Damage Control Duty for Chinese Officials – 2/26/16

Putting it mildly, China is not doing well. In spite of attempts to control data, China’s situation is clearly dire as shown by the following: its stock market is tanking; its currency is declining and under threat; its leadership’s competence is being questioned; its banking system is being swamped with bad loans and inefficient distribution; its capital is flowing out in hundreds of billions of dollars a month; and its heavy industry and infrastructure, which it has long relied on to drive economic growth, are rife with overcapacity. Air pollution, water pollution, desertification, loss of biodiversity. Rapid population aging, matching Japan in magnitude, combined with a male-skewed gender ratio due to widespread sex-selective abortion. Increasing use of automation onshore by countries that once used offshore labor. Chinese officials have an unbelievable amount of damage control to work on.

Reserves, controls, and other government interventions may protect China from the worst of the first set of problems except doubts about Chinese official’s abilities. For an economy heavily managed by the government, the importance of trust in the people running the government cannot be overstated. To help restore trust after sloppy stock market regulation and currency manipulation, President Xi and the Chinese State Council removed Mr. Xiao from his position as head of the China Securities Regulatory Commission based on such failings as the “circuit breaker” while promising further reforms focused on reducing debt, closing “zombie” business overcapacity, and reducing the housing glut in the many parts of the country where building badly outpaced actual demand.

Overcapacity is a particularly pressing issue for China as it faces worldwide backlash for dumping its supply glut onto other markets which, in turn, consider raising barriers to trade to protect their own domestic industries. Even as internal and external demand shrinks, Chinese production continues to grow. And, as a recent report by the European Chamber of Commerce in China shows, the increased capacity is a terribly inefficient usage of capital. According to the report, the gap between the available capacity and utilization has grown from 0% in 2007 to 13.1% in 2015 for overall industry and much higher for heavy industry. Distortions in the market have been difficult to address in a country where regional protectionism, weak regulatory enforcement, low resource pricing, misdirected investment, inadequate protection of intellectual property rights and an emphasis on market share hinder central government reform efforts.

Although “ghost cities” make for more interesting example of speculative investment, encouragement from the government usually results those cities filling over time in contrast to heavy industry. Massive factories may create the illusion of productivity in a way that empty residential buildings can’t, but heavy industry quickly becomes a money loser when prices fall below break-even levels. Outpacing property in new investment since 2000,  manufacturing of mining equipment and other industrial goods now faces debt overhang that devastates profits as returns on assets of state firms, which dominate heavy industry, are a third those seen at private firms, and half those of foreign-owned firms in China.

In a free market economy, firms would close or consolidate. Cheap credit and subsidies would dry up. Firms would pay dividends instead of ineffectually throwing all earnings at expansion. In China, provincial officials, who control most of the publicly owned firms, oppose such badly needed measures on the grounds of avoiding social unrest from mass firing and the loss of tax revenue needed to pay benefits. The balance between stability and reform will be hard to maintain amid the country’s economic slowdown. Necessary reforms threaten to leave millions jobless during the move from export-driven to a consumer spending- and service-driven economic growth. Distortions caused by cheap credit, price floors, and subsidies flowing almost exclusively to large, state-backed firms  are prime targets for China’s national leadership but province-level administrators are not so easily controlled when their interests are threatened.

Outdated industrial capacity contributes to another major problem in China: environmental devastation. Air pollution in the form of smog is a visible form of the contaminants filling the lungs and lowering life expectancies of Chinese urbanites on a daily basis thanks to the poor emissions control in many coal burning plants and millions of cars. Just as costly, more than half of China’s surface water is too polluted for treatment due to chemical leaks and dumping. Reuters reports similarly disturbing levels of groundwater pollution as well as attempts by the government to cover up the extent of the problem. Desertification due to deforestation and agricultural development has left as much as 1/4 of the nation’s total land surface defined by bare soil and rock, suffering from dust storms, mud-choked rivers and eroded topsoil due to a lack of vegetation.

Exacerbating all of China’s problems is an aging population. Decades under a one-child policy combined with urbanization and modernization, greatly reduced China’s potential workforce in turn making it harder for Chinese officials to meet growth targets forcing them to rely on traditional boosting methods based around throwing money at over-saturated industry and infrastructure projects. Ironically, increased automation might be China’s best shot at replacing the never born workers though more capital-rich countries like the US are better suited. What cannot be fixed with robotics is the societal tensions sure to bubble up as China’s skewed gender-ratio results in a generation full of men unable to find wives creating a social catastrophe on top of economic and environmental ones.

China’s problems are not insurmountable. Sometimes damage control can be an opportunity to make essential changes. Demographics can change, economies can be retooled, and environments can be restored, at least in the long term. Unfortunately, the short term is what we live through and when the world’s most populous nation stumbles it can be devastating. If you have any doubts about that, just check the energy markets to see much pain reduced demand can bring.

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