China’s Deflation during the Asian Financial Crisis, and Reform of the International Financial System

Abstract

The discussion on the implications of China's experience during the Asian financial crisis on the reform of the international financial system can be divided into two separate parts: China's experience during the Asian financial crisis and China's ideas on the reform of the international financial system. In China, the focus of discussion among economists since the Asian financial crisis has been on how to maintain the momentum of growth under a worsening international environment and how to minimize the loss caused by the unfavourable change of the international environment. Few Chinese economists have participated in the discussion of the problem of reform of the international financial system until recently. This article (written in August 1999) discusses China's experience during the Asian crisis and China's opinion regarding reform of the international financial system. I. China's Economic Performance during the Asian Financial Crisis China did not completely escape from the so-called contagion effect. There were at least six mechanisms through which the Chinese economy was affected. * The income effect: The crisis reduced the domestic demand of the crisis-hit economy, which in turn led to a reduction in its imports. China's export growth has slowed down significantly due to the recession in Japan, crisis-hit Asian economies and the overall slow-down of world economic growth, which was partly attributable to the Asian financial crisis. * The substitution effect: The devaluation of Asian currencies, especially the devaluation of the Japanese yen has put tremendous pressure on China's export performance. The competitiveness of China's export has been weakened greatly by the devaluation of other Asian currencies. China has paid a great cost for resisting the temptation to devalue. (It appears that the income effect has a greater impact on China's export than the substitution effect.) * Dumping: For certain periods of time during the crisis, some sectors of the Chinese economy complained that they were suffering great losses by the dumping of some companies in crisis-hit economies. * Investor confidence: Due to the similarity of Asian economies, one economy's fall will immediately lead to the loss of confidence by international investors in the others. Even though an economy's fundamentals may be basically sound, the stampede of capital outflows caused by the herd effect will bring the economy down. China's financial system has problems with a high ratio of non-performing loans, low capital adequacy, poor management and lack of transparency. The bankruptcy of the Guangdong International Trust and Investment Company (GITIC) in late 1998 dealt a heavy blow to the confidence of the international financial community in China's financial system. As a result, international capital inflows slowed down significantly. In the international capital market, the borrowing cost for Chinese financial institutions and enterprises has increased significantly. * Devaluation expectations: Owing to the worsening of external environment in general, and the weakened competitiveness in particular, the expectations that China would devalue were extremely strong. The devaluation expectations discouraged capital inflows and encouraged capital outflows. In 1998, despite China's tight capital control, current account surplus of about US$30 billion, China's official foreign exchange reserves increased by only US$6 billion. China's Fight against Deflation Since the second quarter of 1997, China's economic growth has slowed down quite significantly. However, the slowing-down can only be partially attributed to the Asian financial crisis. To a larger extent, the slowing-down was a domestic issue. Actually, as a result of the contractionary macroeconomic policy carried out since the middle of 1993, the Chinese economy had begun to slow down as early as in the middle of 1997, following the falling of inflation. …