China needs right tools for growth

Andy Xie says the Chinese government's policy tweaks so far in response to the economic downturn have been misguided and it now facesthree scenarios- stagnation, revolution or forging a new growth path

PUBLISHED : Wednesday, 15 August, 2012, 12:00am
UPDATED : Friday, 30 September, 2016, 2:13pm

China's economic downturn signals the end of the growth cycle that began with its entry into the World Trade Organisation. The country requires painful reforms to deal with the legacy costs and restart a growth cycle.

The government has implemented frequent but minor policy measures. Such symbolic measures only spook businesses and investors who fear that the government may not understand the scale of the problem. While the government has successfully employed a muddling-through strategy before, it won't be enough this time.

China's WTO membership kicked off the last growth cycle. As foreign direct investment poured in, China's share in global trade rose dramatically. While the government used some of the money wisely to build infrastructure to support industrial expansion, it has spent more on wasteful projects and supporting inefficient state-owned enterprises. It has nurtured the biggest land bubble in its history to manufacture profits in an inefficient business model.

As the WTO-cum-bubble cycle unwinds, there are three starkly different scenarios for China ahead.

First, China could opt for stagnation by keeping unviable businesses, projects and government agencies alive by providing liquidity to roll over their debts. This is the path Japan took after its land market began to fall in 1992.

A bubble economy nurtures numerous highly indebted and inefficient businesses. In the past decade, China's business leverage has been about twice as high as the global average and the profitability half as much. As the economy slows, such highly leveraged businesses inevitably have negative cash flows. To cover up bad loans, banks could keep rolling them over and lend more for their cash shortfalls. As such inefficient businesses swallow up all the financial resources, the economy stagnates.

Second, powerful but highly leveraged interest groups could push China towards devaluation and inflation, similar to what Indonesia and Russia chose to do in 1998. Such interest groups first support defending the exchange rate with foreign exchange reserves. The purpose is to fund their capital flight. When their money is offshore and the foreign exchange reserves are exhausted, the exchange rate collapses to induce hyperinflation, which wipes away their debts in local currency. While such manufactured chaos looks very attractive for the establishment, its aftermath is likely to be revolution. The consequences are unpredictable and could set back the country for decades.

Third, China could restructure to boost its growth potential, which gives the government room to handle the bad debts in the financial system resulting from the bursting of the property bubble. This is the path China took in 1998. Through slimming down the state-owned enterprises, privatising public housing and pushing for WTO membership, it induced the market to focus on future growth rather than just the bad debts.

In 1992, Japan's labour costs were similar to those in other developed economies. China's labour costs today are still one-eighth of the level in developed economies. China could achieve growth through catching up in labour productivity. But this is not possible in the current environment. When most resources in the economy are in the state sector and inefficiently deployed, it encourages private enterprises to develop special relationships with the government, state-owned banks and state-owned enterprises for profits, not innovation. To shift from today's bubble economy to one based on innovation, China must slim down the state sector by half.

Last year's fiscal revenue, excluding welfare programmes like social security, was 22per cent of gross domestic product, land sales reached 6per cent, and government and state-owned enterprises' fixed investment, mostly financed by debt, was 22per cent. While these components may have some overlapping elements, they paint a picture that the state sector accounted for half the aggregate demand.

On the supply side, state-owned enterprises' revenues reached 78per cent of GDP last year. In the first half of this year, their revenues rose 11.1per cent but profit was down 11.6per cent. These numbers indicate that they have low profitability during good years, and would probably experience a miserable performance in the lean years to come.

China has enjoyed a quantity-led growth cycle. It tapped into underutilised resources like labour, land and natural resources by attracting foreign direct investment and expanding trade. But this model has reached its limits because the one-child policy means there's now a labour shortage and the environment is so damaged that it's a health threat.

The next growth cycle must rely on consumption on the demand side and technology and quality on the supply side. For this transformation to happen, resources must be shifted from the state to the non-state sector. It requires tax cuts, a downsizing of government, opening up all industries to private enterprises, and levelling the playing field in access to financing for private enterprises.

China's frequent but small symbolic reform measures so far resemble a psychological campaign to revive confidence. The intention seems to be to make businesses, investors and consumers feel better about the future. The hope may be that, when all the economic players are persuaded of a brighter outlook, they would spend and the economic improvement would become self-fulfilling.

But with the bubble economy bursting, such psychotherapy only scares people. It conveys the impression that the government doesn't understand the situation.

Between 1937 and 1977, China's modernisation was interrupted by wars and revolutions. But the country experienced seven decades of modernisation before that, and on the eve of the Japanese invasion, China's eastern seaboard was arguably the most developed area outside the West. Attributing the growth success just to government policy is misleading. If the government doesn't recognise the need to revamp the system that is holding the country back, another period of instability may be inflicted on China.

Andy Xie is an independent economist