Production efficiency is key to maintaining China’s economic growth

Kim Eng Tan, Standard & Poor’s senior director of sovereign and international public finance ratings, explores some of the issues that will influence China’s economic growth prospects.

Is China’s rapid economic growth coming to an end after three decades of reform and openness? Although some commentators certainly read the signs that way, others aren’t so sure. Indeed, Standard & Poor’s Ratings Services still sees scope for improvements in the country’s hard-earned productivity if the country removes a series of obstacles standing in its way.

Why are there increasing concerns of a sustained Chinese economic slowdown?
China is alone among the largest economies expected to produce strong economic growth in the next few years. Therefore, if China’s growth during the next few years falls much below current expectations, it is possible that the global economy could move into a new recession. History gives rise to concerns that China’s strong growth might not last. Developing economies’ growth rates have often slowed to moderate levels after an early spurt in their development. For many countries, the deceleration was steep and sustained enough to prevent them from reaching developed economy status — a phenomenon known as the “middle-income trap”.

Why does China stand a better chance of avoiding the middle-income trap than some other developing economies?
For many years, China’s spending in infrastructure and other types of investment has been proceeding at a rate that is far higher than any other major economies. These investments lay a strong foundation for economic growth. During the past two years especially, the government has sped up public infrastructure works — such as roads and power stations — to expand urbanisation and improve connectivity. Such investments raise productivity and expand consumer choices.

Together with a high literacy rate and ample domestic savings, these investments have also helped China avoid growth bottlenecks that constrain countries such as Indonesia and the Philippines. Some observers question whether such investments have proceeded with excessive haste or pay adequate attention to environmental impact and safety. Nevertheless, we believe that the highways, railways, power stations and urban facilities built in recent years have made important contributions to China’s economic development.

What obstacles stand in the way of China sustaining high single-digit real GDP growth rates?
If Chinese policymakers have moved too fast on infrastructure improvements, the opposite can be said of efforts to remove other barriers to productivity. Parts of China’s export sector lead the world in efficiency, helping to make it the largest exporting country. However, China’s domestic industries are still much less efficient than the export sector. This issue has constrained the growth of household income and distorted income distribution, constraining domestic consumption. We mainly attribute such underperformance to policies that create economic distortions and hinder the efficient allocation of resources among industries. Price controls, government involvement in business, and un-coordinated regulations drag down productivity in many of China’s industries.

Why would cheaper electricity and water tariffs weaken economic growth?
Chinese central and local governments still heavily influence electricity tariffs and water charges, and, until recently, oil prices. The National Development and Reform Council (NDRC) sets electricity tariffs across the country. Local governments, meanwhile, set most water charges. The government-set utility prices often don’t reflect the balance between supply and demand for resources, leading to economic distortions. In recent years, government-regulated tariffs haven’t been steep enough for many power producers to cover their costs due to high coal prices. Most water supply companies, meanwhile, either make uneconomical profits or are losing money. The situation discourages efficient profit-driven firms from entering these industries.

The imbalance between supply and demand also leads to inefficient production behaviour. Underpricing power and water resources gives businesses and households little incentive to invest in power-saving equipment. On the contrary, it could encourage resource-intensive industries that are unsuitable for China. For instance, China is the largest source of imported steel pipes in the US, even though it seems unlikely to have strong competitive advantages in this industry. China is a large net importer of iron ore from distant Australia, and the US is just as far from China. The steel industry is also highly capital intensive. It seems that the main advantage of Chinese producers is their artificially cheap electricity.

Why would better co-ordination between Chinese policymakers lower business cost?
Some current policies are also not well coordinated, leading to inefficiencies. Different rules relating to cross-provincial or cross-regional domestic trade set by different local government sometimes raise the costs of transporting goods within China. For instance, goods may sometimes need to be unloaded and reloaded at regional borders. This slows the movement of goods and increases costs. Meanwhile, the government has granted many export-oriented manufacturers tax and other incentives to base their operations in China. However, these incentives also mean that export products cannot be sold in the country since they would give the exporters cost advantages over domestic producers. To circumvent this restriction, many producers send their goods out of the country before re-importing them for sale in China. The result is that China-made products are sometimes cheaper to buy in Hong Kong than in China.

How does state-ownership affect enterprise productivity?
In principle, government ownership is no different from private ownership if the firms concerned operate along commercial lines. However, the long history of central economic planning in China means that this is not always the case. Despite the country’s move toward a market-based economy, many state-owned enterprises (SOEs) continue to put policy objectives at least on par with their commercial aims.

Profitability, for instance, often ranks behind policy considerations. Despite the losses they sustained, many local government-owned coal-fired power companies continue to increase output. They view supporting the local economy and ensuring social stability as being more important than financial sustainability in a commercial sense. Indeed, some power companies were reportedly charging key industries even less than the already low tariffs that the NDRC mandated.

Local governments can also stand in the way of much needed consolidation in some industries. Several Chinese industries — such as highway construction, utilities and cement production — are highly fragmented. Many firms in these industries are small and lack economies of scale. However, local governments that own many of these firms have stymied central government policies to encourage consolidation. The latter fear losing control of vehicles that could help them attain their development objectives, even if such consolidation makes sense from a national standpoint. Consequently, local governments continue to support these firms with financial and non-financial means, even if they perform poorly in a commercial sense.

Do the prevalence of state-owned enterprises negatively affect private sector firms?
The weak financial performances of local SOEs give rise to more economic distortions. To protect these companies from stronger competitors, many local governments practice regional protectionism. Tactics to achieve this include ensuring that a certain amount of profitable government projects go to their SOEs regardless of how their performances compare with competitors’. Governments sometimes use their regulatory and other powers to put the SOEs’ competitors at a disadvantage.

Government support for SOEs often has an indirect negative effect on the private sector as well. Commercial banks typically prefer lending to SOEs due to the government backing for these firms. This saves them the cost of investing in credit assessment and management capabilities required for lending to private businesses. Consequently, private firms without good collateral (typically land) are often credit constrained.

What if the obstacles that hinder China’s productivity are removed?
Removing obstacles such as price controls, government involvement in business, and un-coordinated regulations could help to extend China’s record of high single-digit growth for several years more. Strong and consistent economic growth could also improve the sovereign credit rating on China (AA-/Stable/A-1+; cnAAA/cnA-1+). The main risk to growth is that China doesn’t address the obstacles to productivity. It has yet to implement many reforms, partly because they undermine the interests of key social or political groups. The central government is likely to face strong resistance to certain changes. If the result is little or no progress, China’s economic growth over the next five-to-10 years could slip from the levels to which it has become accustomed.

A longer version of this article was published in Standard & Poor’s Global Economic Outlook special report. Individual articles on the economic outlook for Korea, India, Asean, Japan and Australia are available by clicking here.

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