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China's State Capitalism and Imbalances

State capitalism has become a focal point of discussion among politicians, economists and the media. China has been an instigator of this talk, along with other BRIC countries which each practice a form of state capitalism. Might this be an alternative growth model for other emerging markets?

Not necessarily, say Professor Xi Li and his colleagues. They have been examining state capitalism in China to assess its development and impacts, and conclude that contrary to being a solution, it is contributing to imbalances that may cause long-term problems for the country.

Their research finds an odd correlation between the growth in exports and the profitability of state-owned enterprises (SOEs) in the last decade - odd, because SOEs generally do not deal in direct exports during this period.

SOEs dominate upstream industries such as the production and supply of gas and electricity, water supplies and transport, while downstream industries such as manufacturers, wholesalers and retailers are dominated by privately-owned enterprises.

“Downstream industries are almost all run by private firms and there is open competition. But the upstream industries are pretty much all SOEs. And where there might have been 10 SOEs in a downstream sector in the past, there are now only about one or two,” Professor Li says.

This division is quite different from pre-1978 days when everything was an SOE. The shift towards privatization of downstream industries began in the 1980s and got seriously underway in the 1990s. This vertical structure of Chinese economy was largely in place when China entered the WTO in 2001.

“There was then a major external demand shock for China to produce a lot of manufactured goods - which are mostly produced by private firms downstream. These firms still have to buy electricity and other things from SOEs, which charge a markup. So as a result, the profitability of SOEs correlates strongly with exports even though they don't export, while the profitability of privately-owned enterprises is relatively stagnant,” he says.

A measure of the imbalance between the two can be seen in the Fortune 500 list. China is second on the list behind the US, with 57 companies represented - all of which are SOEs.

For private firms to be profitable, the main option is to cut input costs. Since the only abundant input over which private firms have bargaining power is labor migrating from farm sectors, this has meant depressed labor income in China's GDP. However, this has had a negative impact on domestic consumption - and put a big question mark over the sustainability of China's growth model, Prof. Li says.

China has a historically low consumption rate compared to other countries (33 per cent of GDP) and a high rate of investment (about 50 per cent of GDP), and it needs to start reversing this ratio, he says.

“China over the last decade and longer has been industrializing and this has led to winners and losers. The winners are the ones who do production, investment and SOEs. The losers are households.

“If you look at household income as a percentage of GDP, it has dropped dramatically, especially over the last decade. The key is not only to stop but to reverse this trend or else you will have a stagnant economy for years to come. But the rebalance process will take time.

“Even if investment grows at five per cent and consumption grows at what it is now, say seven percent, and the government and exports growing as they are, it will take 20 years for consumption in China to reach 40 per cent of GDP. If China wants to achieve that in 10 years, investment growth rate needs to drop to three per cent but now it's more than 10 per cent. The latter would mean a direct impact of a drop of 4-5 percentage points in China's GDP growth rates.”

“So what specifically does China have to do? It probably has to not only cut the transfer from household to SOE but also reverse it.”

The quick way to do that would be to privatize SOEs and transfer the proceeds to households through building Medicare, social security, and free education, as well as plugging the banking hole created after 2009 to prevent further financial repression- in other words, to move away from state capitalism, he says. Prof. Li also mentions another important aspect to rebalance China's economy- let the market determine interest rates.

Prof. Li also offered a prediction: China's GDP growth would drop in the coming years to as low as 3% but this would not necessarily be bad news. If the government could adopt the above policies, China's consumption would still probably continue to grow at the present level, which means that households won't be much less happy. At the same time, the world won't necessarily be less happy because China has largely “stolen” growth from the rest of the world through large current account surplus and has largely redistributed growth among countries and sectors in the process through its growth model of relying on investment, export, production, and SOEs.

Re-balancing is also something happening on the global scale, between Germany and the periphery countries in Europe and also between China and the US. “The imbalance between China and the US has not started to resolve yet. Once the Euro zone imbalance settles down in maybe a few years of time, the resolution of this bigger imbalance will probably come into full swing. Many countries that have benefited tremendously from China's current growth model such as Brazil, Russia, and Australia will experience much dimmer growth prospects and the market will be volatile till the imbalances are largely resolved.” he says.

Professor Xi Li of the Business School's Department of Accounting was speaking at the Business Insights luncheon in May.