Is China the star of the global economic crisis?  Or could it be laying the foundations for a future lost decade?

China has been getting top marks for its massive and quickly implemented stimulus policies.  According to the IMF’s latest forecasts, the Chinese economy will grow by about 10 per cent in each of 2010 and 2011.  This is the same pace as its pre-crisis growth rates.  What’s more, it is better balanced growth.  China has switched growth to domestic demand, and away from its dependence on the US market.  China’s stimulus also seems to have given a boost to trade with other emerging Asian economies, helping them “re-balance” their growth away from the US market.

Overall, exports are now contributing much less to economic growth, while investment is an even more important driver, thanks to the government’s own stimulus, and pressure on the private sector to keep investing.

In many ways, China’s apparently excellent economic management is possible because the government still controls many of the levers of the economy.  The Chinese economy is still not a real market economy.

But as the European Union Chamber of Commerce highlights in a recent report, the price of this is a continuation and exacerbation of China’s long history of excessive and inefficient investment, and excess capacity.  The government’s stimulus package targeted infrastructure, while the government encouraged a lending surge focused on expanding Chinese state-owned enterprise (SOE) production capacity, especially in non-metal mining, cement, plastics and non-ferrous metals.

Many observers have been preaching the merits of investment in infrastructure.  But even here, you can get too much of a good thing.  The number of cars on each kilometer of Chinese highways is only 12% of the seven major OECD countries’ average.  Small airports have an average utilization rate of only 50%.  And many ports are massively underutilized.  China's national and sub-national governments are very keen on infrastructure investment, not to improve the economy, but because it offers many opportunities for corruption, as officials can slice off a share of infrastructure project budgets.

Why do Chinese companies overinvest?  Most fundamentally, the Chinese government is keen to maintain a high rate of economic growth, to ensure high levels of employment, and minimize the risks of social instability.

How does this overinvestment happen?  Chinese companies (especially state-owned) are sitting on masses of profits (retained earnings) which fuel investment.  This is where China’s savings are stashed away, not under the pillows of prudent Confucian citizens who have in reality seen a decline in their share of national income.  By contrast, the Communist Party linked managers of these enterprises pay themselves nice fat salaries.

And these companies are very much investment-driven, they have a culture of market expansion more than profit maximization.  This is facilitated by the fact that Chinese government policy keeps many costs artificially low – not only land, energy and wages, but also the exchange rate and interest rates.  Enterprises have also benefited as they no longer provide social welfare to workers, and they face weak environmental regulations.  And on top of that, Chinese state-owned enterprises basically do not pay dividends.

According to a European Union survey, provincial governments play the biggest role.  They compete to attract investment.  The promotion prospects of government officials depend on achieving economic growth and other economic improvements.  And while national government policies to promote investment in the inland Western provinces have helped development, they have also contributed to excess capacity in these regions.

So, where is all this excess capacity?  Monumental overcapacity in steel, aluminum, cement, chemicals, oil refining, wind power equipment.

Excessive and inefficient investment is a very costly policy.  While it might keep the level of economic growth and employment high, in many ways it is just wasting money.  The likelihood is a whole bunch of non-performing loans, and banks that need to be bailed out somewhere down the track.  And this whole orientation means that the state-owned enterprises are not motivated to innovate or undertake R&D, and become competitive and dynamic.  The Chinese government knows this, but its measures to address this problem are all too timid.

With so much money wasted in inefficient investment, there is less finance available for new start-up enterprises, like SMEs.  It also means that companies cut corners when it comes to environmental regulations, health and safety standards, and labour and social laws.  Internationally, it also means that Chinese companies have a strong incentive to dump their excess production on world markets, giving rise to trade tensions.

A crisis should be an opportunity to set an economy off in a new more dynamic direction, rather than spending money inefficiently as the Japanese have been doing for two decades now.

The fairest and most effective way of stimulating the Chinese economy would be distribute some of these corporate profits directly to Chinese citizens, and to invest in social policies that provided them with much needed pensions, unemployment benefits, health insurance and public education.  This would make a major contribution to the much needed “re-balancing” of the world economy.

And the most effective way of charting a prosperous future would be to ensure that future investments are really market-driven – their efficiency must be tested by the market.  This means removing all direct and indirect subsidies, but also opening up the service sector to the private sector.  And privatization of major state-owned enterprises would make perhaps the most important contribution to a prosperous future.

But a fundamental problem is that both infrastructure investment and state-owned enterprise behaviour are substantially motivated by the practice filling the pockets of Chinese government officials and SOE managers which have close links to the Chinese Communist Party.

References:

World Economic Outlook Update, Tuesday January 26, 2010.  www.imf.org

Overcapacity in China: Causes, Impacts and Recommendations.  European Chamber of Commerce in China.  www.europeanchamber.com.cn