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China was caught up last year in a convergence of slower growth, rising unemployment and the bankruptcies of some regional financial institutions. It chose to fight these dangerous trends by sharply expanding infrastructure investment and financial support to deficit-ridden state-owned enterprises long in need of reform.

At the 11-day National People’s Congress that ended Monday, Premier Zhu Rongji proposed to do more of the same this year. He reaffirmed the determination to stay the course on the restructuring of ailing SOEs and a shaky financial sector. But priority has clearly shifted to heading off the kind of disastrous downturns accompanied by social deterioration that occurred elsewhere in Asia in 1997-98. In a country where a single percentage point of growth or shrinkage means a difference of 1 million jobs more or less, Mr. Zhu could have found few other options, even if he were a reformer with blind faith in the power of the market to turn China into a competitive, modern economy.

After almost two decades of rapid growth averaging close to 10 percent, the Chinese economy’s loss of momentum became apparent last summer. Consumption, exports and inward foreign investment leveled off. As demand slackened, excess capacity, production backlogs and deficits bulged at the SOEs that still constitute the backbone of China’s industrial structure despite the increased importance of the private sector. SOEs also take care of a major share of China’s social safety net, dispensing pensions for retired employees, among other services. Meanwhile, bad loans accumulated at China’s four state banks to the point where they now account for an estimated 25 percent of their total assets.

By expanding fiscal expenditures and the flow of funds to the SOEs through the state banks, Beijing will likely be able to keep joblessness from rising to politically dangerous levels for a while. But it will have to put on hold the needed reform of the inefficient, money-losing SOEs and of the state banks burdened with degraded assets (often resulting from politically directed lending). Developmental economics affords a sympathetic view of China’s near-term policy. Joseph Stiglitz, the chief economist at the World Bank, said in a lecture last year that the cost of reversing a deep downturn once it has started could far exceed that of a preventive policy. His main emphasis, though, was on the importance of China’s tackling the second generation of reforms.

One of the more recent difficulties in China’s foreign relations stemmed from several financial collapses in South China last autumn, especially that of the Guangdong International Trust and Investment Corporation. GITIC’s failure, which resulted from its trading losses and property investments, came as no surprise in itself; Guangdong, perhaps integrated more closely than any other Chinese province with Hong Kong and world markets beyond, had been buffeted by the global flight of capital from the emerging market.

What dismayed Japanese and other foreign banks was Beijing’s abrupt and unusual decision to have recourse to bankruptcy procedures and to make no distinction between foreign and domestic claims in liquidating GITIC. It is also feared that Beijing will apply the same policy to hundreds of similar local financial companies if and when some of them become insolvent. Indeed, many of the foreign lenders made their deals with the financial company without obtaining official debt guarantees from the central authorities, assuming that the fact of its being under the provincial government’s control was an equally good assurance. True, some Japanese businesspeople, long familiar with the Chinese way of problem solving, have not given up hope of getting a practical solution over time. But there was no hint of flexibility in Premier Zhu’s policy speech. Confidence in China as dependable borrower, which never missed a payment even during the anomalies of the Cultural Revolution, is bound to suffer.

Developing a secure relationship with major economic powers in trade and investment, as well as finance, is critical to China’s successful economic modernization. There is no doubt that China has a serious interest in becoming a major player in the world economy by pushing more reform and achieving a breakthrough in the drawn-out effort to win entry into the World Trade Organization. When he is in Washington for an official visit next month, Mr. Zhu will probably argue that internal stability, or Beijing’s ability to maintain it, not only does not impede but will in fact accelerate China’s progress in opening up further to the world.

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