Economic growth forecasts for China have been downgraded across the board to take into account the negative shocks to supply and demand from the ongoing coronavirus outbreak. While the jury is still out on whether this will impact the country’s long term growth trajectory, this article reviews two recent books on what is fundamentally weighing down China’s growth potential.
The Great Wall of Debt by Dinny McMahon
Amazon link – China’s Great Wall of Debt: Shadow Banks, Ghost Cities, Massive Loans, and the End of the Chinese Miracle
McMahon’s book approaches the issue of China’s growth potential from the grassroots level. It is structured around personal accounts of people such as foreigners who have been persecuted for investigative journalism, citizens who have staked their lives in vain against unfair rules and middlemen who have capitalized on the rage for luxury goods. He entwines these stories with the broader theme of investment led economic growth and the massive debt it has generated. He tracks the steady build up of debt year after year since the 2008-09 financial crisis beginning with the surge in the official banking system’s loans to state firms, the emergence of the shadow banking system catering to local government financing needs and microfinance companies serving a motely of small private firms.
There are several examples of how rules are circumvented in China such as the creative accounting practices that make loans disappear from bank balance sheets. He also highlights the strong network of vested interests that stonewall reform with examples such as top executives of state oil firms resisting improvements in fuel quality to lower pollution via their voting power on the board of the decision making committee. He contrasts China’s pledges to adhere to the norms of internationalism and free trade with examples of protectionism in several industries. He criticizes the strategy of massive state funding that allows Chinese firms to dominate in industries where the country has no natural advantage as a strategy that wastes rather than employs resources efficiently.
McMahon’s book scores high on readability due to his journalistic style and also because he talks about people more than technical concepts. The organization style of the chapters makes it easier to stitch together individual pieces and see the big picture.
The State Strikes Back by Nicholas Lardy
Amazon Link – The State Strikes Back: The End of Economic Reform in China?
Lardy’s book addresses the issue of China’s growth potential from a top down and more rigorous perspective. It assumes that the reader has intermediate knowledge of economic concepts.
Lardy shortlists two factors for China’s slowing growth – the normalization of its massive trade surplus and the slowing pace of reform. The meat of the book lies in his detailed analysis of the second factor which is exemplified by the deteriorating performance of state firms relative to private firms. He systematically parses through public data on the financial metrics of state owned enterprises, often bridging gaps with careful assumptions. This involves a detailed explication of their poor performance including their declining return on assets and eroding creditworthiness. He casts further pessimism on the results by highlighting that the losses are likely understated due to the huge government subsidies received by them.
Next he evaluates and refutes popular explanations of the poor return on assets of state firms and gives the real explanation as insufficient profit maximizing behavior manifested by corruption and misallocation of resources such as tolerance of zombie firms. He then turns to criticize China’s “failing strategy” to reform state enterprises. He laments that efforts at corporatization, mergers and mixed ownership for state enterprises have more form than substance. Others like debt to equity swaps are too small in scale while governance and financial reforms are mostly on paper.
The book offers solutions like lowering entry barriers especially in services, promoting M&A and bankruptcy and financial reforms such as changing accounting standards to reflect the true picture on bank’s non-performing assets.
Differing Conclusions
The two books differ in their conclusions about China’s future economic trajectory. While McMahon’s intensely anecdotal take on the issue is more pessimist, Lardy’s detailed technical analysis leaves some room for hope. McMahon thinks China is likely to be stuck in the middle income trap for a long time while Lardy thinks that China has the potential to break out of the trap and achieve rapid growth of 8% and above for the next two decades.
McMahon’s frames the problem as a dichotomy in attitudes of the lower income class and the more affluent class, neither of which has shown a sustained inclination for agitation. The lower income class support for the government is based on the assurance of rising income levels in the future. By contrast, the affluent class’s support for the regime is based on its desire to maintain its privileged position in society. This lack of restiveness in society as a whole, according to McMahon, further reinforces poor institutional accountability, hinders reforms in all fields and ultimately holds down China from realizing its full economic potential. He prognosis is that a slowdown in China would be as much an economic as a political event and could trigger a radical change in governance if not a change in government.
Lardy’s book adopts a more open ended conclusion. He frames the problem as one of homeostasis afflicting the top-most levels of government. He argues that the need to maintain economic and political control and the associated fear of social and financial instability made worse by vested interests is what holds China down. He cites various reasons to be optimistic about the government’s reform mindedness – that slower reform is inconsistent with the government’s objective of ensuring rising income levels for Chinese citizens as well as the stated goal of deleveraging and reducing financial risk. He finally opines that China can’t credibly advocate globalization on the international stage when its own domestic policies move in the opposite direction.
Whatever the future holds for China, one thing that be can be safely assumed is that it is sure to form the subject of many more books.
Macrologue 