Information about Asia and the Pacific Asia y el Pacífico
Chapter

7 China and the Asian Crisis

Author(s):
Wanda Tseng, and Markus Rodlauer
Published Date:
February 2003
Share
  • ShareShare
Information about Asia and the Pacific Asia y el Pacífico
Show Summary Details
Author(s)
Paul Gruenwald and Jahangir Aziz 

China’s economy performed well during the Asian financial crisis of 1997–99, especially when compared with other countries in the region. GDP growth remained high, the external current account in surplus, official foreign reserves at comfortable levels, and the exchange rate stable. Indeed, the stability of the renminbi was seen as an important factor in limiting the impact of the crisis on the region’s economies.

This chapter discusses the factors behind China’s successful passage through the Asian crisis. China’s favorable performance is particularly remarkable given the presence of domestic vulnerabilities, such as a weak financial system and a poorly performing corporate sector, similar to those in the crisis-affected countries. The chapter concludes that low external vulnerability, especially due to ample official foreign reserves and low external debt, was among the main factors responsible for limiting the effects of the crisis on the domestic economy. The still-limited openness of the economy, including the capital account, also helped, even though the controls in place turned out to be porous during the crisis. Moreover, the Chinese authorities pursued timely countercyclical policies to address the growth slowdown and the associated social pressures. Importantly, the Asian crisis motivated the authorities to accelerate reforms in key areas of vulnerability, notably in the banking and state-owned enterprise (SOE) sectors.

Although the reforms undertaken have improved conditions, domestic vulnerabilities remain. The financial and corporate sectors still suffer from weak corporate governance, poor financial conditions, and inadequate regulatory oversight. Following China’s accession to the World Trade Organization, these sectors will face increased international competition, and the effectiveness of capital controls is likely to erode further over time. Left unchecked, the weaknesses in the banking and corporate sectors could eventually undermine fiscal sustainability, the external position, and growth. Thus, even though China successfully weathered the Asian crisis, tackling these weaknesses decisively remains key to safeguarding the economy from future crises.

Macroeconomic Performance

China passed through the Asian crisis relatively unscathed.1 Output growth remained strong at an annual rate of 7–8 percent (Figure 7.1), although substantially below the double-digit rates recorded earlier in the decade, during a period of overheating. Indeed, the slowdown was due in part to the lagged effects of measures undertaken in the mid-1990s to cool the overheated economy. Reserves remained comfortable at over $150 billion, the external current account in surplus (Figure 7.2), and the exchange rate stable (Figure 7.3).

Figure 7.1.Growth in GDP

(In percent)

Source: IMF staff estimates.

1Dashed lines represent ± 1 standard error around the average for the crisis countries.

Figure 7.2.Current Account Balances

(In percent of GDP)

Source: IMF staff estimates.

1Dashed lines represent ± 1 standard error around the average for the crisis countries.

Figure 7.3.Dollar Exchange Rates

(Index, 1994=100)

Source: IMF staff estimates.

1Dashed lines represent ± 1 standard error around the average for the crisis countries.

China was not entirely untouched by the Asian crisis, however.2 Export growth dropped to near zero in 1998 (Figure 7.4), although import growth also fell sharply, partly reflecting the high import content of Chinese exports (estimated at about 60 percent), which dampened the impact on growth. Foreign direct investment (FDI) inflows stalled in 1998 and then declined in 1999. Capital flight, measured as unidentified capital outflows in the balance of payments, increased sharply in 1998.

Figure 7.4.Growth in Trade

(In percent)

Source: IMF staff estimates.

1Dashed lines represent ± 1 standard error around the average for the crisis countries.

How Did China Escape the Turmoil?

The interplay of several factors—macroeconomic, structural, and policy related—helps explain China’s relatively favorable economic performance during the crisis. These factors combined to defend the economy against external shocks, contain domestic vulnerabilities, and support internal demand when exports slowed.

External Vulnerability

During the period leading up to the Asian crisis, China’s external vulnerability indicators were generally favorable. International reserves were large and rising, short-term external debt was low (Figure 7.5), and the current account was in surplus. Although the real effective exchange rate had been rising (that is, the currency had been strengthening in real terms; Figure 7.6), largely reflecting high domestic inflation, its rate of increase was slowing as macroeconomic policies aimed at cooling the overheated economy of the mid-1990s increasingly took effect. Similarly, the growth rate of real domestic credit was also slowing (Figure 7.7).

Figure 7.5.Ratio of Short-Term Debt to Reserves

(In percent)

Source: IMF staff estimates.

1Dashed lines represent ± 1 standard error around the average for the crisis countries.

Figure 7.6.Real Exchange Rates

(Index, 1994=100)

Source: IMF staff estimates.

1Dashed lines represent ± 1 standard error around the average for the crisis countries.

Figure 7.7.Growth in Real Domestic Credit

(In percent)

Source: IMF staff estimates.

1Dashed lines represent 1 standard error around the average for the crisis countries.

China’s limited trade openness and capital controls further cushioned the economy against external shocks. Despite having increased rapidly through the 1980s and early 1990s, the ratio of exports plus imports to GDP was only around 25 percent in 1990–97, less than half of that in the crisis-affected economies (Figure 7.8). In addition, as already noted, the relatively high import content of exports limited the dependence of domestic output on external demand. Thus, notwithstanding the sharp decline in export growth (from an average annual rate of over 30 percent during 1990–97 to less than 5 percent in 1998–99), the impact on overall growth was relatively muted. The contribution of net exports to GDP growth shifted from 1¼ percentage points on average in 1990–97, when the overall growth rate was about 10¼ percent, to minus ¾ percentage point during 1998–99, when the overall growth rate dropped to 7½ percent.

Figure 7.8.Ratio of Trade to GDP

(In percent)1

Source: IMF staff estimates.

1Trade is measured as exports plus imports.

2Dashed lines represent 1 standard error around the average for the crisis countries.

Unlike in most of the countries affected by the crisis, China’s capital account was relatively closed. China’s system of capital controls has favored long-term FDI inflows. Portfolio investment was strictly segregated between residents and nonresidents, and these restrictions appear to have been at least partially effective given the divergent trends between shares in the same enterprise in the two different markets.3 Likewise, restrictions on loans distinguished between domestic-and foreign-funded enterprises, with foreign currency borrowing by domestic enterprises (except for trade finance) subject to annual and multiyear borrowing plans requiring government approval.

The capital controls limited the scope for speculative behavior during the crisis. Residents generally had no legal access to foreign exchange without an underlying current account transaction or amortization payment, nor could residents move freely between foreign and local currency. Access to the futures and forward markets was similarly limited; the only nondeliverable forward market is in Singapore and is thin and without direct links to the onshore market. As a result, investors could not take sizable positions against the renminbi. Thus, in contrast to the crisis-affected countries, where investors could shift out of local currency and reduce their country exposure, rapid exit strategies were largely unavailable in China.

The capital controls, however, did not provide complete immunity against capital outflows. Foreign banks reduced their exposure to China by over $30 billion (3 percent of GDP; figures based on Bank for International Settlements data) from the end of 1997 to the end of 1999. Unidentified capital outflows, which until the onset of the crisis had been around $15 billion a year, averaged $22 billion in 1997–98 before returning to precrisis levels in 1999–2000.

Domestic Vulnerability

In contrast to the relatively strong external position, China’s banking and corporate sectors had significant weaknesses. China’s reform process, which began in the late 1970s, is yet to be completed, and the country remains in transition to a market-oriented economy. As discussed in Chapters 9 and 10, weak corporate governance of SOEs and state commercial banks (SCBs), inadequate regulation and supervision of the financial sector, and lack of transparency about firms’ performance resulted in major inefficiencies and financial losses. The financial position of the SOEs was, on average, considerably weaker than in the corporate sectors of the crisis-hit countries in Asia, with lower overall profits and higher leverage (Table 7.1).

Table 7.1.Selected Financial Indicators in Six East Asian Countries, 1996(In percent)
IndicatorIndonesiaRep. of

Korea
MalaysiaPhilippinesThailandChina
Nonperforming loans as a share of total loans (official)8.80.83.93.57.720
Corporate sector debt-equity ratio200640200170340500
Corporate profits (return on assets)4.70.464.710.1
Source: IMF staff estimates.
Source: IMF staff estimates.

The weak financial position of the SOEs was closely linked with the health of the banking system. Losses of the SOEs were financed by the SCBs, resulting in high SOE bank leverage and poor bank asset quality. Private sector estimates at the time suggested that the recapitalizing cost of the SCBs could be on the order of 15–30 percent of GDP. The weak state of the corporate and banking sectors prompted several analysts, including Lardy (1998) and Goldstein (1998), to conjecture that China might also succumb to the crisis.

Box 7.1Was China the First Domino?

Some economists have argued that although China did not succumb to the Asian crisis, the devaluation of the renminbi in 1994 made China the “first domino” in the chain of events that led to the crisis. Those who support this view (such as Makin, 1997) argue that China’s 35 percent devaluation of the yuan against the dollar in January 1994 was preemptive, and the first in a number of events leading to the Asian crisis. Underlying this view is the supposition that China gained competitive advantage by virtue of its devaluation, and that its improved competitiveness and the subsequent rise in its export market share contributed to the pressure on and eventual devaluations of other Asian currencies, which precipitated the crisis.

However, a closer examination of the data casts doubt on the “first domino” theory. First, the 1994 move was not a devaluation in the traditional sense; rather, China’s official exchange rate was unified with the swap market rate, which remained unchanged after the unification. Since the swap rate was estimated to apply to some 80 percent of China’s external trade, the effective nominal devaluation of the renminbi was on the order of 7 percent rather than 35 percent. Second, given China’s relatively high inflation at that time (24 percent in 1994), any nominal devaluation was quickly reversed in real terms. Indeed, the January 1994 devaluation is seen as a minor blip in the upward trend of the real effective exchange rate over 1993–98, when the currency appreciated in real terms by more than 60 percent. Finally, although China’s exports did grow quickly following the devaluation of the official rate, the 1993–96 period was characterized by relatively stable export market shares across the Asian emerging markets, including China, the newly industrialized economies (Hong Kong SAR, Korea, Singapore, and Taiwan Province of China), and the major ASEAN economies. Thus, the assertion that China was the first domino appears to have little merit (see, for example, Fernald, Edison, and Loungani, 1999).

Supporting Growth and Accelerating Reform

The Chinese authorities responded to the Asian crisis by using countercyclical macroeconomic policies to support domestic demand, while accelerating reforms to address the domestic vulnerabilities. Like other countries in the region, China eased fiscal policy considerably during the Asian crisis. The fiscal deficit more than doubled, from 1.8 percent of GDP in 1997 to 4.0 percent in 1999 (Figure 7.9), largely reflecting increased public spending on infrastructure projects and social security. Low explicit public debt at the outset of the crisis and the absence of external financing needs provided room for this policy course.4

Figure 7.9.Fiscal Balances

(In percent of GDP)

Source: IMF staff estimates.

1Dashed lines represent ± 1 standard error around the average for the crisis countries.

Whereas the crisis-affected economies initially had to tighten monetary policy and raise interest rates to stabilize their free-falling currencies, China did not. Thus, following the outbreak of the crisis, the People’s Bank of China lowered domestic interest rates by about half between the end of 1997 and mid-1999 (Figure 7.10). Although the efficacy of these interest rate cuts in boosting activity has been limited given the weak monetary transmission mechanism, the interest rate cuts helped the SOEs, which were the main borrowers from the banking system, to reduce their debt service burden. The deposit base of the banking system held up well during the crisis, reflecting continued robust economic activity, the lack of investment alternatives, and the credibility of the implied government guarantee of the almost entirely state-owned banking system.

Figure 7.10.Nominal Interest Rates

(Index, 1994=100)

Source: IMF staff estimates.

1Dashed lines represent ± 1 standard error around the average for the crisis countries.

The Asian crisis pushed financial sector and SOE reforms to the top of the government’s policy agenda (Chapters 9 and 10). In the financial sector the reforms aimed to gradually transform the SCBs into viable and competitive universal banks, consolidate and contain losses in the smaller financial institutions, and increase competition by allowing other (non-SCB) banks to assume a growing role in domestic financial intermediation. The reforms involved greater transparency regarding the financial condition of the financial system; stricter regulatory standards; less government interference in the system; recapitalization, balance sheet cleanup, and operational restructuring of the SCBs; the creation of asset management companies (AMCs) to deal with a sizable portion of the nonperforming loans of the SCBs and one policy bank (the China Development Bank); and the merger and closure of ailing small financial institutions.

The National Financial Sector Work Conference in November 1997 underscored the need for renewed efforts to reduce government interference in the financial system. Following this, the central bank was restructured in 1998 to give it greater independence on credit policy and supervisory decisions. That same year the government eliminated credit quotas for SCBs, conferring greater responsibility on them for their lending decisions. In 1999 interference in commercial lending was explicitly forbidden. In an effort to recapitalize the SCBs, the government injected capital equivalent to 3½ percent of GDP into these banks in 1998. During 1999–2000 the four SCBs and one policy bank transferred nonperforming loans equivalent to 17 percent of GDP to four newly established AMCs.

Closures and mergers were used extensively to consolidate smaller financial institutions. Insolvent rural credit funds were liquidated and solvent ones merged with rural credit cooperatives. The number of these cooperatives and of urban credit cooperatives was cut by several thousand in the last few years, mainly through mergers at the city and the provincial level. The reform of the trust and investment companies, including those with international exposure (many of which had run into financial difficulties), has proceeded along similar lines, involving a mix of mergers and closures.

In the SOE sector the authorities accelerated restructuring efforts despite the social pressures brought on by the slowing economy. In early 1998 the government announced a three-year program to revitalize China’s medium-size and large SOEs. The program involved the broadening of earlier pilot reform initiatives (such as the adoption of “modern enterprise systems”) to a national scale, combining them with new efforts to reorganize, upgrade, and improve enterprise management and governance, and strategic reorganization of key sectors designed to eliminate excess capacity and redundant labor. The social consequences of the accelerated reforms were to be dealt with by broadening the social safety net, including through reemployment programs.

References

    CallenTimPatriciaReynolds and ChristopherTowe2001India at the Crossroads: Sustaining Growth and Reducing Poverty (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation

    FernaldJohnH.Edison and P.Loungani1999“Was China the First Domino? Assessing Links Between China and Other Asian Economies,”Journal of International Money and FinanceVol. 18No. 4 (August) pp. 51535.

    • Search Google Scholar
    • Export Citation

    GoldsteinMorris1998The Asian Financial Crisis: Causes Cures and Systematic Implications Policy Analyses in International Economics No. 55 (Washington: Institute for International Economics).

    • Search Google Scholar
    • Export Citation

    LardyNicholas R.1998“China and the Asian Financial Contagion, 1998,”Foreign AffairsVol. 77No. 4 (July-August) pp. 112.

    • Search Google Scholar
    • Export Citation

    MakinJohn H.1997“Two New Paradigms” AEI Economic OutlookOctober (Washington: American Enterprise Institute).

1India, too, weathered the crisis well. For an account see Callen, Reynolds, and Towe (2001, Chapter 2).
2In fact, some economists have argued that China was the “first domino” in the chain of events that led to the Asian crisis (Box 7.1)
3“A shares” were reserved for domestic investors and denominated in local currency whereas “B shares” were reserved for nonresident investors and denominated in foreign currency. The B-share market was relatively shallow and was more severely affected by the Asian crisis than the A-share market. In particular, valuations in the A-share market were significantly higher than in the B-share market. In early 2001 domestic investors were allowed to invest in B shares, and the gap between A- and B-share valuations narrowed.
4As explained in Chapter 8, broader measures of the public debt, including in particular the quasi-fiscal costs of nonperforming loans in the financial system, were much larger.

    Other Resources Citing This Publication