There is a reassuring realism in China today. Greed & Fear has been in Beijing and Shanghai this week, and the mood is the opposite of denial.

Meeting with the usual suspects, be they Chinese or foreign, private or public sector, reveals a complete lack of complacency.

No one pretends that last year's 7.8%

GDP

growth was anything but a fiction, while everyone accepts that the key policy response to the Asian crisis, namely government-financed fixed-asset investment, is unlikely to be effective in dealing with the deflationary crisis.

This is already becoming clear in the numbers. More than six months into the government spending surge and there is, as yet, little evidence of a pickup in consumption. Deposits are piling up in the banking system with the rate of deposit growth even increasing over Chinese New Year, the traditional time for spending.

This reflects the reality of a liquidity trap. Reforms unleashed by

Premier Zhu Rongji

in the recent past have had two undeniable consequences.

First, future income flows have become more uncertain as a result of talk of state-owned enterprise restructuring.

Second, future spending obligations have become more certain as a consequence of talk of pension and welfare reform.

The clear message from the Japanese experience is that fiscal stimulus can be ineffective in countering this trend.

This is now well understood in China. But the government will continue with the policy nonetheless -- not because it will work, but because it will, as in Japan, mitigate the impact of the downturn until demand is generated from another source.

For what would have happened to Japan's economy during the 1990s without a decade's worth of fiscal stimulus?

This reality has again been reflected in the latest Chinese data showing fixed-asset investment growing by 28% year on year in the first two months of 1999, almost all of it doubtless state financed.

Watching Fiscal Costs...

There are two problems with this continuing policy of growth by steroids.

First, the fiscal costs are mounting. Chinese official fiscal deficit this year is projected at less than 2% of GDP. But on a broader definition of the public sector, it rises to the range of 6% to 7%. Total debt to GDP remains in the comfortable range. But then a look at the contingent liabilities, in particular the banking sector, presents a far-less-comforting picture.

The markets will begin to worry about the fiscal consequences of current polices if there is not a meaningful pickup in domestic demand before the end of the year. For this would suggest a third year of fiscal stimulus which by then would mark a radical departure from China's tradition of balanced budgets.

If few people anticipate a pickup in domestic demand this year in China, there is some hope that China could be bailed out externally by a revival in demand from Japan and the rest of Asia. A total of 53% of China's exports go to Asia.

If they are hoping for a pickup in Asia, Chinese officials are also focusing intently on the U.S. stock market. There is a clear awareness in China of the close relationship between the U.S. stock market and U.S. consumer confidence.

The risks here are again considerable, given the latest parabolic rise of the

Dow

and the fact that 21% of China's exports go to the U.S.

... and Government-Financed Investment

The second problem with growth by steroids is that it means more government-financed investment. Non-productive capital formation was clearly a lead indicator of the Asian crisis.

There is considerable skepticism within China about how much of this "infrastructure" spending is really going into the target areas, such as roads and electricity transmission. During the just-concluded

National People's Congress

session, outspoken members of the

Chinese People's Consultative Conference

strongly criticized the construction of poor-quality, inefficient infrastructure projects, condemning them as "bean curd" projects. They revealed that poor-quality infrastructure projects worth about Rmb100 billion were built in 1998, almost equivalent to the Rmb100 billion in extra fiscal spending on fixed-asset investments.

Policy-driven bank lending also continues. This links with the fiscal issue.

China' s Achilles' heel fiscally is the same as Russia's, namely the inability to collect revenue. Total revenue accounted for just 12.4% of GDP last year. Increasingly frantic efforts by the tax collector mean that banks are now being pressured to lend to state-owned enterprises simply so these SOEs can in turn pay the tax man.

The fixed-asset investment story may be where the action is in China. But the big problem remains the lack of demand in an economy still characterizd by huge excess supply, a problem that has rural and urban components, given the decision since 1996 to support grain prices.

To boost domestic demand, the authorities need desperately to encourage the flow of credit to the private sector, be it corporate or consumer. This is now understood, as is clear from the rhetoric at the National People's Congress this month.

Still, the reality remains that an estimated 80% of state bank lending goes to finance the working capital requirements of the SOE sector, most particularly the payment of wages.

If the immediate problem remains a lack of demand, reflecting an environment of rising uncertainty, it cannot be argued that China is on the brink of a financial crisis. The banking system may be as insolvent as some of Asia's worst basket cases, given the black hole of SOE lending.

But it remains extremely liquid based on the ordinary Chinese people's unquestioning faith that the state will guarantee deposits. Indeed, the increased inflows of deposits as a result of the declining propensity to spend is a sign that the system is becoming more liquid.

This is reassuring in one sense since this faith, combined with the closed capital account, prevents a Russian or Indonesian-style collapse.

But it is also disconcerting. Without the discipline of an open capital account, structural problems can continue to fester in terms of the continuing misallocation of Chinese savings via a command-driven banking system.

Need for Reform Understood

It is true that the Chinese leadership now knows, as a result of the Asian crisis, that it needs to reform the banking system. There is a clear sense that the status quo cannot be allowed to drift indefinitely. Thus, asset management companies are to be set up, starting in a test case with

China Construction Bank

. Still, it remains to be seen whether this will prove to be anything more than a parking lot.

It is interesting to note that the China Construction Bank is apparently having a problem getting its best people to work in the asset management company because nobody wants to be involved in the unit dealing with bad debts.

Meanwhile, Zhu's annual press conference this week has signalled an important policy flip-flop in terms of the attitude to be taken to insolvent financial institutions which have borrowed dollars in an unauthorized manner.

Zhu told reporters that it was unlikely that any financial institutions would go bankrupt a la

Gitic

. This shows that the premier has, belatedly, realized the ricochet consequences of the Gitic failure not just in terms of the new reluctance of Western banks to lend to Chinese entities but also because of the effect on Chinese creditors to Itics.

Future Gitics are unlikely. This is a pragmatic move, though it clearly has moral hazard consequences. China's external debt, based on

Bank for International Settlements

data, is not massive. But it is also not insubstantial.

Meanwhile, the Gitic move should be seen, like most decisions in China, as primarily politically motivated. The intention was to make an example of Guangdong and therefore to appease popular sentiment against corrupt local officialdom. Other state Itics will be treated more favorably.

Devaluation Risk

If there is a risk to the health of the banking system it remains devaluation, since the perception of exchange-rate risk could trigger outflows of deposits from the bank system, especially if the deposits are not quite as evenly spread as the egalitarian precepts of the

PRC

would like to make out.

Many people made a lot of money in China's A-share boom. These sorts of people will be thinking in dollar terms, not renminbi terms.

The recent decision to raise dollar interest rates shows the Chinese authorities are aware of this problem. The rationale is to make dollar returns commensurate with those available outside China, since the Chinese government wants to keep the dollars within China. (In China it is quite legitimate to open dollar bank accounts even though it is illegal to buy dollars.)

This raises the thorny issue of exchange-rate risk. The economic pressures are undeniably growing for devaluation, given the sharply deteriorating export trend.

Still, devaluation remains unlikely because the exchange-rate question, like every other issue in China, is first and foremost a political one. The perception in Beijing is that devaluation would be viewed as a blow to the prestige of the PRC and could lead to questions among the Chinese about the competence of the government. This matters in this most symbolic year with the 50th anniversary of the Communist Revolution and the 10th anniversary of Tiananmen Square.

From an economic point of view, there is also a concern for now that a devaluation would not make matters better.

First, there is widespread acceptance of the fact that the problem is primarily a lack of demand for products, not price.

Second, there is a view that the competitiveness issue can be dealt with by export rebates and the like. China's exports have been increasing in volume terms though declining in value terms, reflecting a willingness by exporters to reduce prices.

Third, there is genuine concern that a devaluation would spark a fresh round of currency contagion in Asia and could therefore prove ultimately self-defeating in what is seen as a zero-sum game.

Such is the political calculation for now.

Still, it would be sheer folly to dismiss prospects of devaluation out of hand later this year or early next.

The pressures will grow, especially from SOE exporters, if consumption does not revive and if exports decline.

It should also be remembered that China has a history of administered devaluations. That tradition is not about to be abandoned. But the timing of the event will be dictated by political considerations.

Declining exports may not themselves trigger such a move. But any evidence of rising social tensions as a consequence of the economic slowdown certainly would.

Still, devaluation is not an immediate threat, as also evidenced by significantly reduced activity in the currency black market, although the parallel exchange rate remains in the Rmb8.9 to 9 range.

Zhu's Contradictions

For all Zhu's fuzzy rhetoric this week and assorted quotes from

Shakespeare

and

Rousseau

, it is also important to remember that China's premier remains by instinct and background an economic planner. This results in a tendency toward micro management.

The most positive developments at the latest National People's Congress have been the constitutional and legal endorsements of the private sector. That legitimizes the efforts to get the banks lending to the private sector. This is clearly the way to get the Chinese to achieve a more effective use of capital.

Still, for this to occur will require overcoming a central contradiction of Zhu's policies.

Bankers are being urged to lend to the private sector at the same time that they have been put on notice that their jobs are at risk if they incur rising non-performing loans. They are also simultaneously being told to continue policy-driven lending to the SOEs.

This incompatible cocktail reflects the reality that large parts of the Chinese economy, most particularly the banking system, retain the chief characteristics of a command economy. That suggests that what is really required to get the banks lending to the private sector is a state directive stating that, say, 30% of new loans should go the private sector. At present it is estimated that 10% to 15% of the Big Four state-owned banks' loan portfolios are to small and medium enterprises, some of which are private. The big SOEs hog most of the rest.

This raises a bigger issue. The PRC has been reluctant, as in any command economy, to give up its control over being able to mobilize the savings of the people. True banking reform implies relinquishing that control and allowing the credit system to work.

Is the PRC and the instinctive economy planner that is Zhu really ready for such a radical move? Greed & Fear doubts it.

Progress will therefore be extremely gradual in the absence of a cathartic crisis, which seems unlikely given the closed capital account.

It could therefore be a long, slow and painful decline for China with the problems being driven by domestic factors.

That is the opposite of the externally driven bonfires seen in Southeast Asia and South Korea.

But the slow-motion deflation can in a way be more debilitating in the longer run, as is clear from the Japanese experience. This points to a rather dreary picture for China and, by implication for Hong Kong where the authorities have further compounded the process by delaying their own asset price adjustment.

Natural Rotation

The significant rally in the

Hang Seng

Index in recent weeks has clearly been primarily due to external factors, namely

HSBC's

proposal to list on the

New York Stock Exchange

and

Hongkong Telecom's

proposed deal with

Microsoft

(MSFT) - Get Report

.

Prior to the long-overdue correction in Hong Kong, HSBC and HKT accounted for 43.2% for the move in the Hang Seng Index. This points to Wall Street's euphoria beginning to infect Hong Kong valuations.

Greed & Fear will retain the 1% asset allocation in China for now, since the recently commenced rally in red chips and H shares, though punctured, still has some way to run. This is part of the natural rotation process in any stock market rally where the good stocks go up first and the bad stocks go up last. Meanwhile, Wall Street is beginning to look parabolic from a long-term point of view.

Hong Kong-based Christopher Wood is the global emerging market strategist for ABN-Amro. Wood, a former bureau chief for The Economist, has written three books on Japan and global markets, including The End of Japan Inc. (Simon & Schuster, 1994). At time of publication, he held no positions in the securities or instruments mentioned in this column, although holdings can change at any time. Under no circumstances is this to be used or considered as an offer to sell, or a solicitation or recommendation of any offer to buy. While Wood cannot provide investment advice or recommendations, he welcomes your feedback at

commentarymail@thestreet.com.