China Fail?

"[the Chinese] will have to align their political reality with what has been happening in the last 20 years under the impact of reform. . . the issue of reform, of political reform, will have to be substantially up to the next group of leaders."

--Henry Kissinger, to the Wall Street Journal

And maybe not just political reform. Economic reform as well.

John Berthelsen of the “Asian Sentinel” writes about a “provocative report” by political scientist John Lee of the Center for Independent Studies of Sydney. Lee prepared his report for the Hong Kong-based independent economic research firm Asianomics, and titled it "China Fail."

For me, the report’s most remarkable conclusion is that the money-losing state-owned enterprises (SOEs), seemingly discarded in the 1990s for being a huge drag on the economy, in fact have been growing in number and economic share. The successful export sector, employing 150 million people, attracts far less of the domestically funded fixed-investment that has underpinned 40% of China’s growth for two decades. Lee doesn’t believe the SOEs are any more efficient today than they were in the 30 previous years, when they paralyzed the Chinese economy.

Significantly, Lee links the government’s continued support of SOEs directly to the 1989 Tiananmen massacre, which coincided with the collapse of communism in Russia and Eastern Europe. Lee posits the Chinese leadership decided that European Communists lost power because the interests of the political elite and the economic elite had diverged, and China’s leaders vowed that would never happen in China.

The Communists created their own elite, ensuring the Communist Party (CCP) held an economic, professional and social monopoly. Lee’s report says, "the party has not just co-opted but created the country's middle class elites." Today’s established middle classes—the group foreigners engage with most frequently or exclusively—have become the “strongest supporters of the CCP. Of the 85 million CCP members, over four-fifths are China's elites."

According to the “Asian Sentinel” article that quoted Lee's report,

The numbers of bureaucrats on the state payroll jumped from fewer than 20 million in the 1980s to 46 million by 1994 to somewhere between 50 and 55 million today. A vast fleet of 2.5 million state cars, paid from the public purse, is available to them. Local officials have spent an estimated $80 billion each year on overseas trips, banquets, travel and other entertainment. In addition, the government spends about $200 billion on health care for bureaucrats, compared with only $50 billion to $60 billion spent on rural health care for its 400 million rural citizens.

The report documents distortions and difficulties springing from elite Party rule of the economy:

• In the early 1980s, the government encouraged farmers to make their own land use decisions and sell produce at market prices after meeting state quotas, and total factor productivity in agriculture doubled over the next 10 years. Farming has since stagnated.

• Chinese private-sector firms struggle with ‘'credit and capital constraints,” and even very successful private small and medium enterprises tend to flat-line at 30 employees, since that’s the limit of informal finance (savings of friends and family).

• China’s state sector now owns over two-thirds of the country’s fixed assets, a direct reverse of what occurred in China during 1979-89, when the majority of new fixed assets went to the private sector.

• Even though SOEs produce only 25-33% of all output, they receive more than 75% of capital, well over 95% of the post-global financial crisis stimulus funds in 2008-2009, and 85% of the funds in 2010.

• Most SOEs don't make any money. Sinopec, China Mobile and China National Petroleum make enormous near-monopoly profits; 80% of SOE profit comes from less than a dozen of the 150 major and 120,000 smaller SOEs.

• Locally-managed SOEs are “even more abysmal," with 19% of such state-controlled enterprises unprofitable in 1978, 40% in 1997, and 51% in 2006.

• At least 40% of bank loans to local SOEs are extended on a “policy” rather than “commercial” basis at artificially low interest rates, meaning banks are performing political, not economic, tasks.

• Since 1995, bank profits have come from massive loan growth, combined with increasing spreads between the lending rate and the returns on deposits, with spreads now accounting for 80-90% of overall profits.

• The rescue of banks between 1990 and 2005 cost perhaps $300 billion as junk assets were transferred from the banks to asset management concerns. Few, if any of the assets were worth anything.

• Transferring wealth from depositors to banks reduced the private-consumption share of GDP from 45% in the late 1990s to 35% now. Bank nonperforming loans may range from 40% of annual GDP to more than 100%.

Lee believes that China’s technocrats know how to fix the country’s economic problems. The barriers to reform are political, with leaders already exhibiting policy paralysis.

There are additional signs of strain in the current Chinese economic system. According to an AP report:

When millions of workers didn't return to their southern China factory jobs after Lunar New Year holidays, a turning point was reached for foreign manufacturers scraping by with slim profit margins. . . 30 to 40% of migrant workers didn't return to their factory jobs in Guangdong province's Pearl River Delta manufacturing heartland after the annual Lunar New Year holiday in February. . . Typically the proportion is 10 to 15%. That was despite Guangdong authorities raising minimum wages by up to 20% in March.

Of course, as Ben Omarsson, “guangzhou-information.com” notes, the failure of migrant workers to return to their previous jobs is “also a sign of improved economy in inland China, and better job opportunities for people in smaller, less developed cities.”

Related to rising workers wages is the linked problem of Chinese inflation. CNN Money‘s Colin Barr quotes Boston assets manager Jeremy Grantham saying China already “accounts for more than half the world's consumption of cement, and nearly half its use of iron, coal, lead, zinc, aluminum, and (oink oink) pigs.” Such a voracious demand relentlessly pushes up prices.

When the subject is China, there is always much to cause observers concern. Yet the country’s amazing growth continues, now in its fourth decade.