About China’s capacity to absorb more capital

About China’s capacity to absorb more capital

Kate Mackenzie | May 22 10:30 | 42 comments | Share

We’ve all heard, many times, the story that China’s capital stock is nowhere near that of more advanced economies, therefore it will inevitably increase. And we can count on continued efforts to build roads, buildings, airports, and other infrastructure — just look at how the less-developed eastern provinces have been pouring money into new projects, the argument has gone, more recently. Or went. We really hope it’s not necessary, here, to go into the weaknesses of that argument. Here are a few places to start, but it’s partly a causal problem — does growth cause increased capital stock or vice versa? What kind of growth are we talking about, anyway? Fine. But surely investment is still a net positive if it creates infrastructure that people will actually use, sooner or later? Leaving aside the question of financing burdens, we’ve struggled here with the idea that there’s ‘bad’ and ‘good’ investment. How does one know, in the short term, which is which?We looked at this a bit in April, partly drawing on a Michael Pettis note, and an IMF report he mentions. Short version: Yes, every country should ideally have enough capital stock to facilitate an excellent standard of living for all. However, just building lots of infrastructure and apartments doesn’t make a country ‘developed’ or enable its people to lead developed economy-type lifestyles. The reason for this is something Pettis (among others) call ‘social capital’, and it includes institutions, the legal framework, social trust and other somewhat nebulous concepts. Fortunately Pettis’ latest note goes into it in more detail on what exactly he means by ‘social capital’, drawing on some historical examples and how they might relate to China.

To me one of the most obvious pieces of evidence that it takes a lot more than increases in capital stock to achieve sustainable wealth is the experience of previously advanced economies that have been laid low by war. It is noteworthy that – excluding trading entrepôts like Hong Kong and Singapore or small, commodity-rich entities like Kuwait or 18th Century Haiti – very few poor and undeveloped economies have made the transition from poor to rich. The exceptions may be South Korea and Taiwan, both under very favorable circumstances during the Cold War. “Poor” but advanced countries, however, like Belgium and Germany after WW1, or Germany and Japan after WW2, saw their GDP per capital soar after devastating wars as they made the transition from newly poor to rich with relative ease.

The reason, it seems to me, is that although war may have destroyed physical capital in these countries, because it did not destroy social capital these countries were able sustainably to increase investment at a rapid pace after the war and see their per capita incomes soar permanently. Why is this so easy for advanced economies made poor by physical destruction of their capital base but so hard for developing economies?

The most plausible reason I can think of is that the advanced economies already had in place the institutions that allowed them to exploit investment fully, and so once they were able to increase capital stock, they quickly became rich again. This argument is reinforced, I think, by the well-known fact that most cross-border capital flows (over 90%, I think) are to rich countries, not to poor ones. This wouldn’t make sense at all if rich countries didn’t have a greater ability to absorb new capital efficiently and profitably than poor countries. If what mattered on the other hand was distance from the capital frontier, the further a country was from that frontier, the more profitable it would be to invest there, and so more capital would flow to poor countries rather than to rich countries. The opposite is true.

So what kinds of institutions might matter? Economies with clear and enforceable legal systems, to take one factor, tend to have higher levels of social capital because it is much easier for entrepreneurs to take advantage of conditions and infrastructure to build profitable businesses. Without a clear legal framework, business opportunities tend to be monopolized by entities that have the political clout to take advantage of the legal system, and not only is it not obvious that more powerful entities are more economically efficient, but in fact the opposite may be true – these are what Acemoglu and Robinson call “extractive” elites.

Pettis examines the question of ‘extractive’ elites; crony capitalism, etc:

There are many social and political reasons to be concerned about the various characteristics of what is often called crony capitalism – corruption, guanxi, nepotism, limiting access to credit to powerful insiders, protecting national champions from more efficient competitors, etc. – but the important point in our context is that because they limit the ability of economic agents to take advantage of the benefits of capital stock by heavily tilting rewards towards agents that can play the political game better rather than towards those that can play the economic game better, they undermine the economy’s ability to absorb high levels of investment. The purpose of investment, in countries with high levels of crony capitalism, is often not to maximize productivity but rather to reward political access, and so agents that can exploit capital stock more efficiently are undermined in their ability to do so.

This is not to say that crony capitalism cannot deliver growth. Clearly it can. But I would argue that it can deliver growth only when the interests of the elite are correctly lined up with growth. So, for example, I would argue that in the early stages of reform, especially in countries that have suffered many years of terrible economies and weak investment, crony capitalism can be consistent with high levels of growth because the kinds of programs that lead to growth – mostly massive investment programs in countries in which capital stock is excessively low – benefit the elites directly. Once there is a divergence in interests, however, crony capitalism can become inconsistent with rapid growth.

Beyond that, Pettis suggests things like education matter, and social trust (he thinks it no accident that Quakers were key players in Britain’s industrial revolution — their creed of honesty made them attractive targets for business relationships.)

There are other constraints specific to China, such as the ‘hukou’ household registration system. Stephen Green from Standard Chartered (a respected China analyst and somewhat more optimistic than Pettis) wrote an excellent list of the sorts of reforms China needs to undertake. It’s worth a look.

 

China’s (not remotely insignificant) rebalancing challenges

Kate Mackenzie

| Jan 09 11:24 | 10 comments | Share

A great new year piece from Standard Chartered’s China economist Stephen Green. The country’s economy, he writes, is “running along at a reasonable pace” as 2013 begins. But potential growth is already sliding, he says, and clouds are gathering…

We all know that China’s current growth model is not sustainable. It is not going to collapse tomorrow, but there are clearly problems with it – and we believe those problems have gotten worse in the past couple of years.

The imbalances are not just rich/poor, rural/urban, and east/west, writes Green. There are four key dynamic imbalances affecting the country:

1. The current urbanisation process

2. The current investment/financial model

3. Relationship between the government and the services economy

4. Government’s role as both growth facilitator and interventionist

The first point — urbanisation — we wrote about here. This alone is a huge problem: many of China’s internal ‘rural migrants’ contribute their labour, but due to birthplace-related restrictions on their access to welfare, they’re unable to fully participate in an urban, consumer economy.

Most of you will probably be familiar with the second point about the investment model and the financial sector.

What about the third, then — “relationship between the government and the services economy”? Green explains this is key to building a large middle class:

The urban residents who form the middle class have money, but now they want to buy quality services. They are concerned about food safety, corruption, health and education for their children – all the things that the government, which is very efficient at taking land from farmers and building infrastructure, is not yet very good at delivering.

As for the fourth point on government role, Green says the government’s interventionist approach has often balanced its unfortunate crony-ist tendencies with support for growth through infrastructure investments and the like. More recently, however, and as the country grows wealthier, the cronyism has tended to outweigh the benefits of interventionism, as a growing number of revelations about high-level corruption suggests.

Green lists a series of reforms he’s broadly hoping to see come into focus this year and next. They sound rather bigger — and certainly more far-ranging — than the ways China could rebalance outlined by Michael Pettis last year.

Green’s suggestions for reform begin with abolishing the one child policy and include instituting a good legal framework, supporting NGOs, allowing citizens to report on corruption via social media, reforming the ‘hukou’ household registration system. We won’t go through them all (the whole note is in the usual place), but you could pick any one of the challenges Green identifies and ponder the momentous political will that would be required to enact it.

Oh, and for finance specifically: Green points out that China’s banks are bailed out about every 10 years and have accustomed to receiving this support, thus raising moral hazard. Furthermore, StanChart estimates the debt-to-GDP ratio, when corporate debt is included, was a whopping 206 per cent in 2012. And Green believes some kind of reckoning is not far off:

[…]we believe it is highly likely that Beijing will need to recapitalise the banking system in the next five years. We believe the NPL problem is already big, resulting from massive infrastructure project lending during the 2008-10 stimulus, and from the 2011-12 downturn. We believe banks are “evergreening” loans to avoid classifying them as NPLs. The scale of the hole will demand either a large MoF bond issue or the use of the FX reserves.

Back to the recommendations. Will any of this happen? This is the point in this China post where we say: we don’t know, and nor probably does anyone else. Green, however, mentioned to us in an email that he thinks the new leadership will need some time to get its bearings — understandably. But he thinks there is some level of political will:

It appears to us that a reform consensus is being built in Beijing around two big ideas that many can unite around. The first is a centre-left focus on putting in place a decent welfare safety net and improving the quality of public services (health and education). This was the broad emphasis of policy in the 2000s. The second is a pro-market emphasis on given the private sector more room to grow, allowing the market to set prices in order to direct resources more efficiently, and reducing opportunities for rent-seeking by diminishing administrative power. This was the general thrust of economic reform policy in the 1990s.

Ideologically, these two agendas can work well together; indeed, they do so in much of the developed world. The big stumbling block, as commentators such as former People’s Daily deputy editor Zhou Ruijin have noted, is interest groups blocking such reforms rather than ideology („新“南方谈话”开拓改革开放新局面‟). As a result, successful reforms will require some serious political manoeuvring. Apart from this, we believe reformers should keep the following principles in mind in order to ensure the success of economic reform.

Look to a big party conference in September/October for signs of advance on these fronts, he writes.