Thank you for inviting me to testify before this distinguished commission. I am testifying on my own behalf, not as a representative of any employer or interest group.

I spent 21 years as an investment banker, including 16 based in Hong Kong. My experience with China includes extensive consulting on national security issues in the 1970s and my current writing as a scholar based at Harvard University’s Asia Center. In 1993 I published a book, The Rise of China, arguing that China’s economic policies would lead to success whereas Russia’s would lead to disaster.

The Importance of China’s WTO membership

China’s WTO membership is most important to our country as a Chinese commitment to the stability of the global system that we and our allies have created. Only 25 years ago China was committed to destabilizing the world market system and the world political system. It was working together with groups of other third world countries to transform the world economy in a highly socialist direction, with among many other things tight controls on multinational corporations and all trade in raw materials managed through a vast network of cartels. Above all, the Maoists proclaimed that the world was chaotic and that chaos was good.

Since that time, China has moved virtually to the opposite pole, promoting stability and promoting the market. It is now more receptive to our corporate investments than most of our old capitalist allies. Only Hong Kong, Singapore, and Taiwan are as accepting as China of our corporate presence. Japan, South Korea, Thailand, the Philippines, and Malaysia, together with most Latin American and African countries, are more restrictive. China’s change of direction disheartened insurgent movements all over the world. Since most of these movement were Maoist, not Brezhnevist, this was at least as important as the collapse of the old Soviet Union in stabilizing much of the third world. Today, the strongest rhetoric about the dangers posed by Western financiers comes from Kuala Lumpur, not from Beijing.

China’s commitment to the system is not merely economic. Like most other Asian countries, China has become convinced that a focus on economic development is the only strategy for restoring pride and prosperity and that regional and global stability are prerequisites of such focus. Through the mid-1970s China was sponsoring guerrilla warfare in every non-communist country in East Asia—and in much of the world. In contrast, today it is on friendly terms with every non-communist country in East Asia. Although half a century ago China was an ally of North Korea’s assault on South Korea, for almost two decades it has been (in everything but words) much closer to South Korea than to North. For a quarter century, notwithstanding verbal and tactical differences, China has been more important to us than any other country in assuring stability on the Korean peninsula. Although it wasn’t covered entirely accurately in some of our media, President Jiang Zemin was very early and very strong in his denunciation of the September 11 terrorism and in his assurance that we would have China’s support against terrorism.

When I returned to Harvard after an absence of 33 years, I was amused to discover that some residual Cambridge Maoists were publishing a newspaper that among other things denounced China for being a capitalist country. The paper was particularly vituperative about the fact that Beijing had supported the Nepalese government’s attacks on the Communist Party of Nepal as a necessary measure to prevent terrorism. There are very few Maoists left at Harvard, but there are more of them on the major U.S. campuses than on the major Chinese campuses. This is symptomatic of China’s changed role in the world.

Former President Lyndon Johnson once said of a candidate for high office that it would be better to have him inside the tent pissing out than outside the tent pissing in. We have seen China both outside the tent and inside. China outside the tent caused trouble in every corner of the world, from the jungles of Thailand to the diplomacy of Tanzania to the university campuses of the major NATO countries. The whole world is clearly better off with China inside the tent.

The signing of the WTO agreement is the economic counterpart of China’s restraint of North Korea, underlining a Chinese belief that its interests are best served by fundamental economic and political stability.

For the financial world, the importance of China’s change from revolutionary to conservative policies is a pervasive diminution of risk. Two kinds of risk diminish. First, the likelihood that, under pressure, various countries might use the alleged unfairness of the “imperialist, unequal” global economic system to repudiate debts or to harm foreign investors has declined throughout the third world. Second, there is a vast diminution of specific financial risks to various countries and regimes that are once were systematically undermined by Beijing and now are systematically supported by Beijing.

This diminution of risk is equivalent to an important decline in interest rates, and that decline stimulates business throughout Asia. This is not just a bilateral issue; it is regional and global.

Aside from the general diminution of risk throughout the third world, specific opportunities have arisen from China’s evolution from a power that seeks to destroy the system to one that seeks to gain advantage from it. China’s trade is now several hundred billion dollars per year, most of which needs to be financed. Foreign direct investment in China now exceeds $40 billion per year, all of which is processed by banks; much of it is venture capital, an area in which U.S. investors excel. China’s WTO accession should be seen as part of this ongoing process, an attempt to consolidate past achievements and an attempt to promote it further.

Consolidation is important; one cannot take past successes completely for granted. One key htmect of consolidating the progress that has been made is reassuring everyone that there is agreement on the basic rules of the game. Given China’s history, the public agreement on the basic WTO rules is a dramatic symbol.

There is also a series of efforts to reduce the risks of the game. Here I will mention just two. First, financial agreements sometimes come asunder and when that happens all parties need assurance that problems will be resolved in a n orderly way. While China’s payment of its sovereign debt has been exemplary, at lower levels there have been problems. The laws have been unclear, the judges have proved erratic, and enforcement of rulings has proved difficult at best. (Arbitration processes have worked much better.) Both sides understand that existing business carries unnecessary risks and new kinds of business are inhibited by the current erratic system. Foreigners and the Chinese leadership are equally anxious to use the WTO process to promote a more effective and predictable legal system.

Second, both foreign investors and the Chinese have been concerned about the unusual degree to which China-based business can be suddenly threatened by political restrictions or by arbitrary protectionist decisions taken by China’s trade partners. WTO is expected to reduce the scope for both kinds of problems. All this gradually drains the risk out of business, thereby expanding the volumes and reducing the risk premiums.

The process of reducing these risks is equivalent to another major reduction of interest rates affecting business with China, and the expected consequences are occurring. I quote here one example from a consultant report published while I was writing this testimony:
The chemical industry is currently in the midst of a major wave of investments in the billion-dollar-plus category stretching out to 2005, represented by leading companies such as BASF, BP, Bayer, ExxonMobil and Shell.
These mega-projects were justified based on a perception of reduced risk—directly affecting the shareholder value calculation—in which China’s political and economic stability and entry into the World Trade Organization were discounted well in advance.

Beyond consolidating the existing business expansion, China’s WTO accession should expand and improve business not just with China but also regionally and globally. In the process of becoming a system-supportive power, China has gone well beyond most former members and is now becoming a leader in creating a truly open market economy. Many Americans are surprised to realize how much more open and market-oriented China has become than many of our traditional allies. For instance, trade now is three times the share of GDP in China that it is in Japan. Other indicators such as foreign direct investment provide similar results. China is so welcoming of foreign direct investment (FDI) that it now receives every year more FDI than Japan received in the entire decade of the 1990s. Similarly, the trade regime is more open to foreign goods than those of key capitalist neighbors. Stand on any street corner in a major Chinese city and your will see Buicks, Jeeps, and Volkswagens in profusion—something that has never been true in Tokyo or Seoul.

The benefits that China is receiving from being so welcoming of FDI are beginning to put pressure on the neighbors to become equally welcoming. From Japan and South Korea in the North to Thailand in the south, many Asian countries (not to mention Latin American and African countries) structured their foreign investment rules and institutions in an era of great skepticism about multinational corporations; the result was a strong preference for financing growth primarily through domestic bank debt, and second through foreign bank debt, rather than through foreign investment; Taiwan, Hong Kong, Singapore, and now China proper have been the leaders in overturning this old nationalistic approach, which has slowed growth and led to financial crises for many decades, particularly in Latin America. China’s success based on enthusiasm for a more open market will prove seductive to these more restrictive regimes.

China has become a leading advocate of free trade. Having moved so far toward commitment to free trade in its WTO accession agreement, China has little to lose and much to gain from promoting free trade. Since it is the low cost producer in many labor-intensive areas, it sees very direct gains from freer trade. This lies behind China’s promotion of CAFTA, an Asian version of NAFTA which appears (on admittedly early indications) to be quite compatible with the principles on which we promoted NAFTA. It is fascinating to watch China and ASEAN promoting real regional free trade agreements while Southeast Asian countries plead with Japan to abandon its contradictory approach of promoting bilateral “free trade agreements” that are actually designed to institutionalize protectionist measures, particularly in agriculture.

Another area in which China has gone to the free market extreme is in the decision to legislate that the WTO accession agreement is takes legal precedence over any domestic law. That kind of priority for international trade and investment rules is unthinkable for most countries, including of course our own.

These Chinese initiatives increasingly put pressure on neighboring countries to follow suit. The pressure comes not from political arm twisting but rather from force of example. This is how Japan led from the 1960s to the 1990s. At that time, Japanese methods led to superior growth, so other countries studied Japanese management and often followed Japanese and Korean examples even when they involved painful reforms. China’s achievement of currency stability in an era of devaluation crises, and of 7 percent growth in a time of global recession, are making a big impact on neighboring countries. Likewise, the ability of China, Hong Kong, Japan, South Korea, India and Singapore to make huge gains in foreign direct investment through quite modest efforts to be investor-friendly will undoubtedly drive further improvements throughout Asia and eventually the world.

The greatest expansion of the financial industry in the history of the third world has occurred throughout Asia as an htmect of this broad risk reduction and the general expansion of commerce and investment that has accompanied it.

China’s Willingness and Ability to Meet WTO Requirements

The WTO agreements require China to make adjustments that go far beyond anything most other countries would be willing to attempt. Industries that are in a primitive, fragile condition are required to open within five years. In contrast, the normal pattern among OECD countries has been to provide 15 years for far more modest adjustments. The U.S. textile industry has had four decades to adjust to Asian competition and gets another dozen under the WTO agreement with China.

China’s financial industry is a case in point. China’s four big banks have millions of employees, all of whom lacked any credit training until a few years ago. Throughout most of China’s territory, sending somebody a check will simply frustrate the recipient, who is likely to be told, “We don’t have the money now. Come back in a few weeks.” Even in the big cities, people mostly pay their utility bills in cash. The biggest banks are estimated to have non-performing loans amounting to just under half their assets, yet they are expected to compete in five years with the biggest U.S. and European banks. If someone suggested opening all of Africa’s banks to full foreign competition in five years, he or she would probably be derided, but China’s banks are probably in worse shape than the typical African banks, and China is the size of many Africas.

On the other hand, there are positive signs.

China’s leaders are very serious about confronting their financial problems. Instead of waiting for their country to hit the wall as South Korea, Thailand, and Indonesia did, China’s leaders saw the problem coming and took action years before crisis was imminent.

Second, unlike Japan and Taiwan, which have allowed the banks’ problems to fester and multiply long after these problems had created a national malaise, China has taken very decisive action. The primary strategy has been: to save the banks, we must fix the banks’ customers, which are mostly the state enterprises. In pursuit of that strategy, they have spun off the vast majority of the state enterprises, retaining only the larger ones and imposing drastic reforms on those. In the last few years, the state enterprises have been forced to lay off 47 million people. In a particularly dramatic contrast with Japan, China has begun auctioning off banks’ bad assets on the model of our own Resolution Trust Corporation, at discounts that sometimes run 80% of face value.

Unlike most third world countries, China took decisive early action to curtail moral hazard in its dealings with foreign banks. The leadership retracted formal guarantees even from its most prestigious companies, and it allowed the prestigious but mismanaged GITIC to go bankrupt, setting an example that corrupt, mismanaged companies would not be bailed out. GITIC had been the showcase company of China’s most successful province. Angry foreign bankers, who expected developing countries to bail out corrupt companies if they were well-connected, deprived China of what would have been tens of billions of dollars of loans. For a while there were questions about the futures of the leaders who made the decision to bankrupt GITIC, but history may well say that that decision made the difference between success and failure for China.

China has also transformed its financial system. To take a few examples: the central bank was separated from commercial banks and made a pure regulator. It was then reorganized along regional lines, modeled on the U.S. Federal Reserve System, in order to make it less vulnerable to local political pressures. The commercial banks were separated from the development bank. The commercial banks have been put under the control of young reformists, who have been provided with incentives for good performance and strong sanctions for poor performance. Disclosure requirements have been continuously raised. In the spring of last year, Bank of China led in opening its books to an extent that would be unthinkable in Japan or Taiwan.

The Chinese banks are creating elite divisions that increasingly can compete with world class foreign competitors in certain areas, even while they struggle to deliver checks in much of China.

The financial dilemma is a microcosm of the larger Chinese system.
The good news is that China works much harder than anyone else at digging itself out of a hole.
The bad news is that the hole is frighteningly deep.
The good news is that the financial markets are very generous with people who are as serious about reform as China clearly is.
The bad news is that there is no margin for error, no willingness to tolerate even a short period of weak management.
The good news is that growth comes from improvement at the margin, from how fast you dig. Since China digs fast, it grows fast.
The bad news is that China has grow fast continuously in order to survive. If you lay off 47 million people, you have to create a lot of jobs and that takes more growth than anyone else in the world can muster these days.

Optimists look at how hard the Chinese work at filling in the hole. Pessimists look at how deep the hole is. Both have plenty of exciting numbers.

The WTO requirements are just one more piece of this larger picture. A David with broken legs is supposed to be ready quickly to fight off Goliath at his peak. A bank with two million employees who have no credit training is supposed to compete with Citigroup in five years.

The risk to China is that the foreign banks come in and take away the best customers, leaving the Chinese banks decapitated.

The opportunity for China is that foreign banks could resolve China’s greatest problem, namely the efficient financing of job-creating firms. The problem arises in the following way. In order to avoid a financial catastrophe, China has had to retract bank support from a vast array of state enterprises, leading to loss of 47 million jobs there and another 8 million elsewhere. Having laid off all those people, it desperately needs to create new jobs. Political stability depends on that. The state enterprises will be job shedders for the foreseeable future, so they can’t help. But the Chinese banks only know how to lend to the state enterprises. If an institution with limited credit skills starts lending to entrepreneurs on a large scale, the results will be as disastrous as lending to the state enterprises.

Foreign financial institutions are a necessary part of the answer to this dilemma. Foreign venture capitalists, primarily from Taiwan, Hong Kong, and the U.S., will play a big role. Foreign banks will both lend to Chinese companies and teach Chinese banks how to do so without losing their shirts.

Chinese leaders will have to maneuver to prevent the decapitation and collapse of their banking system, and we will undoubtedly see some interesting controversies as they do so. But if they focus on defending their domestic banks, as most politicians in most countries would, then they will risk destabilizing their country for lack of job creation. To stabilize China, they must make pervasive use of foreign banking skills. I am inclined to believe that this will require a much bigger upheaval in the Chinese banking system than has yet been mooted. South Korea provides perhaps the most helpful model for what China needs. In the past four years, the South Korean banking system has been shattered and then sufficiently rebuilt with extensive foreign participation that it is beginning to offer a credible financial foundation for a very prosperous Korean future. This contrast sharply with Taiwan, which four years ago was in much better shape than South Korea, but has been so defensive about its banks that it has fallen behind.

The key role of legal reform

As foreign financial participation increases, the most intractable problem will probably be China’s legal system. Inadequate laws, judicial ignorance of the law, political pressures on judges, and inability to enforce court judgments are pervasive problems. There is almost complete agreement between the Chinese government and foreigners about what needs to be done. The problem is not disagreement in principle but the depth of the hole that China finds itself in.

The bulk of Chinese financial law was written in the last few years. Only last year were judges required to have formal legal training. Most judges are hired by local governments and dependent on them for continued tenure in office; hence, regardless of national policy, they are vulnerable to local political pressure. Different courts in different regions reach contradictory conclusions and there is no satisfactory mechanism for resolving the contradictions. With the best will in the world, Chinese courts have great difficulty persuading anyone to implement their judgments. In financial terms, this creates an insuperably high risk premium on doing business below the top few corporations. To understand the scale of this problem, imagine yourself plunked down in, say, Zaire, with a mandate to make all of Africa’s courts consistent and credible within five years. Then imagine having the same job for many Africas simultaneously. That is the dilemma of reforming Chiina’s legal system.

Because of the legal and accounting and transparency shortcomings, foreign banks will initially have maximum incentive to concentrate their energies on decapitating their local counterparts. But to the extent the legal and transparency problem can be overcome, vast increases in the size of the credible market and the potential profits will be enormous. On the Chinese side, to the extent financing can be delivered to lower tiers of companies, there will jobs, prosperity, and political stability.

The stakes in this game go far beyond profit margins. Western politicians see WTO not just as a way to increase access to the Chinese market but also as a way of exerting political influence by creating a pervasive commitment to the rule of law. Chinese leaders see exactly the same benefits, and the current generation of leaders is trying to use WTO to lock in its successors.

The Shift to Domestic-Led Growth

About four years ago, China made a deliberate decision to begin shifting from export-led growth to domestic-led growth. Foreign banks may well play a vital role in the continuation of this shift.

Most Asian countries achieved their economic takeoffs by emphasizing export-led growth, but starving the domestic market in order to promote exports eventually has negative consequences. The sources of growth at home become unacceptably weak. Foreign countries eventually resist the interminable export offensive. For both reasons, foreigners began urging Japan in the late 1970s to shift to domestic-led growth. Beginning with the Maekawa Report in 1986, the Japanese government urged itself to make the shift. But for political reasons nothing was ever done. The result has been both a chronic trade war with the rest of the world and now an incipient economic crisis at home.

To the extent China is successful in making this shift, its economic growth will be healthier and its trade problems with the U.S. will gradually be ameliorated. So far, the results have been quite successful. China’s housing, car, retail and infrastructure industries have experienced buoyant growth even in a time of global economic slowdown. Last year, China’s net export growth was negative, but its economy grew about 7 percent. It has achieved growth without beggar-thy-neighbor currency devaluation. This is the benefit of having had the political courage to take the steps that more prosperous neighbors have been unwilling to take.

Foreign banks should be able to help China accelerate this shift to domestic-led growth, and to do so very profitably. As noted, the dynamos in the shift are housing, cars, consumer spending, and infrastructure. All these are areas where Western banks have superior expertise. The first three also happen to be areas where the Chinese customers have an excellent record of repaying their loans. To the extent the foreign banks participate vigorously in these areas, they will contribute not only to their own profits but also to the continuation of rapid economic growth, to rapid job creation, to the development of sectors where the Chinese banks can become profitable, and to gradual resolution of trade imbalances.

Direct Financial industry benefits

China’s accession to WTO will lead to a vast opening of the Chinese banking system. Within five years, foreign banks, now restricted to a few cities, will be able to bank anywhere in China. Foreign banks, now largely restricted to foreign currency business, will be able to deal in local currency’ of course most financial transactions in China are in the Chinese currency. To the extent that legal and transparency problems are resolved, whole new tiers of business could emerge.

I will not attempt here to estimate the size of the potential markets, but a few comments may be helpful. In every sector that has opened up, there have been optimists and pessimists. In the late 1980s Fortune magazine proclaimed the death of foreign investment in China. Today we debate whether China is hogging foreign investment from the whole third world. In November 1999 a distinguished China scholar published an article in Foreign Affairs saying that the China market was a myth; he didn’t notice that trade was headed toward $300 billion per year, that companies were passing the billionth sale of Coke or of soap bars, that China was consistently one of the top two global markets for aircraft, or that China was on the way to having more mobile phones than the United States (something that it achieved last summer).

In 1995 the Chinese stock market was among Asia’s smaller markets. Today, except for Tokyo, it is Asia’s biggest market. Combined with Hong Kong’s, in 2001 it surpassed $1 trillion in market capitalization. (Most of the recent growth of Hong Kong’s market was due to the listing of mainland companies.) Historically, before Mao’s minions crushed it, Shanghai’s stock market was always bigger than Tokyo’s. Mao’s successors aren’t crushing it anymore. The opportunities presented to foreign banks by such developments will begin slowly. Today it is virtually impossible to make a profit by participating in Chinese equity markets. However, assuming the risks noted below, the opportunities should accelerate quite sharply as has occurred in other parts of the Chinese economy.

Similarly, Chinese insurance markets are currently small and primitive. But there is a pervasive need for insurance. The Chinese government’s need for help in setting up pension and medical insurance systems may lead to greater participation by private companies than is typical in the capitalist world. If this happens, nobody should be surprised. China’s housing and medical systems in the big cities are already more capitalist than Hong Kong’s.

The opportunities for U.S. banks and insurance companies in all of this are clearly substantial. China will not soon become one of the biggest profit centers for U.S. institutions, but it is the great frontier, the great source of potential growth at the margin.

The risks

So far, China has undertaken heroic reforms and been heroically successful. But China is still in a very deep hole, and even its vigorous digging poses risks.

China’s banks are still in a very deep hole. China’s state enterprises are still in a very deep hole. China’s physical environment is in a very deep hole, always susceptible to droughts, floods, and clouds of the world’s worst pollution. China’s system is very personalized; there is for instance a warm personal welcome for foreign investment, but because the system is based on persons rather than institutional structures and rigorous laws it is susceptible to sudden changes. Digging fast enough to keep from being smothered in these holes requires some of the fastest social change the world has ever seen. If the Chinese leadership were to lose its momentum, or its courage, even for a couple years, it is quite possible, even likely, that all these problems would go critical simultaneously. When we fantasize about the China threat, we need to keep in mind that China remains in a very deep hole and that all its frantic digging is just fast enough to prevent disaster.

There are also risks in the opposite direction. Digging too fast can cause a heart attack. China has been laying of tens of millions of people, cutting its government in half, getting the military out of business, opening its economy to competition, going from one airline to thirty. As financial analysts, we applaud their foresight and their heroism, but governments can step on too many toes at the same time and achieve upheaval rather than prosperity. As people concerned about global stability, we have to be cautious in demanding that China move even faster than it has.

So far, Beijing has kept its balance between these extremes. Given the size of the problems and the scale of the country, maintaining balance has been a remarkable feat.

It is in our national interest for China to keep its balance. It is in our national interest, not just our financial interest, for the emergence of an open, cosmopolitan China to lead to success. We may fear a China that is too successful, but that is not a present danger. Rather, it is a scenario that presumes decades of future balance and future success, neither of which is assured. We have experienced in the twentieth century a China that was divided and weak, a China that was a vacuum drawing in competing predatory powers. Had China and Korea found their balance at the beginning of the century, we would have had European War I and European War II rather than World War I and World War II. Today, as Japan sinks deeper into financial trouble, the last thing we need is a China in trouble too.

China’s switch from a policy of revolutionary upheaval to a policy of joining the system has benefited the whole world and in particular has contributed to the stabilization of Asia that was the core postwar goal of the United States in Asia. If that policy of joining the system were to lead to failure, it would drastically set back throughout the world the kinds of open, market-oriented progress we have promoted throughout the postwar era. When Argentina gets into trouble, it raises questions throughout the third world. If China gets into trouble after all it has done, many will see ominous answers rather than just questions.

What We Can Do

In the invitation to testify at this hearing, I was asked to comment on what we could do as Americans to help ensure smooth implementation of WTO.

The first thing and most important thing we can do is to press for proper implementation by China. That is important to us. It is also important to China. The Chinese leaders are counting on us to keep the pressure on.

We can also set a good example by rigorously implementing our part of the bargain, even when some domestic interests squawk. We are demanding that the Chinese make changes at a pace that we would never even consider. We must at least keep our slower-paced promises or there will be a popular outcry in China against the sacrifices they are being required to make.

When there are positive results, we should acknowledge them. The Chinese people remain poor, but they are a lot less poor than they used to be. The Chinese people are unfree, but they are a lot freer than they used to be. Imports from China have forced adjustments in this country, but they have also kept our inflation down and thus played a vital role in perpetuating the longest economic boom in American history. We need to talk about both htmects. We need to talk about the depth of the hole but also need to talk about the speed of the digging.

Given the vital need of both sides for legal progress, we could contribute a great deal by setting up a program to train Chinese lawyers. Since we seem to have a surplus in this country, maybe we could teach some of them Chinese and improve the trade balance by exporting them.

A balanced tone and a sense of humor would probably contribute more than anything else to the successful implementation of WTO and to the broader relationship with China. To a degree that Americans seldom recognize, the Chinese leaders welcome many of our reformist pressures. Nowhere is this more true than with WTO, and within WTO nowhere is to more true than with the rule of law. We have a strong national interest in keeping it that way, but sometimes the stridency of our rhetoric weakens the welcome.

In our relations with both China and Japan, there has been a tendency over the years to humorless exaggeration. We have important issues with them, but we also need to celebrate their successes. We can complain about China’s courts and appreciate their efforts to improve their legal system. We can condemn their human rights abuses and applaud the recent improvements in their freedoms. When they get richer, we do too; when they stumble, we do too. Neither Japan in the recent past nor China today has run much risk of taking over the world or of displacing our role. Stridency does not become us, but too often we succumb to it. We are players in a game where we are currently the world champions in every dimension, economically, politically, and geopolitically. We have overwhelmingly important shared interests and we can afford to emphasize them. We can afford to compete and complain with grace and magnanimity.