In the news today, the limelight of the press is focused on China. China is one of the most populated countries in the world with 1.3 billion inhabitants. This figure accounts for approximately 22 percent of the world’s population resting on seven percent of the world’s arable land. However, China’s vast population is not the only reason the world views China as a giant awaking. Between 1978 and 1995, the real GDP per capita grew at a rapid eight percent per year. In addition, the income per capita has quadrupled in the past fifteen years. China is a large market growing quickly and therefore a growing opportunity as well.

China’s growth is a boon for the economy. However, as we have seen, the financial boon and eventual crisis devastated the Asian financial tigers, such as Indonesia and Thailand. China however is fundamentally very different from these countries. In comparison, China has not completely opened to the capital markets. Zhu Rongji, China’s economic chef and premier, practicing philosophy has been described as "the government should intervene if the capital markets do not conform to his rules of behavior." The Chinese government has formulated a three-part plan to restructure the foundations of the economy. The plan revolves around the state-owned enterprises, financial institutions, and infrastructure projects. China is attempting to create a new hybrid economy melding socialist and capitalistic ideas by balancing the state owned enterprises with the rapidly growing private sector. However, these efforts are futile if the economic foundations are not stable. Therefore, the Chinese banking system must be reorganized and restructured in order to prevent another financial crisis. In addition, China cannot overlook the social ramifications of the economic restructuring on its 1.3 billion inhabitants. The government has increased spending for infrastructure projects due to both social and economic reasons. Therefore, China is wrestling the vestiges of its past in order to create a new paradigm in economic models.

In the Great Leap Forward, Chinese Communist Party formulated communes, which were government-planned communities of individuals. More importantly, these communes were established as community work units for a particular industry. Mao envisioned these communes comprising of the core of China’s output; through hard work and socialist solidarity, communes could produce China’s need for industrial products, such as steel. The Great Leap Forward proved to be disastrous, resulting in one of history’s greatest famines. The Great Leap Forward was China’s great leap backward in comparison to the rest of the world’s industrial revolution.

The state owned enterprises (SOEs) are the modern existence of the communes of the past. There are approximately 300,000 SOEs in China involved in both industry and service sectors. Industrial SOEs account for 56 percent of the total SOEs, and include such products as agriculture, industrial raw materials, and construction. The other 34 percent of SOEs are service sectors, which include transportation, communications, trade and financial services. As with the communes, SOEs provide a broad range of social services to its employees. In the U.S., these services would be both individual and government responsibilities. However, in China, SOEs provide housing, education, and social services. Due to this structure, approximately 70 percent of the inhabitants in a region are employed by the local SOE. The financial implications of this burden on the SOEs are significant; these social services comprise of half of the total wage expenses. Since the SOE business model is drastically different from U.S. businesses, the profitability and efficiency of the SOEs are closely examined. SOEs are the heart of China’s economic structure, however are not at the core of the country’s industrial output. SOEs only generate 30 percent of China’s industrial output. In addition, Chinese statistics state that 40 percent of SOEs are unprofitable, however the actual number is likely to be higher. Therefore, the core of China’s infrastructure is not economically solvent. A closer look reveals that most of the losses are concentrated in final industries such as consumer goods, textiles, and other garment manufacturers. These SOEs create an enormous financial hole that drains millions and billions of dollars each year.

Changan Automobile Company in Chongqing is a typical example of a SOE. Changan plant produces Alto automobiles for Suzuki of Japan. Before concentrating on the automobile industry, the Changan plant attempted to manufacture many products, such as alarm clocks, sewing machine parts, and oil drilling equipment. The broad range of products and failed attempts draws the Changan plant’s management into question. In addition, the resulting profitability of the automobile manufacturing is also questionable. Plant management states that the Changan plant’s total production value was $5.6 billion. However, total production value is a metric developed by the government incorporating material, labor, and administration costs; profits are still not delineated clearly. As a typical SOE, Chagan Automobile plant must also support the social services of its employees. The plant sponsors "two kindergartens, three primary schools, two polytechnic colleges, two hospitals, housing for 14,000 families, and an old people’s home." SOEs are strongly woven into the economic market and social life. However, SOEs drain the country of multiple resources, therefore the companies and the environment must be restructured.

The Chinese government is restructuring the SOEs to be able to viably compete with the growing private sector. However, Chinese government cannot simply dismantle the unprofitable companies. Rather, the government has implemented initiatives to foster an environment where small to medium sized companies will gradually merge with strong SOEs, merge with foreign entities, or discontinue business.

Influencing this environmental transformation, the banks have started to reexamine their current credit risk associated with loans. The government has announced a mandate for banks to reduce bad loans by 2% to 3% each year for the next five years. Therefore, the banks have established a credit squeeze. The government has also tightened the squeeze by becoming more selective in allocating government funds to SOEs for special projects, such as technological transfer. These two initiatives will quicken a more competitive environment for credit, and as a result force SOEs to use cash efficiently.

The government has also established other policies to hasten the pace of an increasingly market driven economy. In 1993-1994, the government provided public companies with fourteen autonomous rights. In hopes of evolving to a market economy, these rights include major watersheds in the liberalization of SOE operations. Previously, the government set capacity and production requirements for all SOEs in order to centrally plan the economy. Due to the autonomous rights, SOEs are able to determine these production levels on their own accord. Therefore, the SOEs must be able to accurately analyze the market capacity toward their product. Even more radical, the government has lifted price restrictions within certain industries. By 1992, retail sector prices set by the government fell from 97 percent to 10 percent and production materials fell from 99.7 percent to 20 percent. Since price and production liberalization are large steps towards producing a competitive environment, SOEs must concentrate on overseeing an efficient production process and operating within a market like economy. Although these are major steps towards a capitalistic market, the government closely monitors the resulting effects. Recently, the government has slashed production of certain industry capital equipment, such as production equipment for textiles. The action was taken in light of the recent economic downturn and lackluster SOE efficiency. Zhu Rongji reflects on the decision, "The market economy, if let loose, will create redundant investment and overcapacity." Therefore, the government will intervene in the best interests of the country’s economy if necessary. This action reinforces China’s intent on developing a state controlled market economy

In contrast to the other market economy initiatives, the government has selectively chosen particular SOEs in core industries to benefit from government pilot programs. Rather than promoting a competitive environment, the pilot programs will help selected companies with many financial and social restructuring initiatives. Financially, companies will be aided in refinancing outstanding bank loans. SOEs have developed high debt to asset ratios at approximately 70 percent as well as interest that has risen from an average of 10 percent to 12 percent of outstanding loans. Governments will also begin divesting SOEs of their responsibility to provide social services. In 1996, 5,700 hospitals and schools were transferred to the responsibility of local governments. This process has been developing slower than the other pilot program initiatives because local governments are reluctant to assume the financial burdens. The pilot programs also involve SOEs slowly remove excess labor. Redundant labor totals to approximately one third of all SOE employees. The SOEs cannot simply fire these employees since the social ramifications of such an action would drastically change millions of lives. Therefore, it is in the government’s best interest to redirect these individuals to other jobs. One solution involves encouraging employees to work with thriving private sector companies. Major cities have also established specific initiatives to handle this influx of unemployed individuals. Beijing has reserved 20,000 taxi driver permits for former SOE employees, and Shanghai gives special treatment to private businesses founded by former SOE employees. Through these pilot programs, the government has essentially selected the SOEs it believe will develop to be the cornerstones of the Chinese economy.

With the Asian financial crisis of 1997, many Asian countries revealed national banking systems with fundamental flaws. China is only an anomaly due to the fact it can restructure the banks to prevent serious flaws from destroying the financial system. Chairman of Hong Kong Shanghai Banking Corporation Holdings remarks, "China must continue to cease giving out bad loans, loans that borrowers are unable to pay back, and they need to recapitalize the banking system. If the Chinese do not follow on this course, the result could lead to economic chaos and send financial shocks." Unlike the decentralization efforts of the SOEs structure, the Chinese government restructuring is focusing on centralization. Currently, the Chinese banking system comprises the central bank, i.e. People’s Bank of China, four specialized banks, eight comprehensive banks, and state-owned banks. The structure of the banking system gives leeway to the individual banks to implement disparate practices. It is widely known that local influence and corruption is strong on local levels. For example, state-owned banks simply disregarded national loan ceilings due to poor regulation by the central bank. As a result, non—performing state bank loans account for 20 percent of total outstanding loans, totaling to $120 billion. It has been estimated that $30 billion of these non-performing loans are unrecoverable. State-owned banks have disregarded prudently assessing credit risk, leaving China with a great financial burden.

The government has strongly reacted to centralize the system and establish more central control. Along the lines of the U.S. Federal Reserve, the government is restructuring by establishing regional banks. Regional banks will dampen local influences and disparities influencing credit policies. In addition, the central government had mandated major banks to curb non-performing loans by 2 percent to 3 percent per year for the next five years. Banks will need to become stricter in analyzing credit risks and establishing credit, which will directly effect the SOEs as mentioned previously. These banks will then be subject to through audit teams to ensure compliance with national laws. In order to establish central control, a recent passage of Central and Commercial Bank Laws give more authority to the central bank in controlling other banking entities.

After restructuring, the government must establish a procedure for handling non-performing loans in the public and private sector. The issue is very delicate due to the moral hazard and precedents that were learned from the Asian financial crisis. As the next step in restructuring, the state-owned non-performing loans will be distributed to newly established asset management companies. As for handling non-performing loans in the private sector, an example has emerged relatively recently. The Guangdong International Trust & Investment Corporation (GITIC) was a company established to aggregate foreign capital and distribute it to the mainland. Recently, GITIC declared bankruptcy with $4.37 billion in liabilities and only $2.6 billion in assets. Similar to the Asian financial crisis, China needs to balance many factors in deciding on a course of action. On one hand, foreign investors will be reluctant to further invest in China without government support. On the other hand, a moral hazard is created when the government underwrites bad debt. The Chinese government chose the middle ground. The government supported all bad loans, but only 60 cents to each dollar of foreign investment. In the short term, investors were unsatisfied and threatened to pull out capital from China. Some investors are even attempting to call loans prematurely in order to protect their investments. However, a capital flight is not an issue for concern. The Chinese government has established a law that major banks must obtain approval from the government for early withdrawals. In addition, investors with long term investing plans will not liquidate their investments because strong relationships are key in China. In the long term, the Chinese government’s procedure is beneficial by forcing investors to appropriately analyze investment risks. In the early 1990s, foreign institutions heavily invested in risky real estate assets assuming the government would support their investments. The moral hazard created will now dissolve after the example set by the GITIC bankruptcy proceedings.

Even though the GITIC bankruptcy will cause less foreign capital inflow, the Chinese economy will remain stable due to a massive infrastructure program implemented by the government.

Over the next three years, the government will spend approximately $1 trillion dollars. The projects will regionally focus on the underdeveloped interior and northern parts of China by building highways, power stations, and telecommunications networks. These infrastructure projects are important for economic and social factors. Economically, these projects must be undertaken in order to support the steady GDP growth of 8 percent. The 8 percent growth is important from a social perspective because this rate of growth is necessary to sustain the labor force. A labor force growing from China’s population growth as well as the restructuring of the SOEs. Hiroto Arikawa elaborates, "First priority [of the Chinese government], stimulate the economy to feed the 1.3 billion people. Second, how to allocate resources in their country." The government’s infrastructure project directly fulfills both goals.

The Chinese government is a player in many tenuous situations. With regards to SOEs, the government must maintain a socialist economy with capitalistic overtones. As for banks, the government must balance short-term foreign investment liquidation with long term structural reforms to the banking system. With infrastructure projects, the government must weigh the social implications of the unemployed versus the action of spending billions of dollars of government money. The Chinese government is in a balancing act of handling many different forces, to the extent that some actions conflict. In creating a competitive marketplace, the government is contradicting this initiative by selectively choosing certain SOEs to participate in pilot programs, which will yield a significant competitive advantage. After bestowing 14 autonomous rights to the SOEs, the government have sent conflicting signals by halting the production of certain goods. These seemingly irrational actions could result from a government who is revising their economic plan as the learning process continues. Instead of having a model system to follow and emulate, the government must learn from the past failures and successes of many countries. By integrating these lessons into the Chinese hybrid economy, the government will hopefully create a prosperous and stable economy. If the government is unable to accomplish these objectives, the downfall of China’s communist party might become another country’s lesson.