4 ways to tackle China’s overcapacity problem

China has narrowly escaped major financial crises for over two decades. But the good times may soon be over — and not because of the recent stock market crash.

The roller coaster of Chinese stock prices this summer has triggered debates about whether China now faces a serious economic crisis. The Telegraph compared China’s equity bubbles to the situation that led to the 1929 Great Depression. The New York Times and Fortune, on the other hand, have argued that the equity bubbles are merely false alarms, and fears about China are overblown.

In the short term, the latter argument is more convincing: China’s equity crisis has affected fewer than 15 percent of Chinese households. And the majority of these middle class investors have only lost money gained a few months earlier, when stock prices spiked. Even after the recent crash, the Shanghai Stock Exchange’s Composite Index still stands 1,000 points higher than it did in July 2014. In any case, stock values are just 1.5 percent of total assets in the Chinese banking system, and most Chinese companies are not financed by the stock market. The consumer confidence index shows that the trend of growing consumption by both urban and rural Chinese remains stable. And Chinese authorities still have the power and flexibility to mobilise economic growth, for example, by loosening monetary policy to allow high liquidity of credit, or by expanding fiscal measures to stimulate household consumption.

But while the Chinese economy is unlikely to crash anytime soon, China nonetheless faces a high probability of being the next major power to face an economic collapse.

One major reason is industrial overcapacity. Overcapacity is not new in China, but in sectors such as iron and steel, glass, cement, aluminum, solar panel, and power generation equipment, the overcapacity rate has recently surpassed 30 percent, the threshold at which overproduction may trigger loan defaults by companies that have borrowed and then watched their profits fall. According to the China Iron and Steel Association, oversupply has depressed steel prices so much that the profit from producing one ton of steel cannot even pay for an ice cream cone.

Production has run rampant because of vicious competition between local governments. In order to achieve high GDP growth, local governments attract new manufacturing facilities by offering all kinds of financial subsidies such as tax holidays and rent-free use of government land. Further, local governments help firms to get cheap loans from state-owned banks. These favors unnaturally decrease production costs.

Industrial overcapacity has become a time bomb that threatens the Chinese economy because it has led companies to take on debt to repay loans. As of 2014, Chinese iron and steel companies collectively have $489 billion in debt. The publicly-listed solar panel manufacturing companies collectively have as much as $19 billion in debt. The combination of economic slowdown, excess production in manufacturing and rising debts at the macroeconomic level may cause a massive wave of firm closures and bad loans.

If this bomb detonates, the repercussions could be extraordinary. Because China does not have the mature social safety net of a country like Japan, and also lacks the political stability of the United States, it could face not only an economic blow-up but also serious social and political upheaval.

To avoid a crisis, Xi and his policymakers must focus on reining in China’s overcapacity problem.

First, Xi should set up strict rules for local governments that regulate tax concessions, and ensure that all government subsidies to private firms are transparent. Based on these rules, Xi could better guide the country’s economic transition towards an innovation and services sectors economy.

Secondly, Xi and his administration should allow and even encourage bankruptcy liquidation of failed firms, in spite of opposition from local governments. Overprotection of failed firms has helped to perpetuate bad management and low efficiency.

Thirdly, Xi’s government needs to accelerate reforms of China’s financial markets. In the current financial system dominated by state-owned banks, firms focus on growing as big as possible rather than innovating, which is leading to overcapacity. State-owned banks prefer lending money to large-scale projects that are backed by local governments because the bigger the firm, the more protection it receives from the government. China must encourage private equity, small and medium enterprises bonds, and equity crowd-funding, and it should allow the development of community and village banks that serve local firms. In these areas, the United States has lots of experiences and expertise to offer.

Finally, Xi should promote freedom of the press, which plays a crucial role in economic development, poverty reduction and the establishment of good governance. A free press would help Xi’s reform agenda by monitoring and criticising rule-breaking by local governments, as well as making government budget and subsidy programs more transparent.

Xi’s visit to the United States and his attendance at the United Nations Sustainable Development Summit take place at a moment when the Chinese economy has reached its tipping point. Xi should be confident, but not complacent.

This piece first appeared on Reuters. Publication does not imply endorsement of views by the World Economic Forum.

To keep up with the Agenda subscribe to our weekly newsletter.

Author: Shuaihua Cheng is a Group Manager of the E15 Expert Group on Industrial Policy. He is Senior Programme Officer for Asia Pacific and China at ICTSD, Managing Director of ICTSD’s China Office, and a Yale World Fellow 2015.

Image: A Chinese national flag flutters at the headquarters of a commercial bank on a financial street. REUTERS/Kim Kyung-Hoon.