Welcome to Pacific Exchanges, a podcast from the Federal Reserve Bank of San Francisco. I’m Cindy Li.
And I’m Sean Creehan. We’re analysts in the Country Analysis Unit, and our job is to monitor financial and economic developments in Asia. Today we continue our series Rethinking Asia, as we consider noteworthy and unusual trends in finance and economics in the region.
We sat down with Nick Lardy, senior fellow at the Peterson Institute for International Economics. Nick is one of the world’s most prominent analysts of China’s economic development and the role of its private sector in generating growth. We spoke with him about his new book, The State Strikes Back: The End of Economic Reform in China? We should emphasize that there is a question mark at the end of that title, and we’ll get into that in our conversation.
Nick provides a great perspective as someone who has watched and researched the Chinese economy for many years. Nick is generally considered a champion of the contributions of China’s private sector in the country’s modern success, but he is increasingly concerned about the private sector’s diminished role. He gives us a snapshot of this downward trend in private sector contributions, both in terms of data related to credit and investment, as well as a qualitative assessment of changing policy environment that increasingly favors state-owned enterprises.
It’s a great conversation and really gets to a central question about the future of China’s economic development, so with that, let’s just get to it.
So, thanks for joining us, Nick. Your previous book, Markets over Mao, documented the bigger role of private sector played in the Chinese economy, as well as the progress of market-oriented reform. Your new book, The State Strikes Back, seems to suggest a step backwards in terms of the reforms, so what has happened to China’s private sector?
Well, the role of the private sector has been significantly diminished over the last five, six, seven years. Their access to credit has been dramatically curtailed, the share of investment undertaken by private firms as opposed to state firms has shrunk, and in the industrial sector, which still a very important part of the Chinese economy, in both 2017 and 2018, for the first time in decades, the private sector grew more slowly than the state sector.
So, do you think that is a temporary change, or do you think that’s a grander trend that’s going to define China in the medium-term?
It’s very hard to know for sure, whether this more state-orientated pattern of policy will continue or whether the market and private firms will resume playing a greater role. I think Xi Jinping has been the driving force on the resurgence of the state, but in the last year and a half he’s also talked about the importance of the private sector, and the banking system has said that they are going to adopt policies that will lead to a greater flow of funds to the private sector. So, we’ll have to wait and see how that turns out. There are some hopeful signs in terms of talking points that Xi Jinping has made, but we haven’t really seen much change in actual policy on the ground.
So Nick, in addition to that role of Xi Jinping in bringing the state sector to the forefront of the economy, to what extent is some of this state sector growth, at least the larger extension of credit, a relic and maybe even an unintended consequence of the credit-fueled stimulus post 2008 crisis? Is that also part of this?
Well, it’s a complicated story. The private sector actually got a huge increase in credit in the aftermath of the global financial crisis. In 2010, ‘11, ‘12 and ‘13, over half of all the new credit from the banking system was flowing to private companies. So I think the conventional wisdom that the state got all the credit as a result of the crisis is certainly not reflected in the Chinese data. The resurgence of the state companies in terms of their access to credit came in after 2013.
So you have a lot of great data in the new book. Your research shows that the average number of SOEs has declined by half over the recent period, but that their total assets have increased by a remarkable five times over the past decade or so. So, there’s obviously a lot of M&A or some other sort of consolidation going on, but it’s not leading to efficiency gains. Could you talk about that, why there is that disconnect?
Yeah, a lot of the biggest state non-financial companies have been under the jurisdiction of an organization that’s called the State Asset Supervision and Administration Commission, and they have started out with… Well, they had tens and tens of thousands of firms, but these were all in various big group companies or conglomerates. There were almost 200 of them when they started, and they’re now down to a little bit under a hundred. So they have merged companies in the same industry. The firms on average are 10 times larger than they were before the global financial crisis, but their return on assets has declined dramatically from the range of 6-7% to an average over the last three years of only 2.5%.
So one possibility is that they have reduced competition through these mergers and given these firms less incentive to innovate, improve products, and control costs.
So Nick, looking at some of the recently emerged large private sector companies such as Alibaba, looks like large SOEs do have an efficiency issue. Could you compare the efficiency parameters of state-owned enterprises and private sector companies? Are China’s private sector companies more productive and more efficient than the state-owned counterparts?
Well in the industrial sector, the return on assets, which is a common metric for judging performance, the return on assets of private companies in the industrial sector is roughly three times that of state companies. And that’s been true really for most of the last eight or nine years. We don’t have quite as good data for the service sector, but it looks like there’s a big gap also in that private companies are far more productive in the service sector than state companies.
I think, if you look at data, it still suggests that state-owned enterprises are getting the larger share of bank loans, so what’s the rationale behind that?
Well, I don’t think there’s a good rationale. I think the increase in the share of credit going to state companies since after 2013 reflects a very substantial misallocation of credit, because the returns of these firms has been going down, their ability to service their debt is much more doubtful than on average for private companies. And if you look at the broad universe of state non-financial firms, about 40% of them actually lose money year after year after year, which means that they cannot fully service their debt. They borrow funds this year to pay the interest on the loans that they took out last year. So I think that there has been a significant misallocation of credit over the last three or four years.
Nick, I know you’re an economist and not necessarily a political economist, but could we talk a little bit about the policy motivations here. You mentioned Xi is interested in consolidation of power, but thinking back to recent years where there have been slowdowns in the Chinese economy, a lot of people talk about the Party’s desire to maintain minimum levels of growth to maintain employment and social stability, and then if you think about, not sure the exact share of the private sector in employment in China, but it’s quite big. If you think about those factors in the need to kind of maintain economic health, is that not also a consideration, or it’s just one that’s been given a lower priority, given other political goals.
Well I think there is an element of the desire for political stability and maintaining employment. There’s an element of that in the policy of favoring the state sector, but it is the case that almost all the growth of employment since reform began four decades ago has been generated in the private sector, not in the state sector. The private sector has generated new jobs. The state sector in the enterprise sector, I’m not talking about bureaucrats, civil servants, and so forth, but state enterprises only employ about 10% of the urban workforce. So, their role has diminished dramatically over the decades of reform.
So at one point, I think there was a strong case for having state enterprises play this role of preserving employment and maintaining social stability, but I think that that case has really weakened significantly in the more recent decades, because the share of people employed by state companies is relatively small. They do produce; they may be only 10% of the workforce but they produce a much larger share of GDP than that, and that’s because they have a huge capital stock, they have, as I’ve mentioned, relatively easy access to credit. So the machinery and equipment for every worker in the state sector is much higher than in the private sector. So you have a situation in which the labor productivity is relatively high in the state sector, but capital productivity is very, very low because there’s so much over investment.
One major theme of your book is actually about China’s potential growth in the medium-term. Can you elaborate on that?
Well, there is a view out there that economies, if they have fast growth, eventually slow down. There’s a reversion to the mean phenomenon that Larry Summers and others have written about. I have a somewhat different view. China is still, in per capita terms, relatively poor. The technology exists globally for them to produce a much, much higher level of output. And I think if they went back towards a more market-orientated reform program and put the emphasis on efficiency, they could probably grow more rapidly than they’re growing now.
In other words, instead of growing at around 6% or six point something, they might be growing at something closer to eight. And the reason is, there’s just a massive amount of assets in the state companies that is generating relatively low returns. If you increase competition in that sector, or had bankruptcy for firms that can’t make money, or allowed merger and acquisition activity so more efficient firms could take over the assets of more efficient firms, I think China could grow significantly more rapidly than we’ve seen in recent years.
So, if I may push back a little bit on that, when talking about a potential growth rate for China, two common arguments we’ve seen is that first of all, China faces the aging population, and secondly, productivity has been declining over the last several years. Could you comment on that?
Yes, I think productivity, at least as measured by what economists call total factor productivity, has been weakening, but I think that’s really due primarily, if not exclusively, to the underperformance of state companies, and as I mentioned, massive misallocation of resources which leads to declining productivity. The population dilemma of China is very, very substantial. Their working age population is shrinking, their population is aging rapidly, and many people argue that this means China’s growth must inevitably slow down.
But the biggest generator of growth in most economies is improvements in productivity, and I believe that China has the potential to improve productivity, particularly the returns to capital, by more efficient utilization of the capital resources that are in state-owned enterprises. I think that could more than offset the slowdown in the growth of the labor force.
So Nick, when you go over to China and meet with your contacts there, I mean is there a general consensus on this issue amongst more reform-minded policymakers? Is it a matter of just deciding to sacrifice some of this growth potential for other reasons, for greater control of the center? How do you see the current policy debate going in this area?
Well, I think that most economists, at least the ones that I come in contact with, which tend to be the more reform-oriented, have been very disappointed with the direction of economic policy in recent years. There are some exceptions, but in most areas, reform momentum has been lost and things are going backward in many, many cases. But there’s a reluctance, really, to speak out forcefully, publicly, so the debate is for the most part kind of behind the scenes.
The one exception was at a big National People’s Congress meeting last month, Lou Jiwei, who had been serving of Minister of Finance several years ago and more recently in the Social Security Administration, came out very forcefully in a public statement, criticizing the Made in China 2025, which is probably the signature program for state industrial policy. And he criticized that policy and said that the state should not be in the business of picking winners, that this should be up to the market and private companies, and he charged that the Made in China 2025 was leading to a massive waste of resources. But Lou is an exception, in that he was willing to stand up, and in a public setting, criticize this signature program of President Xi, the Made in China 2025.
Nick, you mentioned the misallocation of financial resources, more credit for the less efficient state-owned enterprises. So, going back several years, there were a lot of hopes that modern capital markets or even non-bank financial institutions, would play a kind of complementary role to the traditional banking sector and help private sector. Is that still the case? Are state-owned banks, the formal banking sector, regaining their dominance in resource allocation?
Well, it is true that after private firms lost most of their access to bank credit after 2013, that they did tend to turn to non-bank financial institutions, as so-called shadow banking, as a source of credit to finance their growth. But that sector grew extremely rapidly, it was less well-regulated, and by 2017, China’s leadership decided that the ratio of debt–to-GDP had gotten out of hand and they needed to slow down the growth of credit indeed to cut it back relative to GDP, a process that is sometimes called deleveraging.
They focused primarily on cutting back non-bank financial institution lending, because that was probably where more of the risk was being created since that sector of the financial system was less well-regulated. But the consequence was, private firms were further damaged. So, first they lost access to bank credit, and in the last couple of years, the credit through non-bank financial institutions has actually been shrinking in absolute terms. So the government, I think probably has had some success in deleveraging, but it’s been at the cost of squeezing out the private sector, and that’s one of the reasons growth has slowed down in the last couple of years.
Nick, do you have a good sense of the breakdown between credit allocation to kind of more small and medium-sized enterprises in the private sector versus the larger private conglomerates, so I’m thinking of giants like Alibaba. Is there a distinction there, where the larger private companies don’t necessarily have the problem getting that credit, whereas a lot of those SMEs may be relying on non-bank financing et cetera?
Well, first of all, I should have pointed out earlier that the tech companies like Alibaba do not depend at all on bank credit or any domestic credit. Alibaba recall raised US $27 billion on the New York Stock Exchange a few years ago. So, they are very, very flush with cash, and they’ve actually devoted a significant portion of it to establishing venture capital funds and venture capital companies that are investing in other startups, I think with a view to becoming the owners of those companies, if they’re successful.
So the tech sector, I think is extremely well-funded. It has flourished, continues to flourish, and for the most part, is not dependent on the formal financial system, at least the banking part of the financial system. They rely a lot more on venture capital.
What sector would you say is being left behind, then? Or, if you could give us a few examples of sectors that are historically, in the last decade or two, have been private sector-led but now are suffering.
Well, private companies came to dominate in the manufacturing sector. Most of the manufacturing output in China a few years ago was being produced by private companies. And this was true in even such traditional state industries such as steel, aluminum, and so forth. In the steel sector, private companies were producing about two-thirds of output a few years ago. But their contribution to output has now shrunk by several percentage points. Some of the firms have gone out of business because they couldn’t get access to credit or they had to repay loans that they couldn’t repay. And some state companies with better funding took over some of the private firms. So I think that the area where private firms have been most disadvantaged has been in the manufacturing sector, where they produce about 80% of output.
So it’s not just traditional light manufacturing like textiles, apparel, and so forth, shoes; it’s even things like steel and aluminum where private firms have achieved a very, very large share, a dominant share, of output, but their relative size is now shrinking.
Based upon your research, seems like private sector are accounting for a larger share of Chinese exports between 1995 and 2015. In 2015, they are almost at the equal share of total exports with the state-owned enterprises. So, I’m just thinking about, given all the trade tension that’s been going on and all the uncertainty associated with the trade negotiation, will private sector firms be particularly vulnerable to the outcome of the negotiation?
Well, obviously it depends a great deal on the details of the agreement, if there is indeed an agreement. The administration has not been very forthcoming in describing or setting forth the terms of the agreement as it’s being discussed. My view is that there’s been a great deal of focus on subsidies as a source of an unfair playing field, giving Chinese firms an advantage. But private firms don’t get very many subsidies, and they’re producing a much larger share of exports than state companies. The share of state companies is down around 10%. Domestic private companies are producing about 40-45%, and there’s also still a very large share of exports that are being produced by foreign-invested companies.
So, the private sector, I think, does operate in general in a more market-orientated, competitive environment. They are less dependent on state subsidies.
So, regarding those ongoing negotiations, are there any particular outcomes you’d like to see, as an economist who’s concerned about China’s long-term growth potential?
Well, I’d certainly like to see some reduction in forced technology transfer, although I think there might be less of that than some people say, but any amount is too much. I think the subsidies that keep inefficient state-owned companies in business need to be eliminated. Most of those companies are not producing exports, but they introduce a distortion in the market that should be eliminated. And I think above all, greater transparency, for example, China has this big Belt and Road Initiative that’s allowing China to get more influence globally, but we don’t have much visibility on what the amounts of money are, how the credit is being extended. So I think one thing would be to get China to participate in the so-called Paris Club that has international agreements on the type of credit that can be extended, the terms, and so forth that would make China’s international lending activities much more transparent.
Nick, you’re a long-term and a strong advocate for market-orientated reforms in China, so looking at what has happened over the past decade also, what are some of the key policy changes you would like to recommend or suggest to the Chinese government?
Well, I think one of the most important would be to significantly modify the Made in China 2025 industrial policy, and I think that modification should have several components. But the most important is that the program should be set up so that foreign firms and domestic private firms can play a key role, and I think the allocation of credit for the industries that have been identified in that program should be driven much more by market-determined finance rather than through government.
The Chinese government has established a huge number of so-called government guidance funds which are being used to promote Made in China 2025, again very un-transparent and certainly does not involve any flow of resources to multinational companies that might be active in some of these areas. So, I’m not necessarily against industrial policy, although I think international experience suggests that it’s not always a great success, but if you’re going to have an industrial policy, I think it should be administered in a way that is neutral with respect to ownership. In other words, foreign firms, domestic private firms, and state firms should be competing on a level playing field for any programs that support particular industries.
So Nick, invoking that 2025 year, and as someone who writes books every so often, let’s say your next book comes out then, what do you think China’s economy will look like at that point? Do you see a return of the private sector, and then from a US-China perspective, how do you see the US-China trade relationship, and more broadly the political relationship looking?
Well, it’s very difficult to predict what the economy’s going to look like. I think if they continue on this state-driven growth pattern, that the economy’s likely to slow down. If they allow market forces to resume the kind of role they have played earlier, I think the economy could grow more rapidly, be more innovative. That, in turn, will influence the nature of the US-China relationship.
I think, when China was heading strongly towards a market economy, which I believe was the case up until something around 2012, ‘13, even though there were some aspects of the economy that discriminated against foreign firms, we did not pursue a very aggressive trade policy with China, because I think there was a consensus that China was moving in the right direction, and things were improving in terms of the access of foreign firms to the market and so forth.
Now in the last seven or eight years, things have been moving in the other direction, and I think that’s the important background factor that has led to a more confrontational policy on the part of the United States. And it has been, for the most part, supported by multinational companies that have been operating in China. They have been feeling the effects of more state-driven policies, and so as the direction of policy changed away from a market-driven approach to a more state-driven approach, the trade relationship and the investment relationship has become much more confrontational. And I think if they stay on the state-driven path, even if we have an agreement sometime this spring or early summer, that there are likely to be very strong, continued frictions. I think those frictions would be dramatically reduced, if we had an agreement where China returned towards a much more market-driven setting of economic policies.
If you had to guess, if there were a more of a deceleration in China’s economic growth over the next couple of years, would you see that as making it more or less likely to see a return of market-orientated reforms?
I think a further slowdown increases the chance that China would go back to more market-orientated reforms, because the party recognizes that their legitimacy is not based on ideology, it’s based on the rapid improvement in living standards and the better provision of social services, education, healthcare, and so forth. If growth slows down, the ability of the economy to generate those kinds of income gains and provide the resources that are needed to continue to improve education and health, clean up the environment, enforce food safety, and so forth, those kinds of resources will be diminished, and I think that support for the party would similarly decline.
So, I think there must be a tipping point as growth slows to some point, the leadership would prioritize efficiency and growth instead of political control, which has been the theme of recent years.
Well Nick, I hope that in several years, when we look back and revisit this episode, your next book’s title might be, The Private Sector Awakens.
Thanks Nick, thanks for joining us.
We hope you enjoyed today’s conversation with Nick. For more episodes like this, you can find us on iTunes, Google Play, Stitcher and Spotify. If you like what you hear, please leave a review. Feedback from listeners like you will help more people find us. And for even more content, look up our Pacific Exchange blog available at FRBSF.org. Thanks for joining us.