress we have seen and whatever we may want to think. We should all remember Mao Zedong's infamous instruction to ìput politics in command.î Today's leader, Jiang Zemin appears more modern as does the party he leads. Yet his words remind us that the old system remains in place. ìTalk politics,î Jiang often says, evoking memories of the first days of the People's Republic.

In short, Jiang Zemin is returning China to an earlier time. We can dismiss his words, but we do so at our peril. The proof lies in what he is doing. The supposedly up-to-date Communist Party still engages in ideological exercises, most notably the Three Stresses (sometimes translated as "Three Emphases") campaign, which focused on studying Marxism, promoting righteousness, and being politically correct. The campaign had all the old elements of Maoist China, such as study sessions and group and individual self-criticisms. The Three Stresses campaign was soon followed by the more modern Three Represents campaign. Again, Party and government units were instructed to hold study sessions while important problems were left unattended.

Jiang's answer to China's pressing problems is to strengthen the Party. This is not mere talk: the Party is currently spreading its cells to all but the smallest organizations, including private businesses. All the Party building campaigns are reminders that the leadership of China will not let go of the past.

The Communist Party still believes that its destiny is to rule China for all time. As we see modern things in China, such as growing capital markets, we must remember that the Maoist system itself is not modern and has not been reformed. Beijing's leaders will continue to permit change, but they will do their best to prevent change that threatens their system. China's officials are, as they so often remind us, building socialism, not capitalism. They can permit temporary retreats from their ultimate goal, but the last thing they will do is abandon their ideology. When we grhtm this fundamental truth, we can better understand what they do. And why their regime will not survive.