The blistering Chinese economy continues to grow at over 10%, despite repeated warnings of overheating from Beijing. Administrative measures to restrain investment and interest rate hikes seem to have been ignored by local governments and enterprises, state owned and private alike. Policy impotence – theorized by economist Robert Lucas two and a half decades ago – is back, though in a very different circumstance and for very different reasons.
China’s ongoing investment boom is driven mainly by the state sector, including governments and state-owned enterprises, which accounts for a large portion of China’s fixed-asset investment. In contrast, multinational firms, which have poured billions of dollars into China in recent years, have contributed to merely 6-7% of total investment.
The government is, by definition, a non-profit organization. It cares less about efficiency of investment, but certainly pays a lot of attention to growth and the scale of the economy. Growth is important – no matter what quality – for tax revenue and employment, and hence social stability. Provincial and municipal officials have also been in a hurry to boost economic performance in their jurisdictions before the ruling party’s national congress next year. For state enterprises, the old adage still applies: while private firms maximize profit, public enterprises maximize budgets.
If a government is concerned with the local tax coffer, a quarter percentage point increase in interest rates will not deter it from pursuing high investment. If managing a state enterprise has as its goal empire building, probably for personal benefits, managers often pretend not to hear the whistle blowing in the centre.
Diminishing returns
The danger of investment-driven growth is well known. If you continue to increase the input of capital to support economic growth, the law of diminishing returns will eventually take effect. When that happens, the miracle will start falling apart: witness Japan in 1989, followed by the “Four Small Tigers” in 1997. You had better hope China will not be another case in point.
There is a limit to growth that relies on investment. It is striking to see that China’s investment/GDP ratio has risen steadily from about 25% in the early years of economic reform to over 40% in 2005. In contrast, Japan’s ratio peaked at 30% in the late 1980s and Korea’s at 38% prior to the Asian financial crisis.
Of course, investment can never exceed GDP. The economy may collapse well before reaching the theoretical limit. We do not know how much higher China’s investment rate can go and whether the country will be lucky enough to avoid major crisis. What we know for sure is that investment growth of 30% per annum and the investment driven economic growth is unsustainable.
China’s central government sees the danger. It has issued policy statements to reiterate the urgent need for “change of the traditional growth model”. It correctly emphasized the importance of switching from capacity expansion to efficiency improvement. But like its tightening measures to cool off investment, the message was heard but not taken seriously outside Beijing.
Solutions
What can China do then? How can it temper the investment frenzy? The textbook prescription of contractionary fiscal and monetary policies will probably have little effect. The issues need to be addressed and the problems need to be tackled at the roots. If the state sector, including governments and state-owned enterprises, was behind the investment boom, it becomes critical then to leave investment with the private sector.
Governments should stay away from allocating funds for industrial and commercial projects, but focus on provision of public goods and services. Evaluation criteria for local governments should be changed accordingly, from economic to social ones such as public security and environment. Also, state-owned enterprises should be privatized, as seems necessary to curb investment.
But suppose the above-mentioned reforms of the state sector are not launched in the near term. How is the Chinese economy likely to evolve? Massive investment in the past few years will turn into huge excess capacity. Under the pressure of excess capacity, firms will be forced to cut prices to keep their market shares. The economy will fall into deflation, rather than inflation. As a result, firms’ profit margins will be squeezed. Only then will economic agents finally realize that the party is over. And only then will the process of “soft landing” begin.
Xu Xiaonian is professor of economics and finance at China Europe International Business School. He was previously managing director and head of research at China International Capital Corporation (CICC)