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China's Reliance on State-Owned Enterprises Poses Growth Risks

Nicolas R. Lardy says China has made progress in making its economy less reliant on exports but worries about the increasingly dominant role of state-owned enterprises (SOEs).
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Unedited Transcript

Pedro da Costa: I’m Pedro da Costa. I’m joined by Nicholas Lardy. He’s a Senior Fellow here at the Peterson Institute for International Economics and also a Resident China Expert. Welcome.

Nicholas Lardy: Thank you.

Pedro da Costa: So, I wanted to ask you about a presentation that you gave recently here at the Institute where you expressed some concern about for the pace and nature of Chinese reforms in particular a tendency by the government to rely excessively on State-Owned Enterprises. Could you speak a little bit to that?

Nicholas Lardy: Yes. I think they’re doing a couple of things. First of all, they’re orchestrating from the top-down a number of mergers of some of the biggest companies that are in the same industries to create what they sometimes call national champions. This was a strategy that was pursued in the 10 years under the previous leadership of Hu Jintao and Wen Jiabao, and it did not produce very good results.

In fact, I would characterize it as a pretty disastrous. The efficiency of those firms after they merged actually declined significantly. Their earnings went way down and I think they became an increasing drag on the economic growth, and it’s not clear that this round of big mergers will lead to a result that’s any different than what we saw before.

Pedro da Costa: And, what is this talk of debt to equity SOCs come in and how does this work, and is this a little bit of pushing money around or is it actually reforming or cleaning up corporate balance sheets in any discernible way?

Nicholas Lardy: Well, I think it potentially can help to reduce leverage in the corporate sector, leverage has gone up quite a bit. They’ve had a big credit boom really since the onset of the global financial crisis. And now, they’re offering the opportunity for firms and banks to agree to engage in some of these swaps.

Now, originally, I was worried that it was kind of the most failing firms that were likely to engage in these swaps, but the authorities are saying, “No, this is not open to firms that are on the verge of bankruptcy.” So, the fear I had, of course, was the banks were going to take on a lot of equity that would turn out to be worthless. And/or instead of having loans that weren’t going to be repaid, they’d have equity, which was worthless which is no net improvement to the banking system at all probably a worsening.

But they’re saying that the transactions have to be voluntary, that banks want to have to want to take equity in exchange for reducing the value of the loans outstanding, the firms want to do it. So, how big a take up there will be remains to be seen because firms that are doing well probably don’t want to give up their equity.

And, for firms that are not doing well, the bank probably doesn’t want to take the equity but there’ll be some move. They’re doing other things as well. Banks are raising a lot of new capital through IPOs over the last several quarters and that is continuing. Bank of Shanghai has a very large IPO-planned sometime in the very near future.

So, banks are raising more capital and they’re also writing off a lot of bad loans. So, this isn’t a problem of bad loans just accumulating with no policy to address that they’re moving ahead on several fronts.

Pedro da Costa: And what do you think are the curbs on property prices? I mean, the ever present expectation and it’s been around since, I mean, I think at least since 2009 to 2010. I remember reading stories about ghost cities and this bubble is about to pop, and of course, Chinese property prices have defied gravity and they’ve continued to rise and they’ve used really their--you could argue at the forefront of macro prudential policy by trying to tweak the rules for mortgages and so on. How is the property market playing into the broader economy?

Nicholas Lardy: Well, the property market has always been very important for the broader economy. It counts for a very large share of investment and this economy until quite recently was driven primarily by investment rather than by consumption. But in certain periods when prices have been escalating too rapidly in some cities particularly what they call tier-one cities, they have used what you call these macro prudential regulations, which is just simply requiring much bigger down payments. Or actually, restricting the number of properties that any family can own because a lot of Chinese are buying properties not as a principal residence but as an investment.

And, those measures have actually been fairly successful. I think we’ve been through about three cycles now where down payment requirements have been raised. And it does subtract from demand and in several previous episodes, prices have actually fallen slightly over a period of about a year slow. It’s not a collapse like we saw in the United States 10 years ago. But prices may go down cumulatively 7%, 8%, 9%, 10% when they take off these restrictive measures, and then the demand tends to come back and then when prices get ahead too far, they reintroduce these measures.

So, it’s a tool they’ve used with some success now for seven or eight years.

Pedro da Costa: On your presentation, you also mentioned the possibility or even the reality that some of these State-Owned Enterprises were actually crowding out private investment and you offered some interesting figures on just how big the gap is in their productivity and their business performance. Could you speak a little bit to that?

Nicholas Lardy: Yeah. The reality is that the reign of growth of investment by private firms has slowed down quite a bit relative to that of state firms. Historically, private investments has been growing much more rapidly, but starting in 2011, that slowed down a bit. And this year, private investment seems to be actually growing slower than state investment.

And, from the point of view of long-term growth, this is not very good because the productivity of private investment is so much higher measured by return on assets, which is a fairly straightforward measure. In the industrial cycle for example, private companies are earning three to four times the return on assets of state companies.

So, if more and more investment is falling into the state category undertaken by state companies, it’s certainly adverse for sustaining China’s economic growth over the medium and long term. So, we have to see how much of this slow down, how long this slow down lasts.

Pedro da Costa: And what is your expectation on that front? Of course, it’s the second largest economy in the world and it’s one of the biggest factors that tends to move markets on a daily basis. In fact, today, the headline was stocks opened lower on (A) China fears and rate hike fears from the Fed. So, these are always the two major points of--you’ve been fairly sanguine about China’s economic prospects and about their ability to move away from nonindustrial economy and towards a consumption-based economy. Where are they in that transition?

Nicholas Lardy: Well, I think they’re making steady progress over the last few years and the underlying factors that wages had been growing more rapidly than GDP. So the wage share of GDP we referred to, it has been going up. And that’s a function currently of demographics. The working age population in China is actually shrinking the last couple of years and will continue to shrink. So the supply of labor is shrinking and the demand for labor is actually going up. It’s a kind of a paradox. The economy is slowing down compared to four or five years ago, but more and more of the production is of services rather than investment goods, and services are much more labor intensive.

So there is more new demand for labor now than there was when it was growing much faster, so you have shrinking supply, rising demands, so wages are growing up. And the rise in the wage share of GDP is feeding directly into a bigger role for consumption. And so, I think consumption will continue to be a major factor and more and more of consumption is focused on services rather than goods.

So, that kind of reinforces, the service sector has become more important on the production side that creates more demand for labor and that’s kind of a virtuous cycle now.

Pedro da Costa: And finally, just to put some hard numbers on it, where does that leave GDP growth in your view in the next six months or a year?

Nicholas Lardy: Well, my view certainly is they’re not heading for the hard landing that a lot of people were talking about a year or so ago. I think they’re going to be able to maintain growth in the 6% to 7% range for some time.

Pedro da Costa: Thank you so much, Nic. I appreciate it.

Nicholas Lardy: Thank you, Pedro.