Streetwise Professor

As goes China, so go the commodity markets. The problem is that where China goes is largely driven by a bastardized form of central planning which in turn is driven by China’s baroque political economy. In past years, China’s rapid growth conferred on the government a reputation for wisdom and foresight that was largely undeserved, but now more people are waking up to the reality that Chinese policy engenders tremendous waste, and that the country would actually be richer–and have better prospects for the future–if its government tempered its dirigiste tendencies.

Case in point: Morgan Stanley’s Chief China Economist uses the ham-fisted intervention into the coal industry to illustrate the broader waste in the Chinese system:

These reforms entail the necessary reduction of excess capacity, particularly in state-owned enterprises (SOEs) and industries where overproduction issues are often the most acute.

While economists agree that a reduction of excess capacity, particularly in heavy industry, is key to the nation’s efforts to get on a more sustainable growth trajectory, China’s supply side reforms bare little resemblance to the “trickle down” Reaganomics of the 1980s, which seized upon tax cuts and deregulation as a way to foster stronger growth.

In Morgan Stanley’s year-ahead economic outlook for the world’s second-largest economy, Chief China Economist Robin Xing uses the coal industry to detail two key ways in which supply-side reforms with Chinese characteristics have been ill-designed.

“The state-planned capacity cuts and the slow progress in market-oriented SOEs reform have come at the cost of economic efficiency,” laments the economist.

In a bid to shutter overproduction and address environmental concerns, Beijing moved to restrict the number of working days in the sector to 276 from 330 in February.

But in enacting these cuts, policymakers employed a one-size-fits-all approach.

“The production limit was implemented to all companies in the sector, which means good companies that are more profitable and less vulnerable to excess capacity are affected just as much as the bad ones with obsolete capacity and weak profitability,” writes Xing.

This is largely true, but begs the question of why China adopted this approach. The most likely explanation is that the real motive behind the cuts has little to do with “environmental concerns”, though those are a convenient excuse. Instead, forcing the most inefficient producers out of business–or allowing them to go out of business–would cause problems in the banking and (crucially) the shadow banking sectors because these firms are heavily leveraged. Allowing them to continue to produce, and propping up prices by forcing even relatively efficient firms to cut output, allows them to service their debts, thereby sparing the banks that have lent to them, and the various shadow banking products that hold their debt (often as a way of taking it off bank balance sheets).

If the goal was to reduce pollution, it would have been far more efficient to impose a tax on coal-related pollutants. But this tax would have fallen most heavily on the least efficient producers, and would caused many of them to fail and shut down. The fact that China has not pursued that policy is compelling evidence that pollution–as atrocious as it is–was not the primary driver behind the policy. Instead, it was a backdoor bailout of inefficient producers, and crucially, those who have lent to them.

Morgan Stanley further notes the inefficiency of the capital markets which favor state owned enterprises:

As such, this misallocation of production serves to amplify the already prevalent misallocation of credit stemming from state-owned firms’ favorable access to capital. That arguably undermines market forces that would otherwise help facilitate China’s economic rebalancing.

But this too is driven by politics: SOEs have favorable access to capital because they have favorable access to politicians.

The price shock resulting from the output cuts hit consuming firms in China hard, which has led to a lurching effort to mitigate the policy:

This month, Beijing was forced to reverse course to allow firms to meet the pick-up in demand — another case of state dictate, rather than price signals, driving economic activities.

“In this context, we think the more state-planned production control and capacity cuts cause distortions to the market and are unlikely to be sustainable,” concludes Xing.

“Beijing was forced to reverse course” because utilities consuming thermal coal and steel producers consuming coking coal pressured the government to relent.

The end result is a policy process that owes more to the Marx Brothers than to Marx. A cockamamie scheme to address one pressing problem causes problems elsewhere.

Methinks that Mr. Xing is rather too sanguine about the ability or willingness of the Chinese government to sustain such highly distorting policies. They have done so for years, and are showing no inclination to change their ways. Efficiency is sacrificed to achieve distributive and political objectives, and the bigger and more complex the Chinese economy the more difficult it is for the authorities to predict and control the effects of their policy objectives. But this just induces the government to resort to more authoritarian means, and attempt to exercise even more centralized power. This is costly, but these are costs the authorities are willing and able to bear. Inefficiency is the price of power, but it is a price that the authorities are willing to pay.