What is to be done about the excess capacity in China’s heavy industry? As the decade-long housing boom has topped out in recent years, companies that had bet on ever-rising demand for construction and building materials are finding themselves with idle factory capacity. The excess is probably most serious in steel, but is also evident in related sectors like coal mining (the fuel for the power plants that drive steel smelters). This idle capacity weighs on the economy by depressing prices and margins in the affected industries, and holding back corporate investment and hiring plans. The debate over how to respond to this issue pits those who advocate letting the troubled companies collapse and markets right themselves, against those who fear too much dislocation and argue for extending more subsidies and bank credit to help troubled companies through a rough patch.

Neither of these options is particularly attractive, and the choice to some extent is a false one. Yet discussion of the excess capacity problem seems to mostly swing between an extreme Andrew Mellon-style “liquidationist” position, and the “extend and pretend” school of hoping the problem will go away eventually if troubled enterprises get enough support. The government of late has seemed to lean toward the latter position: the central bank’s lowering of interest rates makes it easier for indebted companies to stay current on their interest payments. A May decision to lower industrial electricity rates and give iron ore mines a tax break was also clearly aimed at reducing operating costs for excess-capacity sectors. Recently Liu Shijin, an economist and senior official at the Development Research Center, a government think tank, stepped in with a proposal cleverly designed to appeal to both sides.

Because I think his proposal is both interesting and realistic in the Chinese context, I have translated here the relevant section of interview in which it appears. The key point is that he proposes using government debt to fund a restructuring plan to shut down excess capacity–which, because it will have real money behind it, will be more effective than previous such plans. I think he is right that direct government funding will be more effective than indirect measures like subsidies, and that there is a public interest in getting the market to clear sooner rather than later. But his plan does require the government to accept a higher level of official debt–something it has historically been reluctant to do, though recent plans for restructuring local-government debt have shown some acceptance of the principle. On the other hand, the sum of 300 billion renminbi that he quotes is hardly a prohibitive figure, given the size of China’s economy and government revenues. Overall this proposal seems like an advance on the current confused strategy, but I do not know how to handicap its chances of actually becoming policy.

China Economic Times: In recent years, China has been restructuring industries with serious excess capacity, but the speed of adjustment is not satisfactory. What are the underlying causes, and how can the situation be improved?

Liu Shijin: I think that the slow pace of restructuring in industries with serious excess capacity in recent years is due to two reasons. First is the effect of the “acceleration principle” that is inherent to the heavy and chemical industries. Due to the increasing specialization of the modern market economy, the production chain for final goods including infrastructure and real estate has lengthened. When demand for these final goods enters into a long-term phase of rapid growth, intermediate inputs will experience a self-reinforcing “acceleration effect.” So the extent of excess capacity in these industries, and the scale of the required reduction, could be greater than originally expected.

Second is the fact that local governments’ attitude toward industrial restructuring is not very proactive, or even passive. Although everyone has recognized that overcapacity is serious and that restructuring is inevitable, often they hope that others will restructure first so they do not have to. In addition to trying to avoid the conflicts caused by shuttering businesses and dealing with debts and re-employment, there is also a lot of selfish thinking by local governments: maintaining the existing businesses means you have a chunk of GDP, from which you can also get tax revenue. The result of these actions is that businesses are losing lots of money; bad companies want to exit the market but cannot, and good companies are also worn down. This is not sustainable.

To cope with this difficult situation, we must have determination to make progress, within a specific time period, in the exit and restructuring of this serious excess capacity. We can consider implementing an action plan for reducing capacity and raising efficiency in industries with serious excess capacity.

China Economic Times: Can you tell us about the specific ideas and measures you envision being part of this action plan?

Liu Shijin: I think this plan should include the following six parts:

First, select the industries to be included in the scope of the action plan, such as steel, coal, petroleum, petrochemicals, iron ore and other industries.

Second, draft a capacity reduction plan. As a preliminary calculation, the plan can be drafted to cover 10% of nationwide production in 2015, with the affected provinces’ plans made according to their share. State macro management departments can sign capacity reduction commitments or agreements with the affected provinces.

Third, establish a “capacity reduction and restructuring fund,” funded largely through the issuance of long-term (10 years or more) dedicated bonds. The amount of the bond issue will be determined by the scale of the capacity reduction in each province. The bonds will be issued and repaid by provincial governments, but the central government will subsidize the interest. The fund will be mainly used to subsidize corporate closures, restructuring and capacity reduction, as well as the placement and re-employment of affected workers. The size of the fund will be approved on the basis of these costs.

Fourth, the affected provinces will use this fund as a lever to promote implementation of the capacity reduction and restructuring plan. When designating production capacity for exit, we should not use the phrase “backward production capacity,” as this terminology is very characteristic of the planned economy. In practice it often means using the size or age of the equipment as a benchmark, rather than its efficiency or compliance with regulations. We recommend using the categories of “illegal capacity” and “inefficient capacity;” the former meaning that which does not national regulations on environmental, energy saving, safety, etc., and the latter meaning capacity with low efficiency that does not have a strong position in market competition. Local governments should follow open and transparent criteria to make a list of companies with “illegal capacity” and “inefficient capacity,” and guide these companies to take the initiative to participate in the capacity reduction and restructuring action plan. Companies that go through closure, restructuring and other capacity reduction measures can receive corresponding subsidies for capacity reduction, staff placement and re-employment. Regions with a large number of competitive enterprises can try using an auction technique, in which the company that bids the lowest [restructuring] cost will have preference in obtaining the subsidy. In short, the idea is to reduce the barriers and conflicts in the process by giving some compensation and some choice to companies that reduce their capacity.

Fifth, give local governments a relatively large amount of autonomy and scope for innovation in the use of the fund and the techniques for cutting capacity. [trimmed for space reasons] …

Sixth, there should be appropriate preventive and punitive measures to prevent a situation where companies think “other people are cutting capacity so I don’t have cut to cut capacity.” National statistics and auditing agencies can do checks in the affected regions, and we can also introduce mechanisms for public supervision. If they find that capacity reductions have been reduced or falsified, there can be a public report and criticism, and a corresponding reduction in the central government’s subsidy. There can also be a request for political discipline of those areas that have committed to reduce capacity. We can use administrative methods in combination with market mechanisms to ensure the desired effect.

China Economic Times: What do you think will happen if such an action plan is implemented?

Liu Shijin: If you implement this action plan for reducing capacity, restructuring industry and raising efficiency, it will send an important signal to society, which is that there will be important changes in the relationship of supply and demand in the affected industries. This signal may drive a rebound in prices. Coal and steel account for a large share of the industries with severe overcapacity. According to preliminary estimates, the funds required for these two sectors are 80-100 billion yuan and 200 billion yuan respectively. If the term of the bonds is over 10 years, and there is an interest subsidy from the central government, it will not create great pressure for local governments. In the short term, there may be some impact on the growth of local GDP and tax revenue from cutting capacity, but once prices rise, these losses will be more than made up for. This is a process of “trading quantity for price,” and is overall beneficial to the locality. Therefore this should be considered a supportive policy for areas with a high concentration of excess capacity, particularly the old industrial bases that have a high proportion of heavy and chemical industries.