by Harry G. Broadman at Forbes.com
No economy can have its cake and eat it too. The overarching objective of modern China’s economic reform program, which was launched in 1978 soon after the death of Mao Zedung and perhaps best encapsulated in Deng Xiaoping’s 1992 pronouncement of the concept of a “socialist market economy”, has been always fraught with inherent contradictions.
Indeed, as someone who has professionally focused on China’s economy since 1993, worked extensively in many regions of the country—some far, far off the beaten track—and been on the factory floor in more Chinese state-owned enterprises (SOEs) than have most Chinese (so I’ve been told by friends in Beijing), Deng’s notion always seemed to be a blatant contradiction in terms.
The country’s sheer size—in geographic, population and resource endowment terms—coupled with the tremendous ingenuity, determination and patience of the Chinese leadership and society, have, time and time again over the past 35 years, allowed China to largely paper over these contradictions and achieve a globally envied record of economic growth (even if allowances are made for the inadequacies and inaccuracies of Chinese official statistics).
But the recent perturbations in China’s stock markets—less so the price gyrations themselves than the authorities’ as well as the population’s reactions to them–may well mean a fundamental tear in the country’s microeconomic fabric and a breakdown in Deng’s logic are in the offing.
Heightened sensitivity to the prospects of China’s continued economic fortunes has been reflected in news headlines around the world for the past few years. Attention there has largely focused on the apparent slowdown in China’s annual macroeconomic growth rate, from about 10 percent to roughly 7 percent (at present).
To date, however, that performance is, in and of itself, likely reflecting more of a cyclical rather than a secular (or structural) set of changes. Nowhere in the world is the business cycle dead—no matter what label is championed to describe a country’s economic system. In fact, several such macro slowdowns have occurred in China since the advent of its reform era.
Huge changes in share values on China’s stock exchanges have also previously occurred. But now not only are they coming at the same time the economy is significantly softening after a long run of tremendous growth, but also following an unprecedented, dramatic increase in both the extent and intensity of the Chinese population’s participation in stock buying.
Most importantly, however, they are occurring as the confluence of many long-standing fundamental contradictions of the Chinese reform program are being further exposed, driven, in part, ironically, by Xi Jinping’s campaign to root out corruption and instill greater transparency in domestic economic relations.
All this is not being lost on China’s citizenry, business community, government technocrats and People’s Liberation Army. Notwithstanding the country’s strong nationalistic feelings, going forward the risk of loss of confidence in the leadership’s ability to manage—indeed perhaps even unwind—some of the more pronounced contradictions successfully may not be trivial. There has long been a nagging feeling by some China observers that, all told, these contradictions may well reveal an economy built on a house of cards. An exaggeration to be sure, but not wholly out of the realm of possibility.
So what are some of the more worrying contradictions?
Arguably the most subtle is that while the Chinese leadership has been very visibly intent on trying to reorient the economy to be driven by consumption rather than the country’s long-standing compulsion for saving and investment, the fact is that the economic and political lifeblood of China remains highly dependent on continued, if not accelerated, investment. Investment for what? To ensure the state remains front and center in the economic sphere by propping up SOEs and the four nationwide state-owned banks.
Just as the SOEs still dominate–implicitly, if not explicitly–China’s real sector, the four banks command the country’s financial sector. The dirty little secret in China, however, is that these banks have been technically insolvent for much of the past two decades, with the government bailing them out several times over that period with huge infusions of foreign exchange. It is only a bit of an exaggeration to say that China’s state owned banks pretend to lend money to the SOEs, and the SOEs pretend to pay back the banks.
Less subtly, China’s (or any country’s) pursuit of performance from such enterprises and banks to be in line with that typically engendered by privately owned, commercially oriented businesses is a very tall order, if not pragmatically close to impossible. The conflicts of interest of having the state taking on both the roles of owner and provider of oversight are just too rife. In the Chinese context, this has been referred to as “fuzzy property rights”.
There’s no denying that throughout much of the past decade the rapid growth of China’s ‘non-state’ (that is, ‘private’) firms has greatly diminished the overall share of traditional SOEs in the economy, whether measured in terms of output, investment or employment. And it has been no secret that for more than two decades China’s SOEs have grossly underperformed their non-state counterparts in terms profitability, productivity, and innovation.
But China’s authorities actually have little interest in a private sector that provides a direct path to growth. Rather, they have seen to it that the country’s SOEs proactively retreat from low-margin sectors (such as textiles, furniture and food), ceding those industries to non-state firms, while maintaining, indeed strengthening, the role of SOEs in the capital-intensive “backbone” sectors of the economy (such as oil and gas, minerals, banking, telecommunications, electric power, transport, chemicals and machinery) and continuing to nourish them to be world-class competitors in global markets.
Indeed, it was announced in the mid-1990s that Beijing’s policy towards SOEs was to ‘grasp the large and let the small go’. Today, Chinese SOEs are much larger and more capital-intensive than ever. In recent years, the average SOE has employed five times as many workers, produced eight times the output, and utilized fifteen times the assets of the average non-state firm. And three years ago, 54 of China’s largest SOEs were members of the Fortune 500; and the country’s largest SOE occupied the number 5 slot on the list. Two and half decades ago, none were on the list.
The shrewdness of China’s policy-makers goes even further: the leadership has been deliberately cultivating the private sector as a way of providing SOEs with competition as a cost-effective way for them to develop sharper elbows. Why use Beijing’s investable resources for this when the private sector will do it as a matter of course?
In this regard, most outsiders read too much into the November 2013 Third Plenum statement that the market “must be the decisive factor in determining the allocation of resources”, believing this signaled the demise of the state sector. Although worded as elegantly as a passage in Paul Samuelson’s classic textbook, Economics, the fact is that today, two years later, the leadership’s inaction on this matter suggests a misreading of China’s tea leaves.
And more recently, great attention is being given to Beijing’s contemplation to allow the country’s private firms to invest in the SOEs. But a careful reading of the situation indicates that only minority shares would likely be on the table. This is not a privatization scheme. In fact, the state—and the Party, to which Xi has been actively giving new life–will still very much call the shots.
As to China’s stock markets, throughout the world effective exchanges are based on transparency of transactions, integrity of information flows, and stable and well-specified enforceable rules of the game. These are largely missing in China. Yet the country’s leadership has been opening up access to the stock markets at a furious pace in order to pacify the population so it feels it is able to share in the economy’s growth in some fashion. The number of traders has exploded, with many freely admitting that they engage in transactions based simply on hearsay or from informal tips from friends and family members. This is why observers increasingly liken China’s stock markets to casinos. At the same time the number of enterprises listed on the exchanges has leapt. Between 2000 and 2013, the number of listings more than doubled, from just over 1000 to about 2500.
This is why Beijing in recent weeks has had little choice but to prop up share values (as it has done in the past). When a government does this, why even pretend to call these stock markets? No doubt, this is the most glaring of China’s economic contradictions. Worse still, this is a loser’s game. At some point, resources will either have been exhausted or they will be taken away. In the meantime, China’s leadership is treating the stock markets as ‘too big to fail’ and committing moral hazard, which only creates stronger incentives for the Chinese people to continue to buy in.
This is the real knife edge: while the leadership professes it wants the population to believe in markets, having the state jumping in and out of the marketplace to attempt this to happen is simply tautological.
Back to those chickens, seemingly intent to roost: should the Chinese continue to put most of their eggs into a state-owned basket?