China's Economic Growth Falls Short of Potential
There's a fairly widespread view in the West that we shouldn't be surprised that China's growth has slowed from the double digits down to the 6 percent to 7 percent range in the last few years. And of course, this point of view typically leads to the conclusion that we should expect the growth to slow down a bit more as the economy becomes more mature. This view has been articulated in the strongest form by Larry Summers and Lant Pritchett. They have three different estimates of what China's growth will be going forward until 2033. They talk about full convergence where China will grow 2 percent because they have to look at what everybody else does. They have another estimate, a little bit higher based on the idea that there will be some convergence. And then there's a third estimate that also looks to be about 4 percent.
My view is very different. I don't think China's slowdown is a harbinger of even slower growth in the future, but I think that China is growing significantly below its potential in recent years, for several reasons.
First of all, the performance of state-owned companies has deteriorated significantly since the global financial crisis. If you look at the industrial sector, for example, private companies today have a return on assets that is actually higher than it was in 2007, before the financial crisis, somewhere between 10 percent and 11 percent. State companies are turning in returns of less than 3 percent, substantially below where they were prior to the global financial crisis. So state companies in the industrial sector have had a very substantial slowdown. If we look more generally at a big universe of state companies, the ones that are administered under the central State-owned Assets Supervision and Administration Commission (SASAC), which includes a range of industrial firms and firms in the service sector, their returns have gone from 6 or 7 percent down to about 2.5 percent. They represent a very large chunk of overall state-owned companies, so their performances also deteriorated.
In addition to this, which is slowing down economic growth, the share of investment now being undertaken by private companies that are generating higher returns has declined significantly. The slowdown started around 2012 and had deepened by 2016 and '17. Investment for private companies has declined and is now substantially less than the rate of growth of investment of state companies. The share of investment undertaken by state companies, which had been going down for more than 20 years, has now started, at least in the last few years, to go up. The economic slowdown probably has something to do with the decline in the productivity of state companies and, secondly, the fact that private companies' share of investment is declining.
Why are private investments declining over the state investments in the last few years? First of all, private companies have been squeezed out. In the data published by the People's Bank of China, the share of loans going to state companies has almost tripled since 2012.
The second problem seems to be that private property rights have not been adequately protected. A document issued by the Central Committee of the Chinese Communist Party in 2016 along with the State Council stated that private property rights must be better protected. They should be treated according to the law, and there should not be illegal confiscation or freezing of private assets. At his press conference at the close of the National People's Congress in March, Premier Li Keqiang argued that the lack of protection of private property rights played a role in slowing down private investment. These are at least two potential reasons why private investment has slowed down: squeezing out on the financial side, the fact that state companies are taking more; and uncertainties that private investors feel.
Another factor is the continuous emphasis that state enterprises should be bigger and better. The bigger is easier to measure: the SASAC chairman at the Boao Forum for Asia Annual Conference focused on growing revenue rather than efficiency, return on assets, or probability.
I'm relatively optimistic about China's medium-term economic growth, if the government puts in an effective reform program that would raise the productivity of assets controlled by the government. There is a tremendous contradiction between what's happening in the real sector, on the one hand, and the financial sector on the other hand. Since 2013, tremendous progress has been made in financial reform. There are exceptions, but the reform of enterprises is very far behind. Emphasis tends to be on mergers as one of the mechanisms of improving productivity, but most mergers are top-down mergers, and I think this program has failed. The assets of SASAC companies have gone from around 10 trillion yuan ($1.5 trillion) in 2005 to 55 trillion yuan last year. The number of group companies has gone from 196 to something like 98. The average assets of these companies has gone from about 50 billion yuan to 500 billion yuan, but the returns of assets has gone from around 6.5 percent down to 2.5 percent. Thus, the merger program in this very important universe of firms has not led to improvements in productivity.
The second element of the reform program is corporatization, changing the state companies into limited liability companies. The government believes that these changes should be positive for productivity.
The third component is what the Chinese refer to as "mixed ownership." But corporatization and mixed ownership have been pursued now for more than a decade. Almost every state company has been corporatized. Many of them have mixed ownership. But the performance of these companies has not improved. In fact, it's gotten worse. The data coming up from the Ministry of Finance shows that about 50 percent of all state companies have been losing money every year since before the financial crisis. The amount of losses has increased sevenfold from 2005 to 2016. The share of companies losing money has technically gone down a little bit, so it seems like a subset of state companies is losing a larger and larger amount of money, and this is coinciding with the program of mergers, corporatization, and the development of mixed ownership. China should have a more bottom-up merger program in which more productive companies have the opportunity to take over the assets of other underperforming assets rather than all those top-down merger programs. And there should be more bankruptcy. There are very few bankruptcies in China, very little exit. As shown by the government data, 50 percent of the companies were losing money in 2005, and in 2016 it was 45 percent, so there doesn't seem to be much exit of underperforming companies.
Finally, I think there needs to be a much-stronger financial program. Yes, the financial sector is much bigger, it's more diverse in certain ways, but the financial sector is supporting a lot of money-losing companies. And one of the things I think is most important in understanding this is that if you look at the banking sector, the growth of assets that is mostly loans has been most rapidly in city commercial banks, real commercial banks, and smaller banks at the local level. The share of assets of the big banks, the "big four" plus the Bank of Communications has declined by more than half what it was compared to 15 years ago. These local banks are much more subject to pressure from local political and government leaders who want to support state enterprises. So their loans have increased, relying extensively on interbank borrowing as a funding source. There needs to be a reform in the financial sector so the resources can be allocated to the firms that are more productive.
In conclusion, there is an important relationship between the financial sector and real sector. China needs to adjust the financial sector before it completely opens up, and I fear that the financial sector is still somewhat impaired by a requirement or a tendency that it should support state-owned companies. However, I don't think China is facing a hard landing because it has made a lot of progress in the shift toward more consumption-driven growth from investment.