Chinese walk past an
advertisement for a foreign auto maker on a wall on Oct. 27, 2014 in
Beijing, China. The Chinese leaders economic reform plan face several
structural obstacles. (Kevin Frayer/Getty Images)
Experts are predicting that China’s economy is going to
enter a period of prolonged recession. Without doubt, the Chinese
economy is encountering unprecedented difficulties. Similar problems
have cropped up over the past several decades, and various remedies have
been applied, with the most common solution being increased lending and
government investments. This approach is now more and more ineffective
as returns on investment has declined sharply. In this economic
environment, the top-level strategy has changed and is focused on
solving problems on the supply side rather than the demand side.
Here’s the logic: If the Chinese economy has slowed due to lack of
demand, then a quantitative policy on the demand side—increasing money
supply—might solve the problem. But if the slowdown is structural and a
result of inefficiency, increasing money supply won’t help.
From a structural point of view, we see supply-side issues behind the
weak demand. And these supply-side issues, in turn, go back to deeply
rooted institutional problems that include production, consumption, and
national savings. In my opinion, these are the three major obstacles
China’s supply side reforms are facing, and they are the root cause of
major distortions in the supply and demand structure of the world’s
second largest economy.
Low Consumption
In a society that is polarized between rich and poor, extreme income
inequality often leads to a false picture of prosperity and distorted
supply and demand. A typical example is China’s real estate market.
Speculative real estate investments by the rich have pushed up overall
housing prices to the extent that houses are unaffordable to the poor.
Additionally, unrealistically high real estate costs have added pressure
to the purchasing ability of the poor not only in houses, but in other
areas as well.
According to the Chinese Academy of Social Sciences’ 2016 Blue Book,
the top 1 percent of Chinese households now possess 33 percent of the
country’s wealth, while the bottom 25 percent of households only own 1
percent.
With China’s high population and per capita income reaching
mid-to-high levels, why is there insufficient domestic demand and hence
strong dependence on overseas markets? One reason is China’s large
income disparity. While a small fraction of Chinese live like people in
wealthy countries, most have a living standard similar to people in
developing and poor countries. This large income inequality is the cause
of low internal consumption and serious distortions in China’s economic
structure.
Capital Mismanagement
In recent years, China’s financial sector experienced an oversupply
of money and extraordinary credit growth. New RMB loans during this
year’s Q1 period are expected to reach 4.3 trillion yuan (US$653
billion), a record high. The ratio of M2 to GDP quickly climbed to 205.7
percent. In short, money supply is increasing at a pace far beyond the
economic growth rate.
At the same time, economic growth keeps declining and credit funding
is not able to flow into the real economy. Many enterprises that need
capital can hardly obtain a loan from banks, while others, especially
state owned enterprises, have banks lining up to provide capital. Why?
One answer is that a lot of money deposited in financial transactions
never enters the business entities. Where does it go, then? There are
two significant destinations for new money. The first is to maintain the
debt cycle and Ponzi financing by mainly paying off old loans with new
loans. The second destination for surplus money has been the stock
market bubble from 2014 to Q1 of 2015; and in Q2 of 2015, excess credit
pushed up the first and second-tier cities’ housing bubble.
The current finance structure, capital flows, and liability to asset
ratios indicate that local financing platforms, real estate, and the
oversupplied heavy chemical industry are the “black holes” swallowing up
funding. Eventually this capital will turn into hard assets that will
continue to consume resources, relying on more debt turnover, becoming
part of the “Ponzi finance” pattern.
Rising Costs
Huawei recently caused an uproar when it moved its handset production
headquarters out of Shenzhen. Perhaps this is merely an example of
production chain restructuring. But the outside world looks at it as a
sign of economic woes—namely high rental costs causing enterprises to
leave first-tier cities. Actually, the high cost of living has not only
pushed Huawei out of Shenzhen, but many other companies, along with the
entire real economy, have also left.
Housing and rental costs are base expenses in supply and industrial
chains. Labor, logistics, warehousing, and other costs are also closely
related to it. Rising labor costs, factor costs, and financing costs are
among the biggest challenges Chinese enterprises are facing. Labor
costs have increased 79 percent, financing costs 66 percent, and factor
costs 54 percent, according to the 2015 National Report on Company Expenses.
China’s high growth model of the past 20 years that included
large-scale investments and high demand was able to cover cost increases
on the supply side. But with economic growth slowing and PPI dropping
47 consecutive months, rising costs have become the biggest constraint
on China’s economy.
In Western countries, a real estate bubble is mainly reflected in the
financial market and has a limited negative impact on certain
industries. However, the situation in China is completely different. A
highly inflated real estate market not only kidnaps banks and the entire
financial system, but also fundamentally changes the ecological
environment of industry and the nation’s entire economic development.
Think about it: while the manufacturing sector struggles to maintain
an average 3 percent profit margin, those in real estate and finance can
easily earn 30 percent on their money. This kills, or at least
undermines, the mindset of entrepreneurs who are in it for long haul.
When speculation in real estate, stocks, and other financial assets can
reap such huge profits, nobody wants to invest and work in the real
economy. This is the true reason why capital does not flow into the real
economy. If supply-side economic reform does not solve these issues,
the Chinese economy will just dry up, with nothing but a bunch of empty
slogans.
Editor’s note: The term “supply-side reform” has been stressed
as a central component of Chinese leader Xi Jinping’s economic reform
plans since last November. Since May, Xi appears to have been sending
clear signals, whether in his speeches or through headline articles in
state media, that local officials have placed insufficient emphasis on
these reforms. Apart from bureaucratic intransigence, there are major
structural obstacles in the Chinese political economy for these
supply-side reform measures. The Chinese economist Fan Di discusses them
in this article.
Fan Di is an independent economist and part-time professor at
Peking University and Sun Yat-sen University. He obtained a Ph.D. at the
University of California–Berkeley, supervised by Li Yining of Peking
University and Nobel Prize winner George Arthur Akerlof. Fan has been a
senior executive and consultant at major banks, financial firms, and
large companies. A version of this article was first published on his personal blog.
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