When the reform era began in China, following Deng Xiaoping's consolidation of power, many people believed that China could finesse the problem of reforming the state-owned sector by starting the reform process in the agricultural sector and allowing the dynamic growth of a nonstate sector. At the same time, China created one of the world's most open environments for foreign direct investment. The feeling was that if enough growth could be generated in agriculture, the township and village enterprises, and other forms of nonstate ownership, and if enough foreign technology and management expertise could be introduced through joint ventures, the larger problems could be papered over.

The evidence increasingly points to the failure of this strategy, however. While the state sector's share of total output has declined steadily, employment in the state-run industries has increased by more than 50 percent since 1978, and fully three-quarters of China's urban dwellers people owe their jobs to the state. This figure remains unchanged since 1985.

Equally important, the state sector still absorbs three-fifths of all investment resources in the economy. This situation is especially acute in the manufacturing sector. In 1985, state- owned enterprises controlled three-quarters of the assets in manufacturing and produced three-fifths of all manufacturing output. In 1995, the state share of assets had declined to 54 percent, and it produced 46 percent of all output. The state share of assets has shrunk half as fast as its contribution to output. In other words, the state sector controls a very large proportion of all assets and produces very little with those assets.

The state is increasingly inefficient-it controls a disproportionate share of the economy but produces much less than in the past. A study of factor productivity is inconclusive, and the debate on this issue is largely meaningless. The important question is how productivity is transformed into the financial health of the state-owned sector.

A study of the liability-to-assets ratio reveals that the ratio was very low in 1978-10 to 20 percent. State-owned firms had few liabilities because their investment activities were financed by the state. By the late 1980s the ratio began to increase, reaching 40 to 50 percent; by 1995 it was 85 percent. This average excludes additional liabilities like unfunded pension liabilities and debt to the nonstate sector in the form of receivables.

Taking these factors into account, it becomes obvious that today the average state-run enterprise is bankrupt. Even if they liquidated, they would be unable to pay off their liabilities. These enterprises are "value subtractors"-the value of what they produce is worth less than all the inputs expended in the production process-and they are forced to borrow money even to pay their taxes. On average, their cash flow does not come near meeting their costs. Part of the reason for this is inefficiency, but an equally important problem is wage growth in the state sector. Wage growth has outstripped worker productivity, while many enterprises are required to keep excess employees on their payrolls.

Other problems in the state sector include the social burdens these firms are forced to accept. Today one-third of all hospital beds in China are in enterprises where the firm has built the hospital and pays physician salaries and the cost of all treatment and prescriptions out of the income from the sale of their product. These firms are also victims of asset stripping. Managers frequently lease the firm's assets to family members, who run nonstate sector businesses and share the profits with the managers.

There are efforts underway to fix the situation. The two primary methods have been shareholding or turning them into corporations. These efforts are not new, beginning more than 3 years ago, in 1993. Indeed, the government has been accelerating the program for a number of years. Unfortunately, these formulas do not address the long-term problems. Some firms are 100 percent state owned, and after the "transformation" they claim they are publicly owned.

One of the professed goals of shareholding was to separate government functions from economic functions, but this has not happened. To date, 10,000 companies have been converted into limited-liability, share-holding companies in this manner, but the government did not take on the social burdens of the firms. Further, there has been little change in corporate governance and little change in the relationship between enterprises and banks-the enterprises continue to borrow.

Although these companies are "publicly owned," in fact, of the 10,000 firms converted to this form of ownership, only 300 companies are publicly listed in Shanghai or Shenzhen. For at least 40 percent of the money-losing, state-owned enterprises, the government would be unable to sell them off; the market for them would be very small.

Turning to the banking sector, outstanding bank loans have risen from 50 to 90 percent of China's GDP. This is not a sustainable phenomenon. Bank loans have been increasing at more than twice the rate of the underlying economic activity. Banks are experiencing declining capital adequacy, the capital belonging to the bank itself, rather than to depositors. Since 1985, bank deposits have declined by five-sixths, which puts China well below world standards for capital.

Bank profitability is overstated and has declined by more than three-fourths in the past 5 years. There has also been a major squeeze on the banks' margins as they have been forced to loan money to the state sector at very low rates of interest.

Eighty percent of all savings in China are now generated by individual households-in 1970 that figure stood at zero percent. The source of savings has clearly shifted. Ninety percent of that household saving is on deposit in banks. The vast majority of that money has been lent out to state-sector firms, and many of those loans are nonperforming. At this point, the banks must either tell those households that their money is gone or recapitalize the banking system. As the first option is not really politically viable, the only choice is to recapitalize.

The bottom line is that China's long-term growth rate is going to be lower than it has been in the past decade. The optimistic outlook is for the government to undertake a new round of necessary reforms. In this scenario, inefficient firms would be forced into bankruptcy, there would be a tax reform, and banks would be recapitalized and forced to operate on commercial terms. Of course, this would mean a lower growth rate during the reform process, and the government would have to absorb the fiscal costs of writing off bad assets. If the rate of investment is not lowered, inflation will rise.

If the government defers reform and does not take these steps, it will face a major financial crisis and a sharp drop in savings. If this happens, the real source of growth will be jeopardized. In the reform period China could expect to see a growth rate of only 5 to 6 percent.

The pessimistic outlook is for lower growth rates or even for stagnation in real terms. Extrapolations from current trends are dangerous. The growth rate will shrink, and the real question is by how much. If the government undertakes the right kind of macroeconomic policies, it will be a modest reduction.

Long-term growth implications are negative, perhaps very negative. It will be difficult for China to develop financial markets (stock and bond markets) until the banking system is fixed. Likewise, China will be unable to even out economic performance, regardless of the average growth rate, and large fluctuations will continue if the banking sector is not reformed. The Chinese banking system will also be unable to offer much to foreign financial institutions in the way of national treatment, which remains an obstacle in China's entry into the World Trade Organization. China's banks are so weak that they cannot compete with foreign banks. In the short term, the rational course for the government is to limit the amount of domestic currency business transacted by foreign banks.

Politics are the chief constraint on economic reform. If the reforms announced at the 15^th Party Congress are so sweeping, it is important to ask what has been happening in the last 8 to 9 months. As firms have lost access to credit, they have been forced to lay off or furlough tens of millions of workers, and the response has been demonstrations and labor actions. The outcome in most of these instances has been that the banks have stepped in to lend more money to the enterprises that have paid back wages. If this has been the outcome of limited reform efforts, we must ask about the prospects for privatization and the shrinking of the state-owned sector. We can only conclude that the reforms endorsed at the Party Congress are not a breakthrough but are instead the continuation of an experiment underway for a long time. It may ultimately lead to the privatization of many firms, but it will be a slow process that will not solve the difficulties of the inefficient firms or the fragile state of the banking system.

Kevin Nealer: Foreign commercial interests in China have long experienced wild "mood swings"; this phenomenon is nothing new. American business is no exception and it always been intoxicated with the idea of selling "one of anything" to 1.2 billion people.

Today, commercial relations often substitute for the overburdened diplomatic channels, but business doesn't invest in one place or another because it likes or dislikes a particular government. Business goes where it is good for the bottom line.

The Chinese like to deal with American companies, and there is even a bias in favor of doing business with American firms. Anyone currently actively doing business in China knows that business is conducted on the "Tina Turner model"-that is, nothing happens "nice and easy," it all happens "nice and hard."

Of late, American consultants and corporations have soured somewhat on doing business in China because of the mass of press coverage on the World Trade Organization (WTO). It is important to remember, however, that the WTO is not a set of rules for trade but rather a set of rules for using trade restrictions. The WTO obligations the Chinese are being asked to assume are substantially greater than those required to join the General Agreement on Tariffs and Trade (GATT). This is an enormous problem for China because it requires making commitments in areas like government procurement and subsidies regimes. It also means liberalization in key areas that are tied to interest groups like telecommunications.

If we bend the rules of WTO to allow Chinese accession, most of the major problems will remain unsolved. Investment requirements and restrictions and export requirements and restrictions will all survive. A recent neibu, an internal Chinese government memo, on the fee structure McDonald's will have to accept, serves as a reminder of the litany of problems that foreign companies face in China. This type of difficulty, of course, exists in addition to the challenges of raising productivity and of taking advantage of presumed labor-cost advantages in the Chinese market.

Turning to a sector and issue specific analysis, a Gallup poll recently found that the number-one consumer item the Chinese people want is the automobile. Urban income, however, is roughly $1,500 to $2,000 a year, and savings rates are among the highest in the world. Even at the lowest end, at approximately $5,000 per unit, it is difficult to imagine people buying cars, given the savings rate and the absence of mortgage instruments. By the year 2000, two million autos will have been produced in China. However, the government in one form or another makes well over 90 percent of car purchases. Who will buy the high-end product that many companies hope to make?

That is not to say that car companies are not making profits in China, because they are. The largest foreign label in China is Toyota, which until recently did not produce cars in China. Through a complex grey-market system, Toyota has established its presence in China. From the perspective of an American firm, this is a very difficult way to do business.

Intellectual property theft has been ramped down, and there has been some progress in this regard, but consumer goods still face considerable barriers in China. First, they must overcome the lack of interest from a government that remains focused on technology transfer, internal manufacturing, and the creation of jobs in-country. Most importantly though, American consumer goods face the barriers created by a dysfunctional distribution system. China's distribution system simply can not compare to the world's greatest goods-handling system-the United States system is arguably America's main comparative advantage in world trade. The Chinese system is riddled with state trading by the government-owned sector, and there is simply no near-term solution to this problem in China.

American corporations that deal in "intangibles" report some of the biggest near-term successes. The insurance industry benefits as private companies begin to stand-in for the danwei (Chinese work-units that provided cradle-to-grave care for workers and their families) in the withering social structure. Indeed, the Chinese Government is counting on the private sector to offer protection from uncertainty, which it no longer can. Nevertheless, some caution is necessary as we assess the financial sector. Recent developments with Chinese "red chip" stocks provide a sobering example for enthusiasts.

As analysts studied the"collective offerings" of Chinese companies that were agglomerated together and offered as a joint buy, in a mutual-fund type of package, it became clear that 80 percent of one of the premier funds offered was a dairy. The margins in that industry are not 100 to 150 percent, despite the overvaluation of the initial offerings. These offerings were indeed oversubscribed by 300 percent. Another such fund featured the Shanghai Ring Road, which is not a toll road; it was unclear how profits would be generated from a nontoll road. Dividends on the red-chip fund were slated to come from the operations and maintenance budget for the road.

The financial markets are quick to understand these kinds of arrangements. A recent World Bank report has made clear that reforms have been spotty and lacking in predictability. Markets are not patient with these developments, evidence of which can be seen in the Thai financial crisis. China is not immune from this kind of speculative uncertainty.

The decline in foreign investment in China at the end of 1996 and the outset of 1997 reflects a decision by U.S. investors to simply move on, when confronted with the difficulties of investing in China. In the first half of 1997, 35 percent of the U.S. GDP growth was related to exports, a breathtaking figure for a developed economy. The United States needs consistent information about export-led growth and consistent expectations about continued participation in foreign markets. The price for failure is increasing.

American companies can and do make money in China, but U.S. firms want to maximize predictability in addition to maximizing profits. Although some hopeful signs emerged from the 15^th Party Congress, one troubling result is less predictability.