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Overcapacity a time bomb for China’s economy

PUBLISHED : Monday, 28 September, 2015, 2:57pm
UPDATED : Monday, 28 September, 2015, 3:11pm

China has narrowly escaped major financial crises for over two decades. But the good times may soon be over - and not because of the recent stock market crash which has spawned debates about whether the country faces a serious economic crisis.

Some analysts compare China’s equity bubbles to the situation that led to the 1929 Great Depression, but other believe those are merely false alarms, and fears about China are overblown.

In the short term, the latter argument is more convincing: China’s equity crisis has affected fewer than 15 per cent of Chinese households. And the majority of these middle class investors have only lost money gained a few months earlier, when stock prices spiked.

Even after the recent crash, the Shanghai Stock Exchange’s Composite Index still stands 1,000 points higher than it did in July 2014. In any case, stock values are just 1.5 per cent of total assets in the Chinese banking system, and most Chinese companies are not financed by the stock market.

The consumer confidence index shows that the trend of growing consumption by both urban and rural Chinese remains stable. And Chinese authorities still have the power and flexibility to mobilise economic growth, for example, by loosening monetary policy to allow high liquidity of credit, or by expanding fiscal measures to stimulate household consumption.

But while the Chinese economy is unlikely to crash anytime soon, China nonetheless faces a high probability of being the next major power to face an economic collapse and is now at a tipping point.

One major reason is industrial overcapacity. Overcapacity is not new in China, but in sectors such as iron and steel, glass, cement, aluminium, solar panel, and power generation equipment, the overcapacity rate has recently surpassed 30 per cent, the threshold at which overproduction may trigger loan defaults by companies that have borrowed and then watched their profits fall.

Production has run rampant because of vicious competition between local governments. In order to achieve high GDP growth, local governments attract new manufacturing facilities by offering all kinds of financial subsidies such as tax holidays and rent-free use of government land.

Further, local governments help firms to get cheap loans from state-owned banks. These favours unnaturally decrease production costs.

Industrial overcapacity has become a time bomb that threatens the Chinese economy because it has led companies to take on debt to repay loans.

The combination of economic slowdown, excess production in manufacturing and rising debts at the macroeconomic level may cause a massive wave of firm closures and bad loans.

If this bomb detonates, the repercussions could be extraordinary. Because China does not have the mature social safety net of a country like Japan, and also lacks the political stability of the United States, it could face not only an economic blow-up but also serious social and political upheaval.

To avoid a crisis, President Xi Jinping and his policymakers must focus on reining in China’s overcapacity problem. First, Xi should set up strict rules for local governments that regulate tax concessions, and ensure that all government subsidies to private firms are transparent.

Secondly, Xi and his administration should allow and even encourage bankruptcy liquidation of failed firms, in spite of opposition from local governments. Overprotection of failed firms has helped to perpetuate bad management and low efficiency.

Thirdly, Xi’s government needs to accelerate reforms of China’s financial markets. In the current financial system dominated by state-owned banks, firms focus on growing as big as possible rather than innovating, which is leading to overcapacity.

China must encourage private equity, small and medium enterprises bonds, and equity crowd-funding, and it should allow the development of community and village banks that serve local firms. In these areas, the United States has lots of experiences and expertise to offer.

Finally, Xi should promote freedom of the press, which plays a crucial role in economic development, poverty reduction and the establishment of good governance. A free press would help Xi’s reform agenda by monitoring and criticising rule-breaking by local governments, as well as making government budget and subsidy programmes more transparent.

 

Shuaihua Wallace Cheng is managing director for China at the International Centre for Trade and Sustainable Development