CHINA'S RESPONSE TO THE ASIAN FINANCIAL CRISIS: IMPLICATIONS FOR U.S. ECONOMIC INTERESTS

CRS Report for Congress
China’s Response to the Global Financial Crisis:
Implications for U.S. Economic Interests
Wayne M. Morrison
Specialist in International Trade and Finance
Economics Division
Summary
Since 1997, several East Asian economies (notably Indonesia, Thailand, and South
Korea), and since 1998, Russia and Brazil, have experienced significant financial
difficulties, including sharp currency depreciations, plunging stock market prices, and
declining economic growth. The global financial crisis contributed to a slowdown in the
growth of the Chinese economy in 1998, especially its export sector, although it fared
better than most of its East Asian neighbors, many of whom fell into recession.
However, many analysts have expressed concern that a deepening of the global financial
crisis may induce China to devalue its currency, the yuan, in order to stimulate export
growth. Such a move could lead to a new destabilizing round of currency devaluations
throughout East Asia, which would further depress U.S. exports to the region. In
addition, it would make Chinese products cheaper in U.S. markets and thus exacerbate
the U.S. trade deficit with China. Another concern is that China might also choose to
respond to the financial crisis by putting a hold on its plans to liberalize its economy and
lower trade barriers. This could further complicate China’s attempt to join the World
Trade Organization and further strain U.S.-China economic relations.
The Global Financial Crisis and China’s Response to Date
Since 1997, several East Asian economies, notably South Korea, Thailand, and
Indonesia, have experienced significant financial difficulties in their economies, as have
Russia and Brazil since 1998. Such difficulties have included substantial currency
devaluations (as investors have transferred funds overseas), and significant declines in
stock market prices. Most of the other East Asian economies, including Japan, Hong¹
Kong, Singapore, the Philippines, and Malaysia have also experienced varying degrees of
financial difficulties (falling stock market prices and/or currency depreciation). The global

For background information on the crisis, see CRS Report RL30012, Global Financial Turmoil:¹
Contagion, Effects, and Policy Responses, by Dick K. Nanto. Updated January 13, 1999.
Congressional Research Service ˜ The Library of Congress

financial crisis has also seriously weakened (or exposed weaknesses in) the financial
institutions (such as banks) of several East Asian economies. The financial crisis has
contributed to a sharp economic slowdown throughout much of the region.²
China's economy does not appear to have been as severely affected by the global
financial crisis as most of its Asian neighbors. This is likely due to a number of factors:
China’s currency (the yuan) is not fully convertible; China maintains over $145 billion in
foreign exchange reserves; its foreign debt is relatively small compared to other Asian
nations; its financial institutions (banks, stock markets, etc.) are tightly controlled by the
central government (and foreign involvement is relatively minor); and most foreign
investment in China is direct (such as joint ventures in China), rather than portfolio (such
as stocks and bonds), investment.
Over the past year or so, Chinese government officials have made a number of
statements (publicly, through the press, and in meetings with U.S. officials), and have
implemented various policies, in response to the global financial crisis. First, Chinese
officials have pledged not to devalue their currency during the crisis. Second, China has
offered standby loans as part of the International Monetary Fund (IMF) financial assistance
packages for Indonesia and Thailand to help stabilize their economies. Third, Chinese
officials have pledged that their government will spend $1.2 trillion over three years on
infrastructure development (which may have been meant as a signal that China would use
domestic spending, rather than increased exports, to promote future economic growth).³
Fourth, several officials have stated that the crisis will not deter China from making further
economic reforms. Fifth, the government has attempted to clamp down on illegal
smuggling and foreign exchange transfers. Finally, the Chinese government has expanded
export credits and tax rebates to export-oriented industries which have been hit the hardest
by a drop in demand, such as textiles.
Concerns Over Possible Future Chinese Reactions to the Financial Crisis
While China’s economy to date has been relatively insulated from the effects of the
global financial crisis, many analysts believe that the crisis could continue over the next
few years and possibly deepen, which might seriously weaken the Chinese economy in

1999, due to a number of factors:

!Much of China’s economic growth has been fueled by exports which, according to
Chinese government data, grew at an average annual rate of 16% from 1979 to

1997. In 1998, exports grew by only 0.5%. Chinese exports to Asia fell by 10%,

while exports to the United States and the European Union (EU) rose by 16.1%
and 17.2%, respectively. An economic slowdown in the United States and EU in

1999 could result in negative export growth for China in 1999.

!Many analysts estimate that China's real GDP was significantly below the
government's 7.8% estimate. For example, Standard & Poor's DRI estimates
China's real 1998 GDP growth at 5.3% (the slowest annual growth since 1990),

In 1998, the economies of Japan, Hong Kong, South Korea, Indonesia, Malaysia, and Thailand were in²
recession.
In 1998, the Chinese government issued $12 billion in bonds to fund new infrastructure projects.³

and projects that it will slow to 4.3% in 1999. This indicates that China's economy⁴
may have slowed considerably, and that domestic spending alone may not be
enough to achieve the government's GDP growth target of 7.0% in 1999.
!A major factor in the Chinese government's decision not to devalue the yuan in
1998 appears to have been the decline in Chinese imports (due in part to weak
domestic demand). As a result, the sharp slowdown in China's export growth did
not result in a deterioration in China's merchandise balance of trade. Chinese trade
data indicate that China incurred a $43.6 billion trade surplus in 1998, up 7.7%
from the previous year. This enabled China to maintain a high level of foreign
exchange reserves, estimated to have totaled $145 billion at the end of 1998.
Chinese officials believe maintaining high foreign exchange levels is critical to
maintaining the stability of the yuan. A deterioration in China's trade balance might
occur in 1999 if demand for imports outpaces exports.
!Further major East Asian currency devaluations, should they occur, could make
many of their exports cheaper in foreign markets vis-a-vis Chinese products, which
could displace many Chinese exports to the United States and other markets. In⁵
addition, East Asian currency devaluations would further depress their demand for
Chinese products. ⁶
!East Asian currency devaluations have made many of their exports to China
cheaper. To some extent, this has likely benefitted some Chinese firms which rely
on imports from Asia of raw materials and machinery used to make products for
export. On the other hand, cheaper imports from East Asia have put competitive
pressure on many Chinese firms, raising demand from Chinese industries for greater
restraints on imports (such as steel).
!According to Chinese data, foreign direct investment (FDI) in China, which has
been a major factor in China's economic development over the past several years,
fell slightly in 1998 (from $45.3 billion in 1997 to $45.0 billion). A further decline
in FDI could impede China's ability to raise capital in the near term for
infrastructure development and economic modernization.
Chinese officials are deeply sensitive to the prospects of an economic downturn, due
to concerns that if unemployment in China rises too quickly, social unrest will result -- a
condition the government strongly wants to avoid. Many analysts argue that a sharp
downturn in economic growth and/or a sharp deterioration in China's balance of trade
could cause the Chinese government to devalue its currency and/or delay the
implementation of economic and trade reforms.

Standard & Poor's DRI,World Markets Report, China, December 1998, p. 3.⁴
It is not clear whether or not devaluations of East Asian currencies have yet displaced Chinese exports⁵
to the United States and other third markets. However, such devaluations have likely forced Chinese
manufactures to lower prices on many items in which direct competition from East Asia exists.
Chinese exports to East Asian economies (which account for about half of China's exports) fell sharply⁶
in 1998 over 1997 levels, including those to Hong Kong (-11.5%), Indonesia (-36.3%), Singapore (-9.1%),
Japan (-6.7%), South Korea (-31.3%), and Thailand (-23.5%).

Chinese Currency Devaluation. Given the current shaky economic state of many
East Asian economies, most analysts contend that a Chinese currency devaluation in the
near term would likely further destabilize the economies of the region. A Chinese⁷
currency devaluation in 1999 would also likely entail economic and political costs for
China. First, Chinese imports would become more expensive, increasing inflationary
pressures, as well as raising costs for many inputs. Second, a devaluation might be
interpreted in world markets as a sign that China would not defend Hong Kong’s pegging
of its currency to the U.S. dollar, which could significantly undermine investor confidence⁸
in Hong Kong’s economy. Third, it would likely increase the level of Chinese exports to
the United States, thus boosting the size of the U.S.-China trade imbalance (which reached
about $57 billion in 1998) — a politically sensitive issue in U.S.-China trade relations.
Finally, a devaluation would undermine China’s current image as a stable and responsible
economic power in the region and could adversely affect its relations with other East Asian
nations.
Analysts differ on whether China will devalue its currency in 1999. For example,
Standard & Poor's DRI, estimates that competitive pressures from currency devaluations
from the other East Asian economies will force China to devalue its currency by 20%
against the U.S. dollar in late 1999, but only if the financial crisis in Asia has "stabilized
so that the shock of devaluation will be minor.” The WEFA Group projects that the⁹
chances of a Chinese devaluation in 1999 are low, due to Chinese concerns that such a
move would further strain U.S.-China economic relations. ¹⁰
Effects on China’s Economic Reforms. A second major issue is how the Asian
financial crisis will affect the future course of Chinese economic reforms. Most
economists argue that China needs to make several major economic reforms in order to
maintain rapid economic growth, including reform of its state-owned enterprises and
financial institutions. The Asian financial crisis could complicate China’s efforts to reform
these sectors.
Reform of State-Owned Enterprises. State-owned enterprises (SOEs), which
account for about one-third of Chinese industrial production, place a heavy strain on
China’s economy. It is estimated that 75% of China’s largest 100,000 SOEs lose money¹¹
and must be supported by state subsidies. Many of the tariff and non-tariff trade barriers
imposed by China on imports are intended to protect the SOEs from foreign competition.
In the past, the Chinese government, has been reluctant to cut off financial support
to the SOEs out of concern that it would lead to widespread bankruptcies and significant
employment disruptions that could cause social unrest. However, in recent years, the

For example, the WEFA Group, an economic forecasting firm, states that a Chinese devaluation "could⁷
spark a new and possibly catastrophic round of currency devaluation." See the WEFA Group. Asia
Economic Outlook, February 1998, p. 4.
Maintaining Hong Kong’s economic stability since its reunion with China in July 1997 has been a major⁸
priority of the Chinese government.
Standard & Poor’s DRI, International Financial Bulletin, December 1999, p. 1.⁹
The WEFA Group, China, First Quarter, 1999, p. 10.¹⁰
WEFA Group, Asian Economic Outlook, February 1997, p. 4.9.¹¹

government has admitted that it cannot afford to support the SOEs indefinitely. In March
1998, the Chinese government announced that it would, in effect, privatize all but 1,000
“key” industries over the next three years. The government contends that exposing the
SOEs to competition will make them more efficient and able to compete without
government assistance, thus freeing resources for more productive uses.
The global financial crisis may complicate China’s planned reforms of the SOEs in a
variety of ways. First, the Chinese government is counting on rapid economic growth to
help find new jobs for workers displaced by SOE reforms; slower economic growth would
make it much more difficult for displaced workers to find jobs in other sectors of the
economy, and hence raises the prospects for possible social unrest. Second, it is likely
that Chinese officials are counting on foreign investors to play a major role in restructuring
the SOEs by becoming joint owners and thereby providing financing and management
assistance to such firms. However, the global financial crisis could slow down the level
of foreign investment in China, especially from Asian countries most affected by the crisis.
As a result, less capital would be available for restructuring the SOEs. Slowing economic
growth, less foreign investment, and a sharp increase in imports may prompt the Chinese
to slow or delay reforms to open its markets to foreign imports in order to maintain
protection of the SOEs.
Financial Institutions. China’s banking system faces several major difficulties, due
largely to its financial support of SOEs and failure to operate sufficiently on market-based
principles. The central government uses the banking system to keep money-losing SOEs
afloat by pressuring state banks to provide low interest loans. Without these loans, a large
share of the SOEs would likely go bankrupt. Currently, about 70% of state-owned bank
loans now go to the SOEs; a large share of those loans are not repaid. The high volume
of bad loans now held by Chinese banks (estimated to total more than 20% of China’s
GDP) poses a serious threat to China’s banking system. To a large extent, China's state¹²
banks make loans on the basis of political, not commercial, considerations; this promotes
widespread inefficiencies in the economy. However, in January 1998, the Chinese
government announced plans to implement new reforms that would attempt to reduce the
ability of local and provincial officials to use connections to obtain questionable loans.
The global financial crisis may complicate China’s plans to further reform the banking
system. China needs a growing economy to help the Chinese state banks reduce their debt.
In addition, many analysts argue that China’s banking system cannot become a purely
commercial operation until it stops subsidizing the SOEs, a factor that becomes more
uncertain, due to the recent slowdown in economic growth.
Implications of China’s Response to the Asian Financial Crisis for U.S.-
China Economic Relations
China’s response to the global financial crisis has widespread ramifications for U.S.-
China economic relations as well as for U.S. economic ties with other Asian nations. To
date, U.S. officials have generally praised China’s response to the crisis, especially its
pledge not to devalue its currency, noting that it has helped to stabilize the effects of the

Far Eastern Economic Review, World Wide Web page, December 11, 1997.¹²

crisis. However, should China later reverse this policy, it could lead to extensive¹³
devaluations throughout East Asia, which could further undermine the economies of the
region. Should this occur, U.S. exports to the region would probably fall further, while
imports would rise, and the U.S. trade deficit with China and other East Asian economies
probably would increase sharply.
It is difficult to predict whether the global financial crisis will slow or accelerate the
pace of China’s economic reforms. On the one hand, the crisis may cause the Chinese
leadership to approach further reforms with greater caution in the belief that it was the
“openness” of the East Asian economies that made them susceptible to financial crisis;
Chinese leaders may fear that China’s economy, if reformed too quickly or extensively,
could make its currency and stock markets susceptible to disruptive speculative forces
outside of China. On the other hand the global financial crisis may cause the Chinese
leadership to move ahead with planned economic reforms, especially if it is perceived that
many of the causes of the financial crisis, such as government industrial policies, weak
financial systems, and closed markets are also indicative of weaknesses within the Chinese
economy. The crisis may also affect the way China approaches its goals of modernizing
its economy, such as whether to try to emulate Japanese and South Korean business
conglomerates (keiretsu and chaebols) to promote the growth of advanced and high-tech
industries.
The pace of Chinese economic reforms in the wake of the global financial crisis will
likely have a major impact on China’s attempt to join the World Trade Organization
(WTO), the international body that sets rules for most trade. The United States views
China’s WTO accession under “commercially viable terms” a critical factor in expanding
market access for U.S. goods and services in China. Chinese officials have stated that they
will continue to reform China's trade regime in order to gain WTO membership, despite
the effects of the global financial crisis on China's economy. However, U.S. officials have
raised concerns that China has recently imposed several new trade barriers (such as quotas,
registration requirements, restrictions on foreign investment) on a variety of sectors,
including agriculture, telecommunications equipment, and various services. In addition,
new financial controls on trade (imposed in July 1998 in order to crack down on illegal
foreign exchange transfers) have made it more difficult to export products to China.
Should China continue to impose new barriers in 1999 or thereafter, and/or fail to make
substantial new offers to liberalize trade, its accession to the WTO will likely be opposed
by the United States and other WTO members. Failure on the part of China to make
progress on its WTO application could also prompt the United States to use its trade laws,
such as Section 301 of the 1974 Trade Act (as amended) to force China, under the threat
of sanctions, to open its markets.
China’s response to the global financial crisis will also likely affect congressional
action on U.S.-China economic relations. For example, a Chinese currency devaluation
or delay in economic reforms could increase congressional opposition to renewing China’s
normal trade relations (NTR) status.

However, U.S. officials have been critical of China's increasing use of export credits and tax rebates,¹³
arguing that such policies constitute a de facto devaluation.