The price of prudence

The prospect of a speedy recovery from the Asian financial turmoil remains uncertain. However, China still manages to show steady economic growth and have healthy foreign currency reserves while countries such as Japan, South Korea, Thailand, Indonesia and Malaysia continue to struggle.

Many believe that Premier Zhu Rongji's promise not to devalue the Chinese currency for this year is not likely to be broken. The government was also hopeful of attaining last year's targeted eight percent GDP growth and 11 percent industrial output growth. Following a significant decrease in demand from Southeast Asian countries, exports dropped 9.7 percent year-on-year in November and rose just 0.2 percent in the first 11 months of 1998. In the past, eight percent of all Chinese exports were sold to Southeast Asia and 12 percent to South Korea and Japan. Reportedly sales to Asean countries dropped by about 8.6 percent in the first three quarters of 1998.

Incentive for exporters
Notwithstanding the poor economic performance of its neighbours, China is expected to do its utmost to fulfill Zhu's wishes in order for him to solidify political power and for China to emerge as an Asian economic powerhouse. Nevertheless, the continued defence of the currency may carry a hefty price tag that the government would prefer not to publicise. In order to pursue its 1998 export target of US$200bn, Beijing has adopted tax policies hoping to make up some of the currency disadvantages in the export market. At the beginning of 1998 the State Council, Ministry of Finance and the State Administration of Taxation issued four circulars to raise VAT refund for exporters.

In February, the government announced that the export VAT refund rate for various textile products was increased to 11 percent, retroactive from the beginning of the year. In June, the export VAT refund rates for coal, steel, cement and ships exported after June 1, 1998 were raised to nine percent, 11 percent, 11 percent and 14 percent, respectively. In July the export VAT refund rate was raised to nine percent for edible sugar. In August the State Council announced that export VAT refund rate for several categories of products would increase to 11 percent, effective July 1, 1998. The products include telecoms equipment, power generators and transformer equipment, computing equipment, high-grade home appliances, agricultural machinery, aerospace equipment, automobile and related components, bicycles, watches, lighting equipment, shoes, porcelain and pottery.

As admitted by the government, the objective of these tax policies is to help those industries that are affected by the diminishing demand overseas. Many such enterprises experience financial difficulty as a result of the financial crisis in Asia. By promising more tax refunds, the government is essentially subsidising these chosen enterprises in order to make them more competitive, as opposed to devaluing the currency which may have a broader impact on the entire economy at home and abroad. One often-asked question is whether Beijing will ultimately again decide to refund all VAT to exporters, as the rules first issued in 1994. To do so would put all exporters on an equal footing but would require the government to forego a significant portion of the fiscal revenue.

Meeting fiscal goals
While the government wants to assist export enterprises to improve their competitiveness in the international market through increasing tax refunds, it is also mindful of its need to meet fiscal goals. This is a delicate balance that poses interesting challenges for the tax authorities. The tax revenue has been lagging behind the target established for 1998. As a result, the State Council recently gathered many senior tax officials from around the country for a special meeting in Beijing to urge them to strictly enforce the tax laws and collect more taxes. It is likely that the tax revenue target may have been set under the estimated eight percent GDP growth. Many experts predict that annual GDP growth may only be about 7.3 percent. As a result of the lower-than-expected economic growth and the increase of tax refund, the tax authorities may have to adjust their targeted tax revenue collection. However, adjusting the tax revenue target may send a signal that the economy has under-performed and further add pressure on the currency valuation. Therefore, the tax authorities may choose to aggressively pursue tax collection and audit taxpayers. The tax bureaux have stated that they will focus heavily in area such as with-holding tax and transfer pricing.

In addition to using tax policy to alleviate the pressure on the devaluation of the yuan, the government also issued new regulations to control foreign currency transactions. In light of the potential currency devaluation, many companies have been finding ways to protect their currency position. The State Administration of Foreign Exchange was concerned that too much speculation may increase the pressure on the currency.

Seeking a balance
As a result, several rules have been issued to stop companies from entering into unusual or speculative transaction. For example, companies are not able to pay off foreign currency denominated loans ahead of schedule unless the loan document has a provision to specifically allow the prepayment.

Moreover, the authority requires companies to register all foreign currency denominated debts that are of more than 90 days duration. This has a big implication for foreign companies selling to China, as the Chinese purchasers may not be able to remit money without the proper registration. Foreign suppliers are concerned that this 90-day rule may lead to a situation where Chinese purchasers fail on purpose to comply with the registration requirement in order to have a legitimate reason for not making payment. As an extra deterrent, the State Council upgraded illegal foreign currency transaction from a civil offence to a criminal offence.

China has gained respect and prestige by pursuing a stable currency policy. However, it remains to be seen how long Beijing will with-stand the pressure to maintain the value of its currency. Surely, it would be unreasonable for China to sacrifice permanently its own interests for the stability of other Asian countries. Tax policy may only provide a short-term economic stimulus, especially in cases where the policy is industry specific.

If the economy continues to slow, Beijing may rethink its currency valuation position. Furthermore, the government should be mindful that excessive foreign currency regulations may cause too much inconvenience in international trade and eventually slow down economic growth. It is important for China to seek a proper balance between regulatory control and commercial flexibility.

Alan Tsoi is a partner of PricewaterhouseCoopers in Being. He has lived in China for the past four years and advises multinational corporations doing business there.