Rediscovering the importance of export discipline

The new IMF working paper on industrial policy, by Reda Cherif and Fuad Hasanov, has gotten a lot of notice, and indeed it is very clear, comprehensive, and useful. But for anyone who has already done some reading on the history of successful Asian economies, particularly Taiwan and South Korea, it is not exactly surprising stuff. Here for instance is their quick summary of the key characteristics of these economies’ successful industrial policies:

  • Intervene to create new capabilities in sophisticated industries: Pursue policies to steer the factors of production into technologically sophisticated tradable industries beyond the current capabilities to swiftly catch up with the technological frontier.
  • Export, export, export: A focus on export orientation as any new industrial product was expected to be exported right away with the use of market signals from the export market as a feedback for accountability. As conditions changed, both the state and the firms adapted fast.
  • Cutthroat competition (at home and abroad) and strict accountability: No support was given unconditionally although performance assessment was not necessarily based on short term profits. While specific industries may get support, intense competition among domestic firms was highly encouraged in domestic and international markets.

The combination of a focus on exports with tough competition sounds a lot like what Joe Studwell, in his 2013 book How Asia Works (which is not cited in the IMF paper’s bibliography), called “export discipline.” His explanation is clearer and punchier:

Governments in all the major economies of east Asia tried at some stage to nurture domestic manufacturers. That those in north-east Asia succeeded, while those in south-east Asia failed miserably, turned on a small number of policy differences. By far the most important of these was the presence – or absence – of what I call ‘export discipline’.

This term refers to a policy of continually testing and benchmarking domestic manufacturers that are given subsidies and market protection by forcing them to export their goods and hence face global competition. It is their level of exports that reveals whether they merit state support or not. …

Where export discipline has not been present, development policy has become a game of charades, with local firms able to pretend that they have been achieving world-class standards without having to prove it in the global market place. In south-east Asia, the energies of entrepreneurs were directed towards fooling politicians rather than exporting.

I would still recommend Chapter 2 of How Asia Works as the definitive comparison of successful and unsuccessful industrial policies in Asia.

The point of such a comparison is to move beyond sterile debates over whether industrial policy can ever work, since in fact basically all countries have some kind of policy for promoting particular industries. As Cherif and Hasanov put it, “The key question is, if many countries have been conducting industrial policy anyway, what should the right way to do this be.” The presence or absence of export discipline should be a useful way to evaluate whether industrial policy is likely to be successful.

Even within Asia this lesson is not as widely appreciated as it perhaps could be. For instance, former Chinese finance minister Lou Jiwei recently made a surprisingly harsh public criticism of Made In China 2025 (for which he has apparently been forced into early retirement). He called it a waste of taxpayers’ money and an unwarranted intrusion of government: “those industries are not predictable and the government should not have thought it had the ability to predict what is not foreseeable.”

While I have a lot of respect for Lou, I’m not sure this is the strongest criticism of Made in China 2025. It’s not clear that “the market” would necessarily pick different industries as being desirable to invest in now: the ideas that people have about what technologies are going to be important in the future don’t seem to be that different across the public and private sectors. The Chinese government have have a plan to promote artificial intelligence, but private venture capital firms are also throwing plenty of money at that sector as well. Semiconductors are one of the key sectors targeted by The Made In China 2025, and I don’t think many people are seriously arguing that semiconductors won’t be important in the future.

This is not to say that venture capital investors are necessarily going to be right about the future either, just that both government officials and venture investors can read the same things and are influenced by the same conventional wisdom. This point is not original to me: I picked it up from Brad DeLong’s 2010 book with Stephen Cohen, The End of Influence:

Americans like to say scornfully that industrial policy is about “governments picking winners.” Picking winner industries is not that hard—even for governments. Most countries trying to climb the ladder of quality and industrial sophistication through selective promotion compiled pretty much the same lists at the same time. Even at the leading edge of the technological frontier, the industries that governments are tempted to promote are largely the same ones picked by the analysts and brokers at investment firms such as Merrill Lynch, Nomura, or Rothschild’s.  …

Picking “winner industries” is not the hard part; winning is. It is difficult to create actual winners, companies that develop into successful competitors.

And that, of course, is where export discipline comes in.

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How much did outside advice really change things in Russia and China?

Recent polemics against neoliberalism have revived an old debate over the role of the economic advice given to developing countries by the World Bank and IMF. A crude but nonetheless influential interpretation of the relevant economic history holds that Russia’s failed “shock therapy” privatization of SOEs in the 1990s was the result of uncritical acceptance of free-market dogma pushed by the international financial institutions, while China’s successful “gradualist” approach to SOE reform was the result of wise officials ignoring those same institutions and carefully designing policy according to local conditions.

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Chart from Novokmet et al. “From Communism to Capitalism: Private Versus Public Property and Inequality in China and Russia”

This interpretation may accord too much importance to the advice given by the international financial institutions, and too little to the domestic politics of the countries actually making the decisions.

John Nellis, a participant in the World Bank’s first mission to the USSR in 1990, has published an account of that period based on his notes taken at the time. It makes for fascinating reading. It’s particularly interesting that the famous Soviet State Planning Committee, or Gosplan, seemed committed early on to a “gradualist” approach to reforming state ownership:

Even here, in the principal basilica of socialist planning, no one questioned that the old system had failed and that a transition to the market, or something approximating a market, was urgently required. But those we met in Gosplan, and many of those we met in other Soviet ministries and central units, thought that the transition would be a gradual, lengthy affair, and that the outcome would be some sort of mixed approach. In this evolutionary process they thought (or hoped) that Gosplan would retain authority to forecast, analyze, assist, guide and even lead reform. …

As for the future of the real sector, the officials’ evolutionary vision was that the massive, multi-divisional state enterprise/ministerial complexes would be broken down into “correctly sized” units. These would then go through a process of “corporatization” and would become joint stock companies, with all shares initially held by the state. These would then undertake a process of finding private partners, Soviet or foreign, who would bring in capital, technology, management expertise, and access to markets. Some percentage of shares would have to be turned over to these partners, but it would at first be a minority share, particularly for foreigners. These processes had just begun to start and, in their view, years would pass before substantial results were seen. Central organs such as Gosplan would guide and assist this evolution. Majority private ownership was a long-term prospect.

This aspiration is not so different from the course that was actually followed by China. (Nellis also notes that a 1988 Soviet law had allowed for the creation of cooperatives, which, much like China’s township and village enterprises in the 1980s, often functioned as de-facto private companies.) The joint World Bank-IMF report that was published after the mission acknowledged that large-scale privatization was effectively impossible, and focused more on how to manage state enterprises effectively.

All this suggests that China’s “gradualist” approach to overhauling state ownership was less a strategy adapted to uniquely Chinese conditions, but more the approach most likely to be favored by a socialist government that wanted to maintain political continuity and control over the reform process. Yet by 1992, the Soviet Union had been dissolved, and the Russian government launched a program of rapid mass privatization using vouchers–a much more radical approach than anything that had been considered in 1990. Nellis asks the obvious question:

The overwhelming majority of persons we spoke to in 1990 were gradualists. They wanted to effect as painlessly and politically acceptable as possible a transition to the market. …

Why did the 1990 joint IFI mission not get a glimpse of the coming emphasis on mass privatization? How did it — we — miss the fact that the government of the Russian Federation would opt for audacity?

The answer, clearly, is the radical change in domestic politics after the vote to dissolve the Soviet Union in 1991. In particular, the failed coup against Gorbachev, which was led by representatives of the same conservative interest groups that had tried to stymie economic reforms. After the failed coup, the reform and privatization of state enterprises was no longer a technocratic matter of economic management, but an urgent political task to dismantle the strength of the interest groups that had led the coup. The new Russian government was driven by an “overriding fear that the communists might try again to regain power,” Nellis writes. And the reshuffle of domestic politics had elevated to decision-making positions people who were not that important in 1990, and had not previously had well-formed views. 

A more recent, if less detailed, summary of the World Bank’s involvement in Chinese SOE reform by Zhang Chunlin serves as something of a companion piece to Nellis. Zhang is currently the lead private sector development specialist at the Bank, and previously worked on Chinese SOE reform both at the Chinese government and the World Bank. He writes that

The Bank’s work in the 1980s focused on the reform of the traditional SOE model itself while maintaining state ownership. Recognizing the need for state direct control over some “important enterprises” such as public utilities, the [1985] report argued that once a suitable economic environment is created through price reform and competition, pursuit of profit should lead most state enterprises in economically appropriate direction. The fundamental problem remains of the proper relationship between the state and the enterprise.

The central theme of the World Bank’s recommendations for China was not the necessity of privatization, but of corporatization: giving state-owned enterprises the legal form of modern corporations. That promised to improve management and decision-making within SOEs. But it also posed the problem of how the state was to exercise its ownership rights to control these firms. Much of the Bank’s work since the 1990s has focused on finding the right institutional structures for effective state ownership, and it has advocated for reducing state ownership in many sectors.

But the radical downsizing and privatization of SOEs that started around 1995 and continued through about 2002 was a domestic decision driven by the dire financial situation at many firms. A World Bank report in 1997 did call for state ownership to “completely withdraw from inherently competitively structured industries where small and medium sized firms predominate,” but it noted that this recommendation “would formalize a process that is already underway.” (And, of course, China did not actually follow this recommendation.)

Zhang also notes that in later years the World Bank contributed to the debate over the creation and structuring of an agency to represent the government’s interests in SOEs, the body now known as Sasac. It’s less clear if this is a contribution the Bank should be proud of: Sasac is widely regarded as a conservative interest group that has worked to strengthen the position of large SOEs, rather than to further their effective reform. But Zhang mainly wants to emphasize the “productive partnership” that the Bank has had with China. “In retrospective, a clear reason why the Bank managed to stay relevant has been its willingness to adapt to China’s own reform strategy,” he writes.

Yet that is perhaps not so different from how the World Bank worked with Russia in the 1990s: it was willing to adapt to both the gradualist preferences of the Soviet leadership in 1990, and the radical program of the new Russian government in 1992. In the case of both Russia and China, the World Bank seems to have mainly tried to help their governments find the best way to implement decisions that had already been reached by domestic political leaders. It’s not clear that the advice of international financial institutions really played a decisive role in making those decisions.

 

 

The underrated role of fear in economic development

William Overholt’s book China’s Crisis of Success covers a lot of different topics, but one theme that he keeps coming back to is fear.

A lot of what drove China’s daring early economic reforms was fear of falling back into the chaos of the Cultural Revolution. Fear can motivate political leaders to do things that are out of the ordinary, and motivate the population at large to accept them. It is not a coincidence, in Overholt’s view, that the miracles of economic growth in Asia followed national catastrophes:

The societies that have been able to implement the required policies [for rapid economic growth] are all ones that have experienced excruciating trauma and intense fear: Japan after losing World War II; South Korea after the Korean War; Taiwan after the Chinese Civil War; Singapore after its traumatic separation from Malaya (which meant facing two much larger powers, Indonesia and Malaysia); Vietnam after wars with France, the United States and China; and China after a century of foreign humiliation and tens of millions of deaths from domestic strife. …

The policies required for rapid growth entail enormous social dislocations, and political leaders who consider imposing such dislocations reasonably fear for their jobs. They only try when they are terrified of the alternative, and when a population fearful of collapse accepts otherwise unacceptable stresses. These are the political prerequisites of miracle-level growth.

I think there is something to this, even if it’s not the kind of insight that seems particularly easy to run regressions on (parts of Europe after the second world war probably also belong on the list).

Overholt calls China’s current situation a “crisis of success” because it has in fact succeeded in dispelling fear of national collapse. But without that fear, it is harder for political leaders to make disruptive changes to the system, and it is harder to convince interest groups to accept such changes.

One of China’s current problems is that shared national fear of collapse has given way to complacency and some hubris. …

As fear segues into confidence, the willingness of the population to endure terrible stresses dissipates and so does the motivation of the leaders to take great risks.

For this reason he thinks it is becoming difficult for China to continue liberalization that would reduce the role of government intervention and state-owned enterprises in the economy (the book, which came out at end-2017, is somewhat equivocal about this, but in person Overholt nowadays is more decisively pessimistic).

In recent years, advocacy for continued economic liberalization in China has been organized around the idea of the “middle-income trap”: if China does not do XYZ reforms, the argument goes, it will fall into this trap and not realize its full potential. But the middle-income trap is not a disaster or national catastrophe; it’s just things being not as good as they perhaps could be:

The stakes are different now – not war, not chaos, not financial collapse, just slower growth.

Since China’s growth is going to slow anyway, no one can honestly promise China that, if they do XYZ reforms, growth will not slow down. All they can argue is that growth might not slow down as much as it otherwise would. Which is not that compelling of an argument. So fear of the middle-income trap may not be enough to motivate the Communist Party to make politically difficult changes that reduce its ability to direct economic activity.

Fear does seem to be a stronger motivator in environmental policy: families rightfully fear for the health of their children, and political leaders rightfully fear the anger of families. The “fear model” thus suggests China could continue to make progress in reducing pollution, even if future economic liberalization is limited.

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How plausible is the China in Kim Stanley Robinson’s *Red Moon*?

The premise of Kim Stanley Robinson’s new novel Red Moon is that China has taken the lead in colonizing the moon, leaving America far behind. I am a Robinson fan, and since the theme of China overtaking the US is very much in the air these days, I was interested to pick up the book to get his take on it.

Here is how one character describes China’s decision to establish a lunar base:

At the Twentieth People’s Congress, in 2022, the Chinese Communist Party and its Great Leader President Xi Jinping decided that the moon should be a place for Chinese development, as one part of the Chinese Dream. In the twenty-five years since that resolution was made, much has been accomplished in China’s lunar development.

Later a character explains:

In China, if the Party chooses to do something, then the whole country can be rallied to that cause. One out of every six humans alive, in other words, devoted to the project of establishing a base on the moon. This was far more than needed to do the job! Not every Chinese person was involved, and only a small percentage of China’s capital reserves had to be directed up here, even though it was a pretty big project. But it wasn’t that big, and in the end it was just more infrastructure.

This is not bad! For China to treat a lunar base as an extension of the Belt and Road Initiative, and “just more infrastructure,” is a fairly straightforward extrapolation of recent trends in Chinese political economy. And it has a ripped-from-the-headlines feel, given that in January, China became the first country to land a spacecraft on the far side of the moon. With India and Israel also planning lunar missions, lunar exploration is in fact a good reflection of the shift from bipolar or unipolar world to a multipolar one.

But sharp-eyed readers will have noticed that in the above Robinson says “People’s Congress” when he really means “Party Congress.” Annoying errors like this abound. Even more troubling are the names of the many Chinese characters, which often seem to be invented randomly without reference to the actual Chinese language. The president of China in 2047, for instance, is supposedly named Shanzhai Yifan. Not only is shanzhai not even a Chinese surname, it is (as anyone who uses the internet should know) a slang term meaning something like “cheap knockoff.” So did one of Robinson’s sources play an elaborate joke on him? Or is this just sloppiness?

Being fuzzy about the details of foreign languages and political systems is not a criminal offense for a writer of speculative fiction, who after all is supposed to be speculating rather reporting. But it seems that apparently neither Robinson nor his publisher could be bothered to run the manuscript by an actual Chinese-speaking person before publication. I’m not even a native speaker, and I could have fixed most of these minor issues in a couple hours of work. As a result, the book is something that no Chinese-speaking person could ever take seriously.

The more fundamental problem with the future China in this book is that it’s not really a future China: it’s just today’s China with some of the names changed. And sometimes not even that: in 2047 Chinese people are apparently still sending each other messages on WeChat on their mobile phones, and complaining about the Great Firewall. There’s a whole subplot about a social revolution unfolding in China, in which people’s grievances seem to have been lifted from dated magazine articles: the “breaking of the iron rice bowl” and the hukou system. That subplot is very thinly sketched and happens mostly offstage, and as a result is not even convincing as narrative, even aside from the details.

Red Moon has generally received mixed reviews, as it has other narrative weaknesses besides the poor portrayal of China. I think we’re still waiting for a work of fiction that gets to the heart of how America deals with a rising China — admittedly a pretty demanding task.

For better recent Robinson, I would recommend Aurora, and also Shaman, which I think is underrated, and features some of his best nature writing.

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Does the state still love state-owned enterprises even after they’re not state-owned anymore?

That is the question raised in an interesting new NBER paper on the aftereffects of China’s privatization of SOEs in the late 1990s: “Can a Tiger Change Its Stripes? Reform of Chinese State-Owned Enterprises in the Penumbra of the State,” by Ann Harrison and four coauthors.

They report that in 2013, 45% of industrial SOEs received government subsidies, but only 15% of private industrial firms received them. Privatized SOEs, however, are different: 25-35% receive subsidies, much more than firms that were always private. Similar results show up in access to finance: privatized SOEs pay higher interest rates than current SOEs firms but lower interest rates than firms that had always been private.

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Their hypothesis is that “allocation of government support in the form of subsidies, tax breaks or low interest loans favors both SOEs and former SOEs.” They conclude that while SOEs do change their behavior after being privatized, the government does not change its behavior toward those companies: “former SOEs retain ready access to large loans, concessionary interest rates, and outright subsidies.”

But why should this be the case? The paper is curiously silent on this.

The whole point of the SOE privatization over 1998-2003 (after that, privatization basically stopped) was so that the government would not have to keep giving free money to money-losing SOEs. Privatizing the SOEs, and then continuing to give them lots of free money, rather seems like the worst of both worlds. So it seems rather unlikely that this pattern is the result of a deliberate, centralized policy choice.

My hypothesis would be: it’s about people. Let me propose that the managers of SOEs understand the government pretty well and are pretty good at extracting benefits from the system. Since, after all, that is a good part of their job.

Furthermore, the managers of privatized SOEs are often going to be the same people who managed the firm when it was state-owned. One survey of SOE privatizations found that sales to insiders (aka management buyouts) were by far the most common type of deal, accounting for 47% of their sample.

Therefore, privatized SOEs are often going to be run by people who have established relationships with government officials and managers of state banks. It stands to reason that they are going to be better at working those relationships than the executive of a run-of-the-mill private company. And that companies that have been able to obtain subsidies in the past would know best how to continue obtaining those subsidies in the future.

On the financial front, this behavior by state banks is not irrational. If a state bank has an established relationship with an SOE, that relationship doesn’t just evaporate once the SOE is privatized. The bank will still have a lot of knowledge about its customer, and have a history that makes it more comfortable continuing to lend on favorable terms.

So the persistence of favorable treatments for SOEs after privatization is probably mostly about the persistence of relationships–and firms’ understandable unwillingness to relinquish established sources of commercial advantage.

A preview of Nick Lardy’s new book *The State Strikes Back*

A new Nick Lardy book comes along regularly every few years, and each one is an event for the China-watching community. Anyone who cares about the Chinese economy will find The State Strikes Back: The End of Economic Reform in China? interesting and provocative. This is a preview, not a review, since the book is not officially out until next week and so my Kindle pre-order hasn’t downloaded yet. But I saw his book talk in Seattle last night, where he gave a characteristically clear and concise summary of the argument (he also has an op-ed in the FT.)

The new book has to be understood in the context of Lardy’s previous book from 2014, Markets Over Mao: The Rise of Private Business in China. In that book he argued that it was the rise of increasingly efficient and productive private-sector companies that has driven China’s economic growth over the last four decades, not state-owned enterprises, government planning and industrial policy. In contrast to the view in some quarters that China remains a fundamentally state-controlled economy, he laid out all the ways in which markets have been liberalized and competition increased since 1978.

A lot of the key changes in the relationship between the state and private sector happened in the 1980s and 1990s, and are well explained in that book. But Lardy also engaged with the argument that, as he put it, “state-owned firms returned to prominence of the decade of leadership of President Hu Jintao and Premier Wen Jiabao (2003-12)”.

While acknowledging that the Hu-Wen government wanted to make state enterprises and industrial planning play a a bigger role in the economy, he argued that the data showed they had not succeeded. In fact, the private sector’s share of economic aggregates had continued to increase, not because of continued privatization but because private firms are more efficient and grow faster than SOEs. This process was aided by a substantial increase in private firms’ access to bank credit.

The main point of Lardy’s new book, based on his slides and talk, is that the positive trends he had emphasized in his last book are now going in reverse. The data now show that private firms’ access to bank credit has sharply declined, and that their share of various economic aggregates is also falling. He puts particular emphasis on the drop in lending to private firms:

soe-private-loans

(Note: Lardy has a chart like this in his slides, but this is my chart not his. It is based on the same underlying data but my estimates come out slightly different.)

The big decline in bank lending to the private sector (the absolute volume of new loans to private companies shrank, not just the share) had major consequences. It forced private firms to rely even more on shadow finance. But in 2016 the government also decided (correctly) that the rapid expansion of shadow finance posed systemic risks. The tightening of regulation led to an outright decline of shadow financing in 2018, putting many private firms into dire financial straits. The financial pressure on private firms has allowed their state competitors to expand at their expense: SOEs in industry are growing faster than their private competitors. Lardy said this is the first time this has happened since 1978.

iva-soe-private

(Again, this is a re-creation of one of Lardy’s charts using public data.)

Lardy thinks all this is bad for China. He is right! He also puts most of the blame on the policies of Xi Jinping–tolerating SOE inefficiency, encouraging the creation of larger SOEs, tightening Party control over private firms–since these trends in the data did not show up until a few years into his administration.

Essentially, both of Lardy’s recent books are about the use of economic data to support a narrative about the direction of reform in China. In Markets Over Mao, he argued that the data did not support a narrative of the resurgence of the state sector, and in fact supported a narrative of the rise of the private sector to new heights. I think it is fair to say that a number of people felt that Lardy in that book was too forceful in downplaying trends that were in fact important, but perhaps were difficult to tease out in the aggregate economic data. Now, Lardy is arguing that the data support a narrative that the state is resurgent and the private sector is losing out. Since this is a recent reversal of a positive long-term trend, he thinks that if China changes course it could significantly boost its economic growth rate, by as much as 2 percentage points.

My own view is more that economic policy under Xi Jinping represents an intensification of trends that were already playing out under Hu Jintao. I think this is pretty clear if you pay attention to China’s official rhetoric and try to understand the underlying political economy. Since I think the problems go back further than 2015, I am less optimistic than Lardy about China’s longer-term growth prospects (thanks to Greg Ip of the WSJ for including a summary of my views in his latest piece).

I also think that it is tricky to tell a clear story about the rise or fall of the state sector using the official economic data–having spent a lot of time and effort trying to do that myself. As someone who very much appreciates Lardy’s careful work with Chinese data, let me offer a couple of caveats to the charts above, in the spirit of seeking truth from facts.

First, on the bank lending data. Lardy is right to highlight the sharp downturn in lending to private companies in 2015-16. But it is not clear to me that this is a result of government policy to favor SOEs. Recall that there was a pretty serious economic downturn in 2014-15. It would make sense for banks to respond to that by trying to reduce the risk in their loan books, and one obvious way to do that would be to curtail lending to smaller and riskier companies, i.e. private ones. (The fact that SOEs are seen as less risky than private companies is a structural problem, but it’s nonetheless true that banks are correct to make this judgment given the realities of China’s political economy.) In other words, the change may have been more cyclical than structural.

There is some preliminary evidence that supports this interpretation. The data that Lardy and I use to calculate lending to state and private firms is released with a long lag, and recent figures aren’t out yet. But banking officials disclosed last year that lending to private firms totaled 30.4 trillion renminbi as of September 2018. This is equivalent to 38% of outstanding corporate loans–which is roughly the same level as in 2013, and a big increase from the 32% in 2016 (again, this is the share of outstanding loans; the chart above is the share of new loans made each year). This suggests that new loans to private firms rebounded in 2017-18 (probably more in 2017) as the economy recovered.

Second, on the industrial data. The fact that industrial SOEs are increasing their value-added faster than private companies is certainly notable. But SOEs and private companies tend to operate in different industries, so it can be hard to tease out the difference between sector effects and ownership effects. Industrial SOEs are concentrated in upstream, commodity-producing sectors, while private firms are more in downstream manufacturing sectors. It seems quite likely to me that the big decline in SOE value-added in 2015-16, and its rebound in 2017-18, have the same source: swings in commodity prices that had big effects on their profitability (value-added is basically profits plus labor compensation). The chart below uses monthly rather than year-to-date data, and we can see that the growth in SOE value-added has recently fallen back below that of private firms as steel and oil prices have come down.

iva-ppi

Lardy is right that the fact that in these charts the red line (SOEs) is above the blue line (private firms) is significant and concerning. But if this year or next the blue line moves back above the red line, will that mean China’s private sector is out of the woods, and all is fine? I suspect not.

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What will it take to lower China’s investment rate?

The below is from Paul Krugman’s latest on China, an argument also strongly endorsed by Brad Setser:

China really can’t keep investing 40-plus percent of GDP. It needs to shift over to higher consumption, which it could do by returning more profits from state-owned enterprises to the public, strengthening the social safety net, and so on. But it keeps not doing that.

Myself, I think it’s weird that people who want China to invest less tell it to do all these structural reforms rather than just, you know, invest less.

They miss the point that much of the low-return investment in China is done by the government and the state sector: it’s all those local infrastructure projects. That’s really where the buildup of excess investment is happening, not so much in the private business sector (which faces hard budget constraints and often tough access to credit). According to the World Bank’s latest China Economic Update, China’s public investment has averaged 16% of GDP since 1978, while OECD countries spend about 3.7% of GDP.

herd-wb-gfcf-chart

So if the government wanted to make a policy choice to invest less, it can just directly make the state sector invest less in those crappy low-return projects. It doesn’t have to overhaul social policy first.

The point of strengthening the social safety net, in this framework, is to reduce precautionary household savings. But high household savings don’t directly lead to excess investment. They do help keep the banking system liquid which enables a lot of borrowing by SOEs.

But trying to impose financial discipline on SOEs by improving the safety net and lowering household savings is pretty indirect. The central government could just require investment projects by SOEs and local governments to clear more hurdles.

Fundamentally, the reason that China invests a lot is that the government has made a decision to keep public-sector investment high in order to boost aggregate demand. If/when that changes, the investment rate will come down. And so will growth. Which is why China is not in a rush to make that call.

The hard choice that China has to make is not whether to undertake complex and difficult technical reforms to social policy. The hard choice is to decide when the efficiency losses from forced high investment start to outweigh the benefits of the boost to aggregate demand.

Some people are interpreting the government’s recent pledges to avoid “flood- like” (大水漫灌) stimulus as a sign that they have in fact reached this conclusion, and want to wean the economy off low-return infrastructure projects. Maybe a bit, at the margin. But the leadership is also going to a lot of trouble to create new funding mechanisms to ensure local infrastructure projects can continue, so it seems clear they don’t want this shift to happen right now.

Redirecting some fiscal resources from investment to consumption (i.e. more social programs) could certainly help soften the blow. But this is a compelling argument only to macro people; the Chinese interest groups that would lose out from less public investment are not going to feel compensated if more social benefits go to households.