China's economy is not at great risk in the short term, because the government still has lots of firepower to keep it afloat. But inefficient and wasteful investment is storing up problems for the longer term, argued the Economist magazine in an excellent survey of the Chinese economy in its 26 May-1 June edition.
While we basically agree with their assessment, we think that it underestimates the gravity of China's looming longer term imbalances. Let's review the Economist article.
Despite its reputation as an export-driven economy, it is investment which is the real leader of the Chinese economy. Spending on plant, machinery, buildings and infrastructure accounted for about half of China's GDP in 2011. But too much of this investment is undertaken by state-owned enterprises (SOEs) which benefit from implicit subsidies, sheltered markets and politically encouraged loans. Another driver of investment has been infrastructure ventures under the control of provincial or municipal authorities, but not kept on their balance sheets. This investment is fuelled by finance from a state-controlled banking sector.
This situation comes about because the Chinese government suppresses consumption in favour of producers, many of them state-owned. It keeps the currency undervalued, which makes imports expensive and exports cheap, thereby discouraging the consumption of foreign goods and encouraging production for foreign consumers. It caps interest rates on bank deposits, depriving households of interest income and transferring it to corporate borrowers. And because some of China's markets remain largely sheltered from competition, a few incumbent firms can extract high prices and reinvest the profits.
SOEs are responsible for about 35% of the fixed-asset investments made by Chinese firms. They can invest so much because they are rolling in cash. They pay extremely low dividends to their shareholders, principally the state. The 120 or so big enterprises owned by the central government earned last year net profits of $142 billion. Nevertheless, returns on equity among SOEs are substantially lower than among private firms. Nor do SOEs really "earn" their returns. The markets they occupy tend to be monopolized sectors, and their inputs of land, energy and credit are artificially cheap.
It has been estimated that the SOEs' profits from 2001-2008 would have turned into big losses had they paid the market rate for their loans and land. And China could have achieved the same rate of economic growth over the past three decades with half the rate of investment, had that investment been undertaken by the efficient private sector rather than SOEs. This also means that China's GDP growth and capital are really lower than they appear, because of wasted investment.
Is there anything good that can be said about the investment behavior of China's SOEs, which are often controlled by children and associates of the country's "communist" rulers, who own large swathes of industry? It is argued that the networks which link the Chinese Communist Party to the SOEs, and the SOEs to each other, mean that the Communist Party has a direct stake in the success of the economy.
China's massive boom in infrastructure spending has also led to lots of wastage from a ghost city in China's northern steppe, Kangbashi, to decadent resorts on its southern shores, and provincial and municipal authorities have large quantities of debt. The banks can however roll over this debt, and if necessary the government can recapitalize banks if this debt becomes non-performing.
The Economist blithely concludes on an optimistic note, arguing that over time there will be pressures on China to improve the efficiency of its investment behavior, and that of its financial system.
In our view, there are many reasons to be much more concerned. It would take a great systemic change to pressure China's SOEs to become more efficient, and it is difficult to see how such pressure could be brought to bear on China's elite. Indeed, there is a grave risk of a widening of China's wasteful investment as the government seeks to diversify away from holding US Treasury bonds by increasing foreign direct investment by China's SOEs, which have much less knowledge of foreign business conditions than those in China. China's SOEs have also become a major conduit for corruption by elite Communist Party members, who are unlikely to give up that privilege.
Further, China's captive finance supplied by compliant citizens may dry up, as capital flight mounts and as the rapid ageing of the population leads to a draw down of savings. Last year already, working age Chinese fell as a share of the population, and soon their number will begin to shrink.
China is in a unique position of being a country which will grow old, long before its becomes rich, and therefore is in desperate need of getting the most out of its investment. The grotesque inefficiency of its investment will surely deeply undermine the country's economic health, with severe consequences in the longer term.
The Economist. Survey of the Chinese economy. 26 May-1 June edition.