Schvets on China’s impossible trinity

Macquarie’s magnificent Viktor Schvets on the tough choices facing China:

While quantifying grow this always more of an art than a science, in China it is even more so. Based on the Soviet-style production and growth targets (vs expenditure derived ex-post estimates elsewhere), China’s economic results are even more opaque than usual. This has created a vibrant field of studies, with views ranging from China soon overtaking the US to China being a ‘Paper Tiger’.

At the heart of this debate is the productivity trajectory, and ability of China to improve efficiency while satisfying a myriad of social and political objectives. Depending on methodology employed, China’s TFP (or Total Factor Productivity, after excluding contribution of labour and capital) has either already gone negative or has suffered from a significant slowdown. One of the best sources of productivity data (i.e.,Conference Board–TED) has alternative measures that show not only a far more volatile trajectory of China’s GDP (vs smooth official numbers) but also that China’s TFP essentially stop growing a decade ago. Even official estimates show a sharp contraction in TFP from 5%-6% in the ’90s to 2.8% pre-COVID. Most other estimates fall in between these extremes, but all highlight slower gains, as relocation of labour to higher productivity sectors has been largely completed, and it is now moving into lower productivity services. The same trends are also evident in simpler indicators (e.g.,output per employee).

The key to further gains lies not in export competitiveness but in domestic non-tradable sectors as well as SOE reforms, and these will be far more challenging than improving external competitiveness. Through a myriad of reforms, China has achieved far more than any other EM in making SOEs as competitive and responsive as possible while avoiding extreme kleptocratic tendencies. Given the size&complexity of China, this has been a major achievement. But, increasingly, SOEs are placed in a difficult position, facing an impossible trilemma: improved governance and oversight, managerial incentives and fulfilling an ever growing list of national and political goals. Better governance and maximization of returns require clarity and environment of laws and impartial regulation. This, however,conflicts with the need to service multiple national objectives under the strict state supervision. It will be a difficult trade-off and could prevent SOEs from raising their low ROEs and ROAs. We estimate China’s domestic productivity (including agriculture) is only 20%-25% of the US’s–hence, opportunities are real.

In the absence of an efficiency boost and given disappearing labour inputs, China faces a choice:(a)accept far lower growth (say, ~3%), courting a backlash from an economy geared to double digit nominal GDP; (b)continue to rely on capital intensive sectors (i.e.,real estate, infra,etc.) causing further overinvestment, lower returns, and need for capital support; or(c) find an elusive middle ground, where politics and economics converge at growth rates that while much lower than 6%, might be just enough to build middle class and avoid extremes of capital or credit volatility. Choice (c) is clearly the preferred outcome, potentially making China’s economy more sustainable but smaller than bullish forecasts. Politics will not change and role of the state will continue to expand–all eyes should be on domestic structural reforms and how SOEs manage their complex trilemma while maintaining stability. We maintain focus on China’s secular, not policy, strengths.

The answer on all counts is SOE privatisation to restore productivity gains and shift wealth from the government to households. This achieves two vital aims of restoring productivity and income growth while rebalancing towards consumption over investment.

The problem, however, is political. To do so, the CCP must let loose the reins of power on the private economy, as well as allow private individuals and the private sector to gain power.

That’s something the CCP cannot do.

I, therefore, see policymakers lurching between Schvets points A and B for years before the economy bogs permanently into the middle-income trap.

From there, the CCP will declare a war on everybody to distract idle hands at home.

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