China Has a Big Economic Problem, and It Isn’t the Trade War

A decade ago, after the 2008 global financial crisis, China seemed to save its economy by decoupling it from the rest of the world’s with a massive domestic investment program. Today, it is progress on the trade war with the United States, or the recoupling of China’s economy with those of other countries, that is seen as the way for it to regain momentum.

But to think in these terms is to miss the main point: The trade war has merely compounded an economic slowdown in China that is substantially of the country’s own making.

The deceleration is serious. In 2018, China’s gross domestic product grew by about 6.5 percent, the lowest rate since 1990. And part of the slowdown is a predictable result of deliberate government decisions, in particular policies that favor the state sector at the expense of the private sector — even though the state sector is woefully inefficient, whereas the private sector long has long been the country’s growth engine.

The most striking evidence, documented by the Peterson Institute of International Economics in October, is the drop in credit to the private sector and the rise in credit to the state sector in recent years. The largest banks in China are state-owned and hew closely to government command. In 2013, 35 percent of bank credit to nonfinancial enterprises went to the state companies and 57 percent to private companies; in 2014, 60 percent went to the state sector, and only 34 percent to the private sector. (The rest went to enterprises with foreign or mixed ownership.) By 2016, the distribution was even more skewed: with 83 percent of credit going to state-owned or state–controlled companies, and just 11 percent to private firms. (According to the Peterson report, 2016 is the last year for which official data are available.)

The official rationale for this policy was to reduce risk in the financial sector overall. Private-sector businesses tend to rely on riskier, shadowy sources of informal finance. But this practice is partly the result of existing policy and legal biases against private companies. And simply strengthening lending standards without improving the treatment of the private sector was inevitably going to squeeze its access to credit.

In the face of restrictions on liquidity, defaults and bankruptcies in the private sector have multiplied. The Chinese banking system operates on the basis of cross-guarantees, which means that a single bankruptcy can ricochet through an entire network of connections. If one company wants to take out a loan, it usually needs to secure a guarantee from another company, and so any company that struggles to pay back its loans is also endangering any companies to which it issued guarantees. The private sector accounted for 126 of 165 bond defaults in 2018.

In late 2018, the Chinese government did begin to increase credit flows to the private sector, but at the same time, it asserted more control over it. For example, the municipal authorities of the city of Hangzhou, an entrepreneurial hub, announced in September that officials would be assigned to some 100 private companies, including the e-commerce giant Alibaba. The stated justification for the measure was to improve communication between the government and private companies — a goal that could more readily be reached (as Hangzhou itself has done before) with some deregulation and less bureaucracy.

Against this background, there has been a significant amount of churn at the top levels of management of flagship companies. Jack Ma of Alibaba, Pony Ma of the internet company Tencent and Robin Li of Baidu, another major internet company, all relinquished some of their executive positions in recent times. These are not isolated events. According to the Southern Metropolis Daily, a Chinese newspaper, there were 1,401 executive-level resignations at listed companies between January 2019 and June 2019. The figure had ranged between 226 and 264 during the first half of the year from 2015 to 2018. Something has gone awry in China’s corporate world.

It’s unclear why China’s leaders want to curb the private sector when it has served the economy so well. One reason could be concern about growing income inequality. China’s Gini coefficient, a measure of such a gap in a society, is both higher than that of the United States and among the highest in the world, according to a 2014 study in Proceedings of the National Academy of Sciences of the United States of America. Yet many of the truly private capital owners in China are first-generation entrepreneurs who hail from humble backgrounds. Much of their income, especially in the manufacturing and high-tech sectors, really was earned, rather than inherited in any way. Their activities aren’t causing income inequality. The true reason for that gap, as the PNAS paper points out, lies in the “structural factors attributable to the Chinese political system.”

That the Chinese economy is slowing down isn’t necessarily a bad thing, at least not in itself. The consequences could be entirely benign. Ultimately, it is a country’s level of development — higher standards of living and a longer life expectancy, among other things — not its rate of growth, that matters most for the welfare of the people. A richer China, even with lower growth rates, would be cause for celebration, not distress.

But a slowdown is a problem if it’s the result of poor policy. Numerous studies show that China’s state-owned enterprises are less productive than private-sector businesses no matter how much support they receive from the government. And beefed-up financial assistance to the state sector hasn’t helped with its solvency so far: State-backed companies are also defaulting on their bond payments.

Throwing resources at the state sector instead of the private sector is a double whammy: Not only does it not improve the performance of (inefficient) state-owned enterprises; it also stymies (far more efficient) private companies. This misallocation imperils growth and job creation, and on a vast scale since, according to state media, in 2018 the private sector contributed 50 percent of tax revenue, 60 percent of gross domestic product, 80 percent of urban employment and 90 percent of all new jobs.

Trade tensions with the United States seem to have hurt China, and this week’s deal, however timid and tentative, is a welcome step forward. But China itself needs to get its own economy back on track — it needs to support its private sector again.

Yasheng Huang is a professor of international management at the Sloan School of Management at the Massachusetts Institute of Technology.

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