EXAMINING ASIA
By HUGO RESTALL
China's Not Overheating,
It's Wasting Capital
The debate over whether China is about to "overheat" came back onto the boil this month. Beijing released the November consumer price index figures, showing inflation year-on-year hitting 3%, up from 1.8% in October. Also, Federal Reserve Chairman Alan Greenspan weighed in, warning that growth in currency and commercial bank reserves means that the Chinese central bank faces "the choice of an overheated economy, with all its potential recessionary consequences," if it doesn't let the value of the yuan rise.
Mr. Greenspan has a point. There are signs that the People's Bank of China is having trouble handling the growing inflows of U.S. dollars from institutions betting on a yuan revaluation. Its most recent bond auctions haven't been very successful, suggesting that it may need to pay a higher rate of interest if it is to soak up the extra liquidity. Its reluctance to do so may be contributing to inflationary pressures.
But then again, maybe not just yet. Much of the inflation in November was caused by rising food prices, which in turn are due to one-time causes. Then there are bottlenecks caused by a booming economy which is running through coal and iron ore and other inputs at an unprecedented rate. But price rises must occur across the board before one can really say inflation is under way, and in many sectors there is still pressure on producers to lower prices because of intense competition. So what's really remarkable is that China's investment, money supply and GDP are all growing quickly and yet inflation is so tame.
The real story right now is overinvestment. Fixed-asset investment was up 29.6% in the first 11 months of the year, and loan growth is running at 20%. The government is issuing bonds to build infrastructure, and banks are giving out loans for companies to expand their production capacity. Property developers are laying the foundations for new office buildings and villas. But for many of these projects, analysts fear that the demand simply won't be there. That would worsen the banks' already serious bad loan problem, and cause a balance-sheet recession as the excess capacity is worked out.
Nevertheless, the government doesn't seem to be interested in slowing down investment. For instance, the central bank, which has repeatedly cautioned about a property bubble, tried to rein in developers by restricting the sale of unfinished apartments, but the State Council countermanded this order. In his economic management style, China's new leader, Hu Jintao, is so far reminiscent of the man who anointed him, Deng Xiaoping. Deng too wanted ever faster growth, and wasn't too concerned with the consequences. The result was dislocations in the mid-1990s that forced Zhu Rongji to prove his worth as an economic czar.
If there's one economist in China always worth listening to, it's Wu Jinglian. And recently he's been warning that the country's most serious problem is its inefficient use of capital. In developed countries, $1 of investment eventually yields $1 in increased output, but in China the ratio is more like $7 for $1 in output. It's only because China's savings rate remains high at 40% that it can afford to go on wasting capital while at the same time growing.
Ultimately, however, it is not a sustainable model. India, for example, has a growth rate lower than China's and its savings rate is only about 20%, but its banks are in much better shape. It's true that if one took all of China's bad loans and added them to the national debt, China and India are in roughly the same condition. But India is becoming more efficient in its use of capital. China seems to be heading the other way, at least at this moment in time.
If Wu Jinglian is the master diagnostician, there's also one technocrat always worth watching, Zhou Xiaochuan. Formerly head of the China Securities Regulatory Commission, he moved over a year ago to head the central bank. And almost immediately he began to emphasize the need to improve China's allocation of capital by deregulating interest rates. After some successful pilot efforts, he is rolling out a nation-wide reform on Jan. 1, when banks will be allowed to widen the range of interest rates they charge on commercial loans.
The benchmark lending rate is 5.3%, and banks currently can charge 30% more for riskier borrowers; in the new year they will be allowed to charge as much as 70% more, meaning a lending rate of 9%. Considering the benchmark deposit interest rate is now just under 2%, that's a pretty good margin. This very profitable higher-risk sector of the banking market has up until now been the preserve of unofficial lenders.
Meanwhile, the local branches of China's big banks lent mainly to the favored businesses in their area, meaning either the state-owned enterprises (SOEs) or entrepreneurial offshoots run by politically well-connected managers. These loans were made at low rates and classified as low-risk. Meanwhile, the rest of the private sector was starved of credit, particularly the small- and medium-sized enterprises.
So certain companies that already tended to be inefficient because of their ownership structures also had access to large amounts of cheap capital. Independent and profitable private companies had to grow by reinvesting their earnings, and officials discriminated against them when they got too big, meaning they tended to diversify into areas outside their core competence.
This isn't going to change overnight on Jan. 1, but creating a differentiated market for capital is an important first step. It gives banks an incentive to take on more risk in order to increase their profits. Given their condition, more risk might sound like a bad idea. Yet when loans are made on a market basis, overall risk to the banking system actually declines in the long run.
In the short run, the government of Mr. Hu still needs to come to a consensus on controlling inefficient investment by less refined means. Curbing credit just as China seems to have emerged from deflation will not be an easy decision. But cases where money is being invested in more capacity than China will need in the coming years is a clear indication that China is in need of better, market-driven means of resource allocation. The debate on "overheating" is just a distraction from this more fundamental danger.
Updated December 22, 2003
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