News of a slowdown in China’s economic growth has been building of late, and many disparate theories have been offered in explanation of the phenomenon. One issue facing the country has been debated particularly heatedly. Commentators cannot seem to reach a conclusion on whether the Chinese economy is a victim of over-investment.
The argument for decline by over-investment is elucidated by Michael Pettis, a Professor of Finance at Peking University’s Guanghua School of Management, a renowned expert on the Chinese economy, and famous author of The Volatility Machine: Emerging Economics and the Threat of Financial Collapse, in his latest newsletter. The structures that have led to the supposed over-investment are engaging, and surprising.
The story, in simple terms, begins with the restrictions China places on the maximum deposit rates allowed by banks there. These restrictions, though slightly relaxed earlier this month, leave borrowers accepting very low rates on deposits, because of lack of other investment opportunities.
The low rates allow money to flow to borrowers, who pay very low rates on their loans. That means householders are effectively losing money to subsidize the borrowing of investors. The Chinese financial system is being used as a machine, that allows this to happen.
The borrowers in China are the local and central government agencies, real estate developers, corporations, and other infrastructure investors. Because their investments are effectively subsidized, they face lower repercussions than borrowers face in free market conditions.
Pettis relies on the concept of economic backwardness as the epitome of China’s growth model, and counters it with an analysis of the effects of that model. Backwardness, as an economic concept, means there is an advantage to constricting household investment in order to increase investment and therefore worker productivity.
This model worked for China and for many other economies but it cannot be prolonged indefinitely. It becomes less effective after a number of years even if the country remains backward as China has done. This is the problem with the investment strategy China is pursuing and has resulted in an over reach which will, according to Pettis, necessarily lead to a rebalancing in the country’s economy.
Primary investment is easily selected correctly, the benefits of basic infrastructure being most easily distinguished. In a later stage of investment however more of the capital is wasted on projects that are not as useful.
China’s low interest rate constraints mean investment that is concentrated in a single area, and therefore provides economic growth in the short term, has its cost spread across the entire country through the household financial system.
The cost of building the infrastructure is much higher than the benefits that come from it. This is over-investment. The scourge is exacerbated by the structure of the country’s financial system. The subsidized lending leads to worse decisions being made because market realities are not in force.
China’s per capita income and worker productivity mean that the level of capital stock in the country should land at a much lower equilibrium level. Advanced infrastructure is not saving labour as much as it does in Germany or the United States. China is over-investing.
Pettis believes that the over investment in the Chinese economy is having the effect of destroying wealth rather than creating it. The cost of capital in China, combined with an unrealistic growth model that relies on investment at all costs is leading to massive problems in the country.
Pettis estimates that the constraints on the interests rates may have accounted for 400-500% of total profitability in the Chinese State owned sector in the years between 2001 and 2011.
The solutions are not as easy to come by as might be hoped. There needs to be reform in China of the kind that has not been seen in decades. The country’s financial system is desperately in need of reform.In order for this to happen China will need to undergo political reform.
The need to alter the banking system so that households are no longer subsidizing the kind of investment that destroys value is great. China seems to be willing to broach some of the necessary reforms but it will take substantial political will in order to achieve the full reform needed.
Politics in China is undergoing its most egregious challenges in decades this year. The succession plans for the replacement of the country’s leaders have already been rocked by scandal. Something special will be needed to avoid the worst effects of the over-investment problems that have been created in recent years.
That is unlikely to come from these appointments. China is still conservative when it comes to reform, even when faced with economic slowdown. The recent tremors in the party’s system of choosing successors, could bring to the fore a more open method of investing leaders but it is not likely to do so.
China’s government has allowed over-investment to become rampant in the east Asian giant. It is not a sustainable situation. If something is not done at the highest levels in the country there will be a market readjustment that will shake China and the rest of the world.
Pettis also makes a startling statement on China:
” A mainland think tank, Unirule, estimated in 2011 that monopoly pricing and direct subsidies may have accounted for as much as 150 percent or more of total profitability in the state owned sector over the past decade. I calculate that repressed interest rates may have accounted for another 400 to 500 percent of total profitability over this period.?Monopoly pricing, direct subsidies, and repressed interest rates all represent transfers from the household sector.”