On Thursday, World Bank President Bob Zoellick warned that without fundamental structural changes, China’s growth could soon wane and its economy stuck in its own debilitating version of the ‘middle income trap.’ The problem for Australia is that our commodity producers are the great beneficiaries of China’s unbalanced model which relies too much on unnecessary fixed-investment to drive growth and not enough on domestic consumption. The good news for us is that China will remain overly dependent on building things to drive growth in the next few years. The bad news for China and its people is that its inability to reform and restructure its economy means an even more damaging hard landing when it occurs.
China is often described as an export-driven economy. This was true fifteen years ago but much less so now. Even before the Global Financial Crisis, fixed investment was responsible for around 45-50 percent of growth, with net exports contributing only about 20 percent.
When the GFC hit America and Europe, Beijing responded by ordering an unprecedented surge in Chinese bank lending and fixed investment. Total bank loans issued jumped from around $740 billion in 2008 to $1.4 trillion in 2009, before falling to $1.1 trillion last year. In 2010 alone, Chinese companies directed over US$2.6 trillion toward fixed-investment in to what was then a US$4.5 trillion economy. Fixed-investment was responsible for an astounding 80-85 percent of GDP growth from 2009-2010.
The other noteworthy thing is that the country’s 150 central and 120,000 local state-owned-enterprises received over 90 percent of the capital. Even before 2008, around three quarters of these loans went to fixed-investment obsessed SOEs. Sources indicate that the domestic private sector received less than five percent of all capital during this period. In fact, while the size of the state sector has expanded, the private domestic sector actually shrunk in both relative and absolute terms from 2007-2010. To get an idea of the dominance of the state sector in the Chinese economy, consider the extraordinary statistic that the revenues of the 150 centrally managed SOEs alone amounted to almost half of China’s GDP in 2010.
The dominance of SOEs in the Chinese economy is essential for ensuring that the Chinese Communist Party remains the primary dispenser of business, professional, career and social opportunity in the country. That the Chinese political-economy is a state dominated one is not an economic accident but a deliberate strategy cobbled together by the CCP after the countrywide protests in 1989 that brought the regime to its knees. But the prioritising of the state sector goes to the heart of why Chinese banks keep pumping money into infrastructure projects that are not needed, offer poor returns, and is creating a massive but hidden non-performing loan disaster for Chinese banks.
For a start, any reform needs the cooperation of provincial and local government officials who significantly influence a large number of lending and investment decisions in local branches of state-owned banks. In many provinces, up to half of all local government revenues are based on SOEs making money from the property market. From 2009 onwards, it is estimated that 20-40 percent of all loans have been used to finance the building of residential property even if occupancy rates could be as low as 50 percent for the new homes. This means construction in China has less to do with demand or rate of urbanisation than is commonly assumed. Even if Beijing could enforce its will on the 45 million local officials—and it cannot—local fiscal reliance on an ever more precarious property bubble means that local officials will not easily accept slower loan growth and a construction slowdown.
Second, stagnating consumption in the United States and the European Union means that Beijing needs to find other ways to maintain and create jobs for its 750 million workers—particularly the 200 million itinerant workers throughout the country. Given the deliberate suppression of the domestic private sector, there is ever more reliance on SOEs to maintain and create jobs throughout the country. And building things through fixed-investment finance is all many of China’s 150 central, and 120,000 local SOEs (and their countless subsidiaries) know to do.
Finally, directing so much of the country’s capital to SOEs has the unintended consequence of creating a system of ‘insiders’ with close links to the CCP and state sector who benefit disproportionately from the fruits of economic growth. It also means that while state sector revenues grow at 25-35 percent each year, mean private household incomes increase by a lowly 3-4 percent each year. It is no wonder that domestic consumption is not taking off throughout the country.
All of this points to even more reliance on wasteful fixed-investment to drive growth and maintain jobs—good for Australia in the short-term but not China, its economic model, or its people in the longer term.