China’s Government Keeps Afloat Money Losing Corporations With Easy Credit Much of China's economy is now inefficient. Fake statistics and "political " loans hide the truth

By Paolo von Schirach

July 23, 2013

WASHINGTON – Imagine for a moment that penniless Detroit had not been forced into bankruptcy. Imagine that, as Detroit finances were getting worse, a year or two ago the Federal Government had decided to step in with a combination of “economic development grants”, tax holidays and long term loans at well below market rates. Well, today there would be no headlines about bankruptcy. Detroit would still be doing poorly, with little chance of a real turn around. But we would not be reading about the largest municipal debacle in US history. 

Cheap credit hides losses

Let’s shift scenarios. Imagine large Chinese state-owned corporations, (SOEs), that are doing poorly because their profit margins are shrinking as their export markets in the USA and Europe are no longer generating demand. The SOEs, if they behaved like normal Western corporations, would fire workers, close down factories, downsize, try to innovate and survive. If, despite their best efforts, they could not cope, they would have to declare bankruptcy.

This may be the case in America, a country in which you can succeed beyond imagination; but where you also have the “right to fail”. But in China different rules apply. We have to keep in mind that Chinese SOEs are at the same time economic and social entities. They make things; but they also provide employment, hence a measure of social stability, a most precious asset for the Communist Party in power, and willing to do whatever it takes to stay in power.  

Therefore, if a Chinese SOE is in trouble, it will go to a state-owned bank and it will have no problem getting easy credit. With this fresh cash in hand it will keep factories opened and workers employed, even though the business prospects look lousy. Well, but what if its products are no longer competitive? Very simple, the SOEs will sell below cost. But how can this be? How can banks keep pouring good money into uncompetitive, money losing companies?

Subsidies are normal

No problem, really. China’s Government can and will do this. Remember that SOEs are only accountable to political authorities and not to private shareholders. While they are economic entities, most of all they are part of the larger political apparatus. They are arms of the state. And the state-owned banks, for the time being, have all the cash the SOEs may need to stay alive.

Indeed, over a period of 30 years, a period in which most Chinese corporations –public and private– won foreign markets on the basis of their extremely low prices, (due to unglamorous cheap labor), vast cash reserves were accumulated. This huge cushion can now be used to subsidise inefficient producers. In the meantime, China’s GDP numbers will keep going up; even though some of the production counted does not amount to new wealth.

More and more construction

Likewise, in order to keep people employed, China continues to invest in construction and infrastructure, even though, because of massive over investment, now there are diminishing returns. This economic growth policy based on large scale over investment makes no economic sense. True, but once again in China efficient capital allocation is secondary. The top priority is to keep people employed, while at the same time impressing the world with still exceptionally high GDP growth figures.

Well, I do not want to give the impression that China is all fake. But there are more and more signs that a lot of its economy is indeed fake.  

Cheap labor advantage, a thing of the past

Cheap labor was an exceptional advantage that China exploited to the fullest extent for 30 years. But it is now evaporating. China’s labor is getting more expensive, while many US factories are reducing the relevance of labor costs (hence China’s low price advantage) through increasing automation, while American producers now benefit from exceptionally low energy costs, thanks to cheap electricity generated by abundant domestic shale gas. 

In the meantime, the Chinese Government, while allowing private enterprises to grow and flourish, kept alive inefficient SOEs that add little value, while in some cases they only consume resources, because they lose money.

The end of the Chinese miracle

As I said, China has huge cash reserves. So it can afford to subsidise even large economic inefficiencies for the sake of social and political stability. But this means less real growth and weaker foundations for future prosperity. To keep things in perspective, China is not about to fall into any abyss. There is no catastrophe ahead. 

But there will be a real slow down. For the time being, through fake statistics and window dressing, the Chinese leadership can hide the truth. But not for much longer.

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