24 December 2008

China's inflation-free route from crisis

The structural problem of the Chinese economy can be described in one sentence: China produces from plants financed by foreign investment that operate with low domestic wages for foreign markets that pay with dollars that cannot be used in the domestic economy.

The solution to this structural problem can also be summed up in one sentence: China must finance plants with sovereign credit to produce for the domestic market where consumer purchasing power will come from high wages, with sovereign credit repaid

from increased tax revenue from a vibrant domestic economy.

The adverse impact from the current global financial crisis on the Chinese economy originates from the export sector financed by foreign capital. Foreign markets have abruptly contracted since mid-2007 to cause massive closure of tens of thousands of foreign joint-ventures or wholly owned enterprises, big, medium and small, in the Chinese export sector located along the coastal regions.

Many of these enterprises normally repatriate their profit continually, leaving little or no reserve funds to keep operating in slow periods. At the first sign of financial distress, the absentee owners of these enterprises find it expedient to simply shut down operations and vanish from the local scene, leaving millions of Chinese migrant workers suddenly unemployed with no severance pay or unemployment insurance payments, not even the train fare to return home. The foreign investors just abandon their money-losing factories, in which they hold little equity, for foreclosure by lending institutions.

These bankrupt export enterprises are not likely to reopen as few expect the global financial crisis to recover soon.

Five years ago, in 2003, Premier Wen Jiabao drew national attention by personally demanding back wages owed to a migrant worker by his abusive employer to be paid. In February 2008, the National People's Congress (NPC) accredited the qualification of three rural migrant workers as newly-elected deputies, making them the first group of "spokespersons" for migrant laborers all over the country in the national legislature. This development is a historic breakthrough that will help normalize the gap between urban and rural development and the oppression of migrant workers by unsavory employers, domestic and foreign.

The Central Committee of the Communist Party of China (CPC) issued a landmark policy document on rural reform and development in October 2008, vowing to enhance safeguards of the rights of migrant workers, ensuring them equal wages and benefits, including their children's education, public health and affordable housing as those received by resident citizens.

Since China adopted the reforms and opening-up policy in 1978, the number of migrant workers to the coastal export regions has grown to over 200 million. China has been improving rules and laws to cope with the new changes and to ensure migrant workers' rights. The unjust condition of migrant workers has become a microcosm of worker conditions in the socialist market economy in general. We need to remember that the driving force of the socialist revolution that began in China in 1921 was to eliminate such unjust conditions for workers.

The Dongguan City Association of Enterprises with Foreign Investment estimates that 9,000 of the 45,000 factories in the cities of Guangzhou, Dongguan and Shenzhen - the heart of China's industrial south - are expected to close before the Lunar New Year celebrated in China in late January. That could mean up to 2.7 million workers facing unemployment immediately, the association said. If the trend continues, unemployment can be expected to double every quarter.

The current global financial crisis has accelerated a process already underway to upgrade China's economy from low-tech, labor intensive factory jobs to high-tech manufacture of higher value-added products and high-skill jobs in the service industry sector. The plan to correct the imbalance of development between the coastal regions and the interior regions is tied to China's effort to shift its economy from excessive export dependency toward domestic consumption and development. Yet the pace of restructuring must be further accelerated with the aim of a full-employment economy based on balanced domestic development and consumption within a period of five years.

For China, the only viable strategy is to shift these bankrupt export factories in the coastal regions toward the domestic market. But the domestic market at present is too weak in consumer demand due to low wages to absorb the overcapacity in export. Thus no funds are available in private credit and capital markets to finance urgently needed restructuring of the export sector on a national scale. Market forces are simply not up to the task.

To kick-start a new economic strategy of shifting the Chinese economy from export dependency to domestic construction, the Chinese government needs to establish a Commission to Restructure the Chinese Economy (CRCE) as a special agency in the State Council under the direct control of the office of the premier, with emergency powers to deal with the unemployment fallout from the sudden collapse of the export sector that will soon threaten social stability.

The proposed CRCE should have full authority to formulate and implement a national economic recovery program with appropriate and adequate credit-creation power to finance an urgently needed recovery to provide full employment at high wages. Equally importantly, the CRCE must have full government authority to commit unconditionally to the timely repayment and retirement of this temporary debt created by sovereign credit.

Economic recovery through shifting from export dependency to domestic development requires coordinated actions by both the state and the private sectors. The government's role is to guide private sector incentives toward a national full-employment plan through tax incentives and regulatory regimes. Government fiscal spending should be limited to funding infrastructure, both physical and social, that cannot be efficiently financed by private or even collective capital. Consumer demand should be enhanced as a priority in a national income policy to quickly raise wage levels in parallel with a well-funded social security program, to eliminate the need for over-saving out of concern for emergency health expenses and provision for old-age security.

The CRCE would be responsible for launching immediately a massive work-creation program to achieve in-place national full employment with minimal relocation of population. This program can be financed outside of the government's fiscal budget by a pre-financing regime through the use of work-creation certificates, a form of special-purpose money specially designed to facilitate job-creation in the socialist market economy.

Under the pre-financing regime, the State Council will authorize the CRCE, with full support of the Finance Ministry, to issue work-creation certificates that mature every three months and are renewable up to five years. These certificates would be distributed by the CRCE to local public works agencies and participating financial institutions that lend to private enterprises engaged in the job-creation in the program to shift export enterprises toward the domestic market.

Firms that need cash to participate in job-creation projects ordered by local public works agencies and private enterprises approved by the CRCE can draw on work-creation certificates against the accounts of local public works agency or industrial customers of the participating financial institutions.

The financial institutions accepting the work-creation certificates can treat such certificates as commercial paper that can be discounted at commercial banks, which in turn can discount them at the People's Bank of China, the central bank. The process would provide the needed liquidity to facilitate the payment of wages outside the range of the government's fiscal budget.

The CRCE would undertake to redeem one fifth of all work-creation certificates issued through the central bank as the economy and tax revenue recover and expand. As collateral for the certificates, the Finance Ministry would deposit in the central bank a corresponding amount of tax vouchers good for paying taxes. As the Ministry of Finance redeems work-creation certificates, the tax vouchers would be returned to the Finance Ministry.

It is important that the government must stand firmly behind the commitment to redeem the work-creation certificates in order to protect their financial integrity. New series of five-year work-creation certificates can be issued as needs.

Credit creation outside of the government's fiscal budget for the purpose of job creation poses no threat of inflation. It is a more responsible alternative to tax increases to support a balanced budget. The fiscal cost of redeeming work-creation certificates will be offset by the corresponding decrease in welfare subsidy costs due to unemployment. As fiscal surplus accumulates from full employment at rising wages, the surplus can be used to reduce taxes and increase fiscal spending on upgrading physical and social infrastructure. This approach is the shortest route to full employment at rising wages while shifting the economy from export dependency toward domestic development.

Since the export market is and will always be small compared to the full potential of the Chinese domestic market, profitability of productive enterprises can be sustained through an economy of scale to reduce unit cost. Such unit cost reduction can be achieved by rising productivity made possible by expanding sales volume in the domestic market. Exports then will only have to pay for the cost of needed imports to maintain a balanced trade.

As industrial enterprises tap the growing domestic market, aggregate sales revenue will support wage rises as the portion of profit previously reserved by middleman foreign distributors and importers can now be use to support higher wages which in turn will strengthen domestic consumer demand. Some upward movement of prices should be allowed to adjust the price gap between agricultural produce and manufactured products to raise farm income.

A government price policy should be instituted to prevent destructive cut-throat price competition and below-cost dumping in both profitable and unprofitable markets. Excess profit should be taxed to prevent over-investment in profitable sectors. Of special importance is to narrow the gap of wholesale and retail prices for farm produce to increase the net income of farmers while holding down consumer prices.

To keep the 10 million migrant workers currently being laid off by the export sector employed at an annual wage level of the equivalent of US$10,000 (68,490 yuan), a work-creation certificate program of $100 billion is needed. To keep the 10 million college graduates from unemployment, another work-creation certificate program will be needed worth $100 billion. This is well within the financial capability of the Chinese economy as it amounts to only 20% of the over US$2 trillion in foreign exchange currently held by China. It is important to understand that this amount is not fiscal spending, but sovereign credit that will be repaid as the economy develops.

China does not have to accept the fate of financial crises made in the US, if Chinese policymakers have the courage to think independently. To eliminate poverty, China must first eliminate a poverty of creative ideas among its policymaking circles overwhelmed by wholesale acceptance of voodoo neo-liberal market fundamentalism propaganda.

Henry C K Liu is chairman of a New York-based private investment group. His website is at http://www.henryckliu.com

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