Is This the China that Can't?

For the first time in more than two years, car sales in China declined in April, recording 1.55 million units, down 0.25 percent over last year against a forecast by the industry of 10 percent annual growth for 2011.

China could be facing a production glut of as many as 10 million cars by the end of this year, according to some estimates, because of the overcapacity built into the system. That is more than the total car production of Japan in 2009. It is at one with massive overinvestment in real estate. The country may have a property bubble approaching 30 percent of its housing. By one reckoning, there are 64.5 million flats with no electricity hookups, meaning they are empty – enough housing to accommodate 200 million people.

It should be noted that China's rush to prosperity in the 30 years since the late Deng Xiaoping reversed Maoist policy, for hundreds of millions of its citizens is real and stunning, and it could well continue for several years. But there are major imbalances growing in the system. China's torrid economic growth over the past two decades appears to have left structural problems lurking behind the facade that spell long-term trouble, according to a provocative report by political scientist John Lee of the Center for Independent Studies of Sydney.

The report, prepared for the Hong Kong-based independent economic research firm Asianomics and titled "China Fail," paints a picture of a country that may soon be going backwards rather than forwards.

Although the west largely stands in awe of a burgeoning country that in the 1990s seemingly discarded the money-losing state-owned enterprises that served as a huge drag on the economy and turned towards capitalism, in fact SOEs have been growing in number and share of the economy. The west mostly focuses on the success of the export sector, which employs some 150 million people, but "the greater contributor to Chinese growth is actually domestically funded fixed-investment which was behind 40 percent of growth in those years," the report says.

Most of that, according to the report, went to state-owned enterprises. There is little reason to suppose they are any more efficient today than they were in the 30 previous years during which they paralyzed the Chinese economy.

The trouble, Lee writes, began with the student revolt in Tiananmen Square in 1989, which actually was a rebellion across many cities in China. At that point, the leaders in the Zhongnanhai compound in Beijing took a look at the collapse of communism in Russia and Eastern Europe and decided that the parties had lost power because the interests of the political elite and the economic elite had diverged and vowed that would never happen in China. In a rapidly industrializing system, the Chinese leaders believed, elites determined the fate of authoritarian governments.

"The great lesson of the Eastern Europe and Soviet revolutions was that authoritarian regimes that become irrelevant to elites do so at their peril." The Chinese would create their own elite, ensuring that the Communist Party remains the dominant dispenser of economic, professional and social opportunity. "In many respects, the report says, "the party has not just co-opted but created the country's middle class elites."

The result is the so-called "Beijing consensus," the state-led approach to development that has produced growth rates averaging 8-10 percent over the last two decades, seemingly outshining the "Washington Consensus" of free enterprise espoused by the International Monetary Fund, the World Bank and the US government.

"In short, Lee says, "the story of China's economic rise since the 1990s is mainly a story about the rise of the 'corporate state' and the emergence of a state-led' model of development – not the flowering of the private sector." Today, the established middle classes – the group foreigners engage with most frequently or exclusively – have become the strongest supporters of the CCP. Of the 85 million CCP members, over four-fifths are China's elites."

A closer look produces an estimate that 1,300 people in China control over US$1 trillion in assets. Victor Shih of Northwestern University, according to the report, contends that 1.5 percent of the population account for 45 percent of the country's bank deposits and 67 percent of managed assets.

While critics have been looking at the stagnating lower classes in the United States, alarmed at the vast wealth being amassed by hedge fund managers and investment bankers, China's Gini coefficient, which measures income inequality, is worse. With zero representing perfect equality and 1 perfect inequality, China's Gini coefficient has deteriorated strikingly. From 0.25 in the 1980s to 0.39 in the 1990s, it is now 0.57, the same level as Brazil's. In India the Gini coefficient is 0.37, the US is 0.43, Japan is 0.38, and Russia is 0.42.

In fact, despite the picture of a constantly enriching population, "the accumulated findings of various studies suggest that the disposable income of some 400 million Chinese has actually stagnated or gone backwards over the past 10 years – a combination of inflation in addition to the cost of health and education provision. Other studies suggest that absolute poverty (which we would define as those living on less than US$2 a day) has actually increased over that period."

Those living on US$2 a day or less are estimated at 50 to 55 percent of the population while incomes in the state corporate sector have been rising by 15 to 30 percent over the last decade. The poor are becoming increasingly restive, partly because an estimated 40 million people have been dispossessed of their land without compensation in the past two decades by government officials wanting it for other purposes.

Reported instances of social unrest involving 15 or more people against the government numbered a few thousand in the early 1990s. They had grown to 124,000 in 2009. NGOs in Hong Kong and on the mainland believe they could number as many as 300,000 annually, with some involving protesters in the tens of thousands, most of them in the rural areas.

That does not hold true for those benefiting from the state. The numbers of bureaucrats on the state payroll jumped from fewer than 20 million in the 1980s to 46 million by 1994 to somewhere between 50 and 55 million today. A vast fleet of 2.5 million state cars, paid from the public purse, is available to them. Local officials have spent an estimated US$80 billion each year on overseas trips, banquets, travel and other entertainment. In addition, the government spends about US$200 billion on health care for bureaucrats, compared with only US$50 billion to US$60 billion spent on rural health care for its 400 million rural citizens. In fact, Asianomics says, "the state-led approach is actually stifling entrepreneurialism throughout the country.

Prior to 1989 the unplanned spontaneous explosion of private initiative in rural China – fuelled by limited land reforms – was encouraged by officials and even supported by government policy." Farmers were encouraged to make their own decisions for how they wanted to use their plot of land (even if it was still owned by the state) and allowed to sell their produce at market prices after meeting production quotas. Under the stewardship of local officials who facilitated private rural initiative, total factor productivity in agriculture and related sectors doubled over the next 10 years.

That, the report says, has stagnated. Even though SOEs produce only 25-33 percent of all output in the country, they receive more than 75 percent of the country's capital. SOEs received well over 95 percent of the recent stimulus funds loaned out in during the global financial crisis of 2008-2009 and an estimated 85 percent in 2010.

"It should come as no surprise that surveys of Chinese private-sector firms consistently reveal 'credit and capital constraints' as the most formidable barrier to corporate expansion. Even very successful private small and medium enterprises tend to flat-line at around 30 employees since relying on informal finance (e.g., savings of friends and family) has limitations. Imprecise but ball-park data suggests that the Chinese state sector now owns over two thirds of all fixed assets in the country."

That is almost a direct reverse of what occurred in China during the first 10 years of reform when the majority of new fixed assets were effectively controlled by the private sector.

Unfortunately most of the SOEs don't make any money. Some giants such as Sinopec, China Mobile and China National Petroleum make enormous profits each year in near-monopoly environments in which they enjoy privileged access to capital.

However, around 80 percent of the profit, the study found, is made by fewer than a dozen of the 150 major SOEs and 120,000 smaller ones.

"The performance of the locally-managed SOEs is even more abysmal," the report says."According to our analysis of consolidated estimates of various case studies, 19 percent of state-controlled enterprises were unprofitable in 1978, 40 percent were unprofitable in 1997, rising to 51 percent being unprofitable in 2006.

"A conservatively estimated 40 percent of bank loans to these entities are extended on a 'policy' rather than 'commercial' basis while most loans to state-controlled enterprises are afforded artificially low interest rates. Banks are effectively fulfilling the political priorities of the government through their 'policy-lending' function: to maintain jobs for state-controlled enterprise workers who are the party's most loyal supporters; to maintain support for state-controlled enterprise managers who are core party members and supporters, and to maintain growth in 'middle class' and urban areas at any cost since the Party needs the continual support of the new and emerging middle classes in order to survive."

Since 1995, the report continues, bank profits have been overwhelmingly the result of massive loan growth, combined with increasing spreads between the lending rate and the returns on deposits.

"Using the example of an on-demand savings account, there was virtually no spread in 1995. In 1996, it was less than 0.5 percent. In 1998, it increased to 2.2 percent and increased to 3.5 percent in 1999. It has since remained between 3 and 3.5 percent. Indeed, net interest income accounts for 80-90 percent of overall bank profits in China."

Saving the Chinese banking system in the 1990s and the first half of this decade was a hugely expensive exercise, costing perhaps as much as US$300 billion as junk assets were transferred from the banks to asset management concerns. Few, if any of the assets were worth anything at all.

"The process of transferring wealth from depositors to banks has resulted in the private-consumption share of GDP declining from 45 percent in the late 1990s to 35 percent now." The report says." If the latest round of state-directed lending has resulted in yet another catastrophic future bad-loan problem, the bailout process is likely to be much messier and much more attributable to the central government's balance sheet."

It is believed that nonperforming loans in the banking system range anywhere from 40 percent of annual GDP to more than 100 percent. The loans pumped into SOEs since the onset of the global financial crisis in 2007-2008 may well have created an NPL crisis as big as the earlier one.

"Although the country is increasingly blessed with excellent economists and technicians who are well aware of China's economic problems and how to fix them, the barriers to the necessary reform and fixes are political rather than economic or technical," the report says. In the face of the problems, "China's leaders are exhibiting signs of policy paralysis rather than dynamism and competence."

Thus any mention of a Jasmine revolution in China, no matter how mild, is being met by a strict crackdown by leaders frightened that political freedom could ignite a firestorm.