BEIJING’S FAVORITE READING MATTER IS NO LONGER MAO’S LITTLE RED BOOK. NOW IT SEEMS TO BE THE WEALTH OF NATIONS: WE’RE BULLS IN CHINA’S SHOP

Espionage, devaluation, tense trade negotiations – the normal topics of conversation about China. Beneath the flak, however, a remarkable transformation is taking place. No stranger to revolution, China is at it again. This time, the revolution is in the marketplace.

Sooner than you might think, China will have an economy that is largely driven by free-market principles. This will be a strong economy, one capable of absorbing the millions of Chinese people entering the work force each year, and one that will allow China to enter the global stage as a key economic player.

To reach this destination, Chinese leaders have changed the road map. Gone are notions of a hundred huge corporate conglomerates, modeled on Korean and Japanese lines. The liberal flow of capital into state-owned enterprises – producing shoddy goods that no one wants – will slow to a trickle. Instead, strong, profitable and efficient companies will emerge as China races down the road of U.S.-style capitalism. Government will be downsized and private companies will dominate the economic landscape.

Chinese Premier Zhu Rongji has had the mandate and the agenda to accomplish this since 1997. Let’s review his progress:

Regulatory reform

In the past year, China has made dramatic strides in reformulating the rules of the game, especially for the financial sector. The central bank is now surprisingly similar to the Federal Reserve, with regional banks scattered around the country. A securities law has been passed. Local mutual funds were launched. An independent insurance regulatory body was established. Weak financial institutions, including small brokerages and unregulated investment trust companies known as Itics, were shut down despite the pain that was an unfortunate byproduct.

The Chinese are now gaining familiarity with implementing these new Western-style laws and regulations. Regulators are increasingly educated and trained in the method and spirit of enforcement. There have been countless stints with Western firms and regulatory bodies and fellowships at Western universities. The Chinese even get regular briefings from Alan Greenspan.

With each brokerage firm investigation and Itic bankruptcy, the Chinese are also gaining invaluable practical experience.

Corporate reform

Encouraging efficient capital allocation tops China’s 1999 agenda. While many Westerners are obsessed with China’s exchange rate and a potential devaluation, this is yesterday’s news. The country that used a trade surplus and capital controls to remain largely aloof from a regional financial crisis is fairly relaxed about the effects of a change in its currency’s value.

Nor are the Chinese overly concerned about a slowdown in foreign capital inflows, which may result from recent foreign exchange restrictions that will act to discourage foreign investment. Put bluntly, the Chinese may have decided they don’t need as much foreign capital as they have been getting.

The big problem in China is not capital scarcity, but capital misallocation. China’s financial system is still dominated by state-owned commercial banks. These huge, poorly run institutions have been lending willy-nilly to state-owned enterprises with little regard to loan repayment. This has resulted in large loan defaults and bank insolvency.

Nicholas Lardy of the Brookings Institution views these state-owned enterprises as one of the biggest threats to China’s reform process. Chinese policy-makers seem to agree, and they are turning up the heat on such entities, long protected and subsidized to keep employment high.

The concern for efficient capital allocation is one explanation behind China’s concessions on World Trade Organization negotiations. A deal on WTO and the accompanying concession to foreign competition will inevitably mean additional competitive heat on the state-owned enterprises. Policy makers know that such entities aren’t being shaken up enough – even if they list on the stock exchange. Ascension to the WTO is a politically acceptable way to introduce more competition into the Chinese economy.

Expect more mechanisms to put pressure on poorly performing state-owned enterprises, marking the end game for the old Communist entities. It will shortly be sink or swim.

Cultural restraints

Commentators who focus on the many structural problems in China – such as the weak legal system and the insolvent banks -may think we’re wearing rose-tinted glasses. Yes, these are serious issues. But they are surmountable.

For example, China is considering an American S&L-type solution to the banking crisis. Many of these reforms are also on display – and working – in Korea and Thailand for the Chinese to learn from.

In our view, the major question is whether China’s culture and politicians (even the reformers) will allow the markets to do their own thing, with all that it implies. We don’t doubt that there are as many entrepreneurs in China as there are in Silicon Valley. Or that reformers can figure out what laws to pass and which regulators to hire.

But can China’s reformers really let the market take its course?

For example, there are many restrictions on the stock market, which should be a major tool of reform. In reality, the Chinese stock markets have passed their experimental stage. There are 38 million investors and 851 listed companies, yet government requirements prevent most private companies – much less new companies like Yahoo! – from listing domestically. Mergers and acquisitions, especially among state-owned enterprises, are basically impossible.

We know that cultural factors have substantially slowed the ability of Japanese companies to restructure themselves rapidly in response to market forces.

And if we’re honest, big U.S. companies were also fairly hidebound until the mid- to late-1980s, when foreign inroads into the auto industry and shareholder activism caused change in management at the top levels.

Interestingly, the Chinese appear to understand that they must fight these cultural barriers to free markets. Within the past few weeks, the non-state sector was given official status within the Chinese constitution. This legal parity should help the damaging discrimination against private companies that has hampered regulatory approvals and credit flows.

Moreover, financial policy-makers acknowledge that banks favor lending to state-owned enterprises over private companies for absolutely no good reason except that state-owned business defaults are more socially acceptable. If China’s reformers can change this attitude, then Adam Smith really will be comfortable in China in the next few years.

Jan van Eck is co-president of New York’s Van Eck Global, which has a joint venture with Shenyin Wanguo Securities, the largest Chinese brokerage firm. David Semple is co-portfolio manager of the Van Eck Asia Dynasty Fund.