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“Overheated” China? Keep the Champagne in the Fridge

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by Arthur Waldron, Ph.D
Published on October 6th, 2004
LOOKING FORWARD

Two of the most astute students of the contemporary Chinese economy are Morris Goldstein and Nicholas Lardy of the Institute for International Economics. Amidst optimistic assessments that China’s economy will gradually settle into a pattern of sustainable growth—or make a “soft landing” as it is usually put—their advice in the Financial Times is to hold the Champagne. What follows is stimulated by their excellent article, though I must make clear that most of the analysis is mine, not theirs, and they may well disagree with some or even all of it. In any case . . .

We have all seen the astonishing double digit growth rates claimed for China. The question is, exactly what do they measure? Some companies grow because consumer demand for their products increases. Others become more profitable because they are able to reduce costs and thus increase productivity. In the West, a large proportion of growth is attributable simply to new ideas that permit the rearrangement of things we already have, but in ways that are far more productive and profitable.

There is, however, another way to grow, which is to get money from somewhere and use it to build things, employ workers, import raw materials, etc. Money spent in this way also counts as growth. The important thing to note is that it counts whether, in the end, the money spent proves profitable or not. Thus if 10,000 workers and a million tons of cement are procured to build a pyramid, all the money expended for that will be added to gross domestic product, even if they are all building a pyramid, which will never make any return whatsoever.

This is why in most countries investments are made only after careful calculations of future profitability—which, despite great diligence, are often wrong. A private investor can misallocate his own capital and see it disappear because he misjudged and investment. Banks guard against this danger by charging interest rates that reflect risk and profitability, and move freely, just as prices do.

But in China that is not the case. Chinese people effectively have little option but to deposit their savings in a state bank. These banks have billions of dollars in assets, which they lend. But the lending is not based so much on evaluation of profitability as on guidance from the Party, which often as not directs loans to state controlled rather than private customers. In addition, of course, there is foreign direct investment and investment from retained earnings by Chinese firms, public or private. Right now these loans—or “investments” as they are called, slightly misleadingly—account for perhaps 40% of China’s growth.

Or to put it another way: many of us have heard how Hewlett and Packard started their now multi-billion dollar a year company in a garage in Palo Alto, California. Only when they were really making money did they use some of it to build their impressive corporate campus nearby.

In China the order is different. First an elaborate corporate campus or skyscraper or stock exchange trading floor (in the age of IT, unnecessary) is built at great expense. This is what you see, and what impresses you so much, say in Shanghai. Then engineers or traders or whatever (many in fact government bureaucrats) are installed in the structure in the expectation that money will now be made. This is not how entrepreneurs operate anywhere—even in China, as anyone who has looked at private businesses in Hong Kong or in Taiwan will testify.

For state enterprises, which are administered variously at central, provincial, and local levels and thus regularly duplicate one another’s activities, the availability of this easy credit has made it possible for unprofitable state enterprises not only to stay in business but to expand production, creating more and more of something that people won’t buy (the reason that the companies are unprofitable to begin with). Such expansion by state enterprises also increases demand for raw materials, such as coal, iron ore, petroleum, etc. And when it is all added up, without distinguishing profitable from unprofitable investments, it looks like a boom.

But it is more like a massive accumulation of risk. First of all, banks and foreign investment simply cannot supply the money to make up 40% of growth. As Goldstein and Lardy put it, “There is nothing in the last 25 years to suggest than an investment share above 38-40 per cent of GDP is sustainable.” Nor is any substitute for this investment, or borrowing, in sight. Most economies are driven by increasing consumer demand which allows companies to make profits and reinvest by selling more of whatever they make. But consumer demand in China is undeveloped, as a vice governor of the Bank of China made crystal clear to this author during a recent visit. Instead, foreign demand for Chinese exports drives things. But this is not sustainable either: international markets can only absorb so much in Chinese exports, and because of certain anomalies in the export regime—the low exchange rate of the renminbi, for example—Chinese goods are artificially cheap. This leads to protest: in Spain, traditionally a major shoe exporter, locals are burning down shops that sell Chinese shoes.

Second, if all this state lending to state enterprises proves, in the end, to have been profitable, China’s economy will soar. But if loans cannot be repaid because no profits are being made, then firms in that position will have either to close and liquidate, or seek yet more good money to throw after bad. Were this a question of private capital, one would not worry so much: something like 5% of all private US firms go bankrupt every year, which keeps the others on their toes, and gets rid of waste.

But China’s huge state owned sector is a bit different. It is too big, as they say, to fail, but it is also too big to subsidize indefinitely—especially since every dollar thrown away in subsidy could have been used profitably.

So when you look at the impressive new skyline say, of Shanghai, remember: this was not built by private enterprise out of earnings. This was mostly built with loans from the state banks, and we don’t know yet whether they will be profitable. (A high percentage of state loans are “non performing.”). My own hunch is that in the next few years we will see a lot of shuttering of state enterprises, as the burden of subsidy becomes intolerable, and a consequent marking down of China’s real growth rate.

China has not yet privatized. Its economy is overwhelmingly in state hands, and capital is, in this author’s opinion, often grossly misallocated. The private sector, which grows far better than the state and provides more jobs, is by and large denied bank credit. This is a recipe for trouble ahead. For a state that increasingly seeks legitimacy by delivering economic growth, it is particularly worrying.

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