Did China Try to Warn the U.S. About the Coming Financial Crisis in 1999?

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In conversation that year with U.S. Fed Chairman Alan Greenspan, Premiere Zhu Rongji predicted that U.S. policy would lead to a massive bubble and financial collapse

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Then-Premier Zhu Rongji (right) speaks to Hu Jintao, who has since become President, in Beijing / AP

Due to popular interest, I thought another excerpt from former Premier Zhu Rongji's published speeches and letters would be in order. Zhu held the office from 1998 to 2003; thousands of pages of his speeches and writings have just been published. It helps that I was able to purchase two volumes of a four volume set of Zhu's speeches that spanned a decade. The two volumes alone contain over 1,000 pages of material. As a result, I will consider doing a series of excerpts that I find interesting and worth sharing.

This particular excerpt below is from a meeting that took place in January 1999 between former Fed chair Alan Greenspan and the Chinese premier. Note that this is about a decade before the latest financial crisis, and I think some of what was said between the two men is fascinating in light of developments over that decade. (Please excuse potential mistranslations or deviations from precise verbatim rendering of the conversation.)

Zhu: Mr. Greenspan, your influence in managing the U.S. economy is growing by the day, you've transformed yourself from human to economic sage. Last December, the Financial Times published a piece that argued that you, Mr. Greenspan, are setting a course to further inflate the U.S. stock market bubble, and that current success could well lead to a collapse of the U.S. financial market in the future. I wonder what you think of that assessment?

Greenspan: China's economic performance is very much owed to Premier Zhu's tireless efforts. The economy is very successful and growing at a relatively fast clip. U.S. growth prospects are quite positive as well. China has already grown into an important global economy. If China can maintain its current growth trajectory, then not only will China become a major cultural and political power but also an economic power in the 21st century.

The past two years have been rather difficult ones for many countries. Several of China's neighbors have been significantly affected by the financial crisis and face anemic growth, which is having an indirect impact on China's growth. And China's economic performance is having an impact on the U.S. economy too. This situation is forcing us to start reforming the international financial system. Yesterday, Central Bank Governor Dai Xianglong and I, as well as other central bankers, met in Hong Kong for a International Bank of Settlements special conference. We discussed many issues in detail, including what kind of actions to take to stabilize global financial markets and how to create a stable, 21st century global financial architecture.

Technological progress has not only closely linked different economic segments, it has also revolutionized the global financial system. In the United States, computers and telecom technology's rapid development has led the financial system's revolution, raised productivity, improved the efficiency of capital, and lifted people's quality of life. Technology's continuous progress has outpaced our expectations just a few years ago. At the same time, factors that have affected US technological progress have also influenced other countries. Financial systems and products are developing rapidly, and capital can help consumers shift from products they don't want to the ones they want in the most efficient fashion. A complex financial system has brought people benefits, but also brings potential risks.

It is very important for the United States to clearly understand this problem. That is, why is it that given Southeast Asian nations have experienced 20-30 years of robust growth, the region couldn't fend off the financial crisis and saw their economies collapse. We believe that this is related to the current structure of the global financial system. Currently, there are too many countries in the world that over-rely on the banking system, and only use the banks as financing vehicle. So banks have become those countries' only source of financing. This is an inflexible system and cannot adequately deal with crises, just like the Russian situation now. The United States is in a different position from those countries. When facing a crisis, we have financial channels outside of the banking system and can easily mitigate a financial crisis.

The US economy is currently in great shape, it is better than any given day over the last 50 years. But we also need to be sober because we cannot know how long these good conditions will be sustained. The US Fed will closely monitor changes brought by technology and whether we can leverage it to develop novel financial products. High tech will bring important changes to the financial system, manufacturing, and services. We need to deeply understand the force of technology and its impact on global economic stability.

Zhu:  The entire world is focused on the US economy, it is the engine of global growth. Right now the US economy is the best it has ever been, almost impossible to be any better than this. There are people who believe that US stock prices are way over valued--just this year the Dow Jones may breach 10,000, but could quickly fall down to earth. You've expressed your views on the US economy on numerous occasions, but I'd like you to discuss your views face to face with me.

Greenspan: Whether the current stock market performance--with skyrocketing prices--reflects underlying economic conditions or a bubble is difficult to determine. Japan in 1996 saw its stock market peak and then the bubble deflated. Some seem to be overly optimistic in their assessment of potential benefits from technological development. They believe that computers and internet will significantly increase labor and capital productivity, lifting corporate profits and their underlying value. The extremely optimistic believe that because of technological developments, the US economy has already reached a new level, and so the stock market reflects reality. I personally am skeptical of this view. I still believe in being sober. Based on historical experience, the current stock market performance is abnormal and does not reflect the underlying realities of the US economy. Under normal circumstances, stock prices and company valuations should be considered relatively high. Nonetheless, I personally believe that even if stocks are currently over valued, there will be a natural correction later on. But even under a scenario of stock market correction, it doesn't mean that the US economy will go into recession; it only means that US economic growth will be modestly slower.

Zhu: Last year Hong Kong felt the impact of global hedge fund volatility, and the HK government first raised interest rates to mitigate the impact, but took huge losses. It could then only use foreign exchange to support the market. At the time you criticized Hong Kong's actions, and Ren Zhigang (then HK financial management bureau head) said he wanted to explain it to you in person. I don't know what kind of explanation he will provide when you two meet this time? What's your view? In terms of the large volume of speculative capital flows that damage the financial market, does the US plan to better regulate it, what kind of regulatory measures are you preparing? I also just met with the Australian ambassador to China, he brought me a personal letter from Prime Minister Howard, who suggested that we should create a "G20" institution to discuss and coordinate how to manage and supervise the global financial system. What's your view on this idea?

Greenspan: Mr. Ren Zhigang and I had a great exchange. We both agreed that short-term capital flows are a double-edged sword, both positive and negative. But, Mr. Ren is more concerned about the short-term downsides brought by speculative capital flows. I was against Hong Kong government's use of foreign exchange funds to support stock prices. I believe that such actions may have a near-term positive impact, but will create distortions in the long term, and will impede capital markets' rational operations. A listed company's value does not derive from who owns it or what investors are paying for the stock; the value of the company is derived from its productivity and productive capacity. Intervention by the Hong Kong financial authority resulted in the government holding a lot of company stocks, this is not beneficial for the efficient allocation of capital. Mr. Ren believes that a healthy economy should not face these kinds of speculative capital inflows.

Hong Kong's challenge with speculative capital inflows associated with many problems that exist in the financial system. The current financial system is drastically different from that of 10-15 years ago. It is now much more complex, broad, and sensitive, with information traveling much more rapidly, both accurate and false information. The issue is how to leverage the advantages of current financial system while minimize the impact from complex factors. There are two main problems: 1) Many countries and regions are borrowing money in the international market, but have not taken measures to prevent exchange rate risks.

So that's why they're seeing losses during market volatility. 2) we should identify clearly which financial institution's lending behavior/pattern is actually counterproductive to market stability--and we should regulate those. The major issue being debated now is that the financial crisis has made people more cautious, and what measures should be taken to better regulate financial markets. I anticipate that in one or two years, we will carefully reflect and analyze the upsides and downside risks of the current financial system and implement some reforms. I personally believe that if we can weather this crisis--and in fact, we've basically survived it at this point--the next couple years aren't likely to see another major crisis. If we don't take the necessary precautions now, then if another crisis happens in four or five years it will be more severe, with much greater impact and breadth. I think all central banks should move toward that goal. I hope that when China further regulates the financial system that it should be prudent and now inhibit the development of the financial market.

Zhu: China is paying close attention to the experiences of US banking reform. We have already made changes to our central bank, dividing it into nine regional branches instead of the original model of individual branches in every province. We are strengthening central bank supervision and eliminating local authorities administrative interference. We are currently developing commercial credit market's principles and pushing forward with commercial bank reforms. The problem for China is the high ratio of nonperforming loans, which is a legacy issue that started in the 1992-93 period of economic overheating. At the time, the property sector was overheating, provincial governments were setting up too many special development zones; they were borrowing to fund these projects but couldn't pay back the loans. And this is why China hopes to borrow from the US experience of setting up asset management companies. We want to first shift the bad assets out of the banks, and then proceed with banking reform to improve the operation of commercial banks. Do you think in this regard the US experience can meaningfully help China? What's your view?

Greenspan: When commercial banks take on too many nonperforming loans, banks' normal functions in facilitating economic growth will be greatly constrained. The problem in Japan is large volumes of NPLs have caused its banking system to contract, and it has even affected the rest of the world. Having NPLs will make it harder for banks to get private financing, and even if they get the financing, it will be at a higher cost. Only once you've resolved this problem can the banking system operate effectively and revive the economy. The People's Bank of China's structural changes and commercial bank reforms are crucial. Right now Chinese commercial banks do not need direct capital injections from the market, it only really performs simple functions of holding saving and releasing credit. But when the banking sector develops to a certain stage, and needs capital, the NPL problem will be a serious one. Before reaching that point, China's setting up of asset management companies to solve the NPL problem is a sound solution in my view. We now recognize that NPL's impact in limiting banks' normal functions is greater than what we thought a decade ago.

Zhu: Today the American ambassador couldn't make it, so his representative is here. Now I will talk about an issue that is not for Mr. Greenspan, but for the ambassador's representative. Recently there has been anti-China rhetoric and opinion coming out of the US; some are attacking China's human rights record and some even falsely claim that China is stealing US military secrets. I don't want to dwell on each of these subjects, but I do want to talk about the bilateral trade deficit issue. Published US data show that in 1997, the bilateral trade deficit was $50 billion, increasing to $60 billion in 1998. These published figures show that the US has very little understanding of China's current situation. Last year, China's total exports stood at $180 billion, of which 60% was processing trade exports. In other words, about $110 billion of those exports are from foreign invested enterprises based in China, including US-China joint ventures. But generating this $110 billion of exports requires $90 billion of imports of raw material and other goods from various countries including the United States. Put another way, China actually only has about $20 billion of deficit. But this $20 billion in not in China's hands but in the hands of FIEs based in China, including those US-invested FIEs.

So if you take out processing trade, then Chinese exports are only $70 billion, impossible to have more exports. If you claim that in 1998 the US-China trade deficit is $60 billion, then that means China only exported $10 billion to the rest of the world, that's impossible. In my view, problems in the US-China trade relationship must be viewed rationally. In reality, the bilateral trade is only $20 billion. My purpose for highlighting this is to preserve good relations between the two countries. Any public opinion that damages the bilateral relationship is good for neither country. The US data on bilateral deficit has no basis and is untethered from reality.

I have accepted President Clinton's invitation to visit the US in April. I hope that during my visit we can seal the deal on China's entry into the World Trade Organization. I've already dispatched minister of foreign trade Shi Guangsheng to continue negotiations with US Trade Representative Barshefsky. If Barshefsky's terms are reasonable, we will accept them. But it must have a timetable. I'm demanding a timetable not because I want to have a protracted process--the timetable may be for 1 year, 3 years, but no longer than 5 years. The toughest problems will take five years, for example opening the financial market. The lesson for us from the Asian Financial Crisis is that too rapid opening of financial markets is not beneficial. Financial market opening must undergo a process, the conditions must be ripe and the regulatory standards must be met. (Now turns to Greenspan) I apologize for speaking on subject matters that don't necessarily concern you.

Greenspan: On the contrary, Premier Zhu's comments do concern me a great deal. I look forward to Premier Zhu's visit. You are a great public speaker, and speaking in front of a US audience you will be able to explain the intricacies of Chinese policy. Because China is not only an important global political player, it is also a key member of the global economic family. From the US government's view, it is very important for China to enter the WTO, myself included. I agree with the premier's view that Southeast Asian nations did not adequately lay the groundworks before opening its financial system, and did not prepare to accommodate the challenges of an increasingly complex global financial system. If the premier's grasp of the financial system is as deep as your understanding of the US-China trade relationship, you will enlighten us with your views.

Zhu: I am delighted to see you again. I always benefit from our conversations. I hope you will visit China often.

So the idea of a G20 was floated as early as 1999, if not earlier. It only took another decade and another major crisis for it to be realized. You wonder that as we continue to face down another crisis brewing in Europe, how many ideas that are dead now will be revived amid a future crisis. Institutions are sticky--it usually takes massive shocks and crises to supplant the existing.


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Damien Ma is a fellow at the Paulson Institute, where he focuses on investment and policy programs, and on the Institute's research and think-tank activities. Previously, he was a lead China analyst at Eurasia Group, a political risk research and advisory firm.

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