via strtfor:China: Using Political Tools to Fix the Economy
Summary
The Chinese government is trying (and failing) to rein in economically questionable activities that are driving up prices without producing healthy growth. Beijing is discovering that traditional economic and financial tools are not serving it well. Next come the more brutal measures.
Analysis
For years, the Chinese economy's problem has been the irrational allocation of capital. In order to stimulate growth, the government has long artificially suppressed the real interest rates charged on loans from state banks -- often to the point that, once inflation is taken into account, those loans can be repaid for less than they are worth. That encourages growth and development, but not in a sustainable way. Many Chinese firms can only survive so long as that flow of artificially cheap credit is sustained.
Such a strategy has a number of downsides, but the main disadvantage is the rampant proliferation of firms that do not operate at a profit. These firms pile up mountains of bad debts which probably total about half of China's total gross domestic product. Yet, because profit does not matter and capital is easily attained, these firms can afford to expand operations endlessly. This expansion then creates sustained and growing demands from these firms for everything from concrete to electricity. The dramatic price hikes in most commodities on the global market these past four years can be laid at the feet of these noncompetitive Chinese firms and their demand. And of course, we all know how foreign governments feel about credit-subsidized Chinese firms dumping their products on international markets.
China's Politburo is well aware that the core dysfunction of its country's economic model is subsidized credit, and Beijing is trying to root out the problem. There are two ways to do this. The first and simplest is to increase interest rates, which makes firms less likely to take out new loans because they have to pay back more than they borrow.
The second strategy was attempted Jan. 5 when the People's Bank of China, the country's central bank, increased the country's reserve requirement ratio by 0.5 percentage points to 9.5 percent. The reserve requirement ratio is the portion of a bank's assets it must hold in reserve, with the remainder (90.5 percent in this case) available for disbursing to customers as loans. If the ratio goes up, banks have to restrict lending. The theory behind the increase is that banks will only lend to firms with relatively sound business plans (which, therefore, would be able to repay their loans).
Neither step is working. Borrowers remain convinced that the government will bail them out (after all, most of the borrowers are government firms), and without a mindset shift among the borrowers, interest rates hikes have a negligible impact. Similarly, in a system where local government officials often control both the state-owned companies wanting the loans and the state-owned banks making them, adjusting the reserve ratio produces only marginal results. Indeed, rate hikes steadily accrued in 2006 to no result, and the Jan. 5 ratio increase was the fourth in seven months.
This should not come as a surprise to the government. After all, Beijing ordered the suspension of all lending activity for a few days in April 2004, but to no avail. Anywhere else in the world, this would have caused an instant recession (if not depression) -- but not in China. The Chinese economic juggernaut lumbers on, with the country's 33.4 trillion yuan ($4.28 trillion) in deposits providing the fuel for annual growth of more than 10 percent.
Traditional economic policy tools -- whether taxes or regulations -- have minimal impact on the Chinese system. And when economic tools do not work on economic problems, Beijing has no choice but to pull a different policy set out of the toolbox. Rates and ratios give way to purges and prosecutions.
This already has been seen in the intensified anti-corruption drive in which Beijing sacked Chen Liangyu, Shanghai's Communist Party secretary and a Politburo member, in September. Chen's dismissal was part of a larger purge in the booming coastal city, which rooted out not only local officials with questionable management skills but also cadres left over from the time of former President Jiang Zemin. The anti-corruption drive has been used elsewhere as well, reaching into Macao and, more recently, into the Shandong peninsula, one of the areas Beijing wants to develop economically in the future.
Ahead of the 17th Congress of the Communist Party of China later this year, Chinese President Hu Jintao is cleaning out political and party officials who oppose his economic (and social) policies, and laying the framework for a more loyal and responsive provincial and local leadership. Hu hopes this will lay the groundwork for an expansion of his "New Left" policies, through which he hopes to reshape the Chinese economic landscape, dictating where certain industries will be concentrated and which entrepreneurs can operate in which sectors.
While such close government-business cooperation allowed a country like South Korea to boom in the 1970s and '80s, China will be trying this on an unprecedented scale -- and will need full political control in order to restructure the freewheeling Chinese economy. In reality, such a strategy is more political than economic in nature, as it seeks not only to revamp the country's corporate environment but also to radically reshape the ways in which Chinese citizens and businessmen act and interact.
To call the process jarring would be an understatement of the grinding conflict to come. Years of attempting to change China's corporate culture using traditional economic tools resulted in the death or disappearance of thousands and a steadily deteriorating security environment. Hu now knows he needs to attack the problem at its source -- the Jiang cadre that created the culture in the first place -- and if he has been paying attention, he knows he cannot be soft. |
