China’s immense promise will not be fulfilled, thanks to its government

I was recently asked the following question. Will China be the future engine of global economic growth? The answer is no. Almost every economic forecast predicts China’s economic growth in every area and places it in the forefront if not the top spot as a global economic superpower. However, every economic forecast at some point will be wrong and sadly China’s immense promise will not be fulfilled.

The reason is simple, China’s government. Its government and the communist party have no intention of giving up power. This is hardly surprising. What political party would voluntarily give up power? But political power is only part of the problem. The real problem is that the communist party does not want to give up economic power. China is still not a market economy. As long as the communist party remains in power, China will not be a market economy and that is why it will not fulfill its promise.

Let us start with something simple, information. Markets are about choice. To make a good choice, whether it is a car or an investment, requires good information. In China information is restricted and tightly controlled. The government believes that it understands the difference between important and dangerous information and that it always has access to both. It doesn’t.

Information has enormous value. It is not provided except for consideration or because there is an enforced legal requirement of disclosure. In societies with protected speech and free press, it is often difficult to cover up fraud, corruption, misdeeds, and even mistakes, because there is a market for their disclosure. In China and other restrictive societies the flow of information is severely regulated if not totally curbed. As a result everyone from investors to consumers and even bureaucrats do not have timely, accurate and complete information. The result is that investors make inefficient allocations of capital. Consumers buy poor sometimes even poisonous products and government officials make and execute ill-informed decisions. Over time the result of this information control can be disastrous.

The second problem is the banking system. In China almost the entire banking system is in the hands of the State. As we saw in the past year Chinese banks lent an amount equal to $1.4 trillion, which any sane economist would question. Much of this money was lent to local governments and other State-owned companies, all political entities. During this spree about 20% of the private export sector went under and another 20% was in danger of doing so. While inefficient State-owned companies were given more money than they knew what to do with, the more efficient private sector, which is responsible for much of the employment, was systematically starved for capital.

The result is two-fold. More of China’s economy has been transferred from the efficient private sector back into State hands. Economic development and economic growth is based on productivity growth. Productivity growth requires gains in the efficiency with which capital, labour and technology are used in an economy. More output from a given input. The Chinese banking system impedes productivity growth; because it has failed in its role as a financial intermediary by allocating capital inefficiently, while restrictions on information impede productivity growth through technological inefficiency. Restrictions also fail to provide a free exchange of ideas and protection for intellectual property.  
 
The second problem is that much of the money lent by the banks will never be repaid. Many of the bad debts left over from the last recession are still on the books of the banks and listed as part of their capital. The bad loans from this recession are sure to be enormous.

Much of the money that was lent was lent to local governments. According to Victor Shih, a professor at Northwestern University the amount of bad loans could be as large as 11 trillion yuan, or about $1.6 trillion.

Toxic assets normally indicate the potential for a banking collapse followed by an explicit bailout often with taxpayer dollars. In China this does not happen, but it does not mean that growth will not be affected. As Professor Pettis of Guanghua University points out, a banking collapse will not happen in China because they are the result of a liquidity crisis. This does not mean that toxic assets will not affect growth. “The bailout implicitly requires that bank depositors subsidise the cleaning up of the banking industry. This in effect represents a large transfer of income from the household sector to the banks, to government and to businesses, equal annually to several percentage points.”

To continue growing China must either continue to export its surpluses or rebalance its economy in favor of consumers. It cannot do the former in a world awash with debt and it cannot do the latter with a system that favours banks, government and business over consumers.

In China power is wielded by the few without question or challenge. These few have and will continue to reap enormous benefit from the system they created and see no reason to change.

(The writer, William Gamble, is president of Emerging Market Strategies and can be contacted at william@emergingmarketstrategies.com or w.gamble@alrroya.com).