Nick Lardy on the crowding-out of private investment

The Australian National University’s annual free China Update book is bigger and more interesting than usual this year, in honor of the 40th anniversary of the start of reform and opening up in 1978. It’s got contributions from lots of prominent China economists that I have only begun to work my way through.

Naturally, I immediately checked out the chapter on private sector development by Nick Lardy. It’s quite a useful update to his work on the economic weight and role of the private and state sectors, and includes a careful, data-driven assessment of the resurgence of state enterprises under Xi Jinping. Here is a section where he identifies the symptoms of the crowding-out of private investment by SOEs:

The most plausible explanation of the waning of private investment is crowding out—an explanation supported by several pieces of evidence.

First, the share of bank loans to nonfinancial corporations that went to private firms fell from 57 per cent in 2013 to only 19 per cent by 2015, while the share that went to SOEs almost doubled over the same period—from 35 per cent to 69 per cent.

Second, financing of private firms through microfinance companies stalled after 2015. Lending by these companies grew rapidly from 2008, when the People’s Bank of China and the China Securities Regulatory Commission first issued formal guidelines on microfinance companies. The volume of such lending levelled off at just less than RMB1 trillion in 2014, but has not grown since.

Third, between 2011 and 2015, SOEs’ profits rose by only RMB30 billion, or 1 percentage point, while the investment of these firms rose by almost RMB2 trillion, or more than 20 per cent. Much of the differential between the growth of investment and the growth of profits must have come from increased borrowing from banks.

Fourth, indirect evidence suggests that SOEs have borrowed increasing amounts of funds to cover their financial losses. In 2005, 50 per cent of all SOEs were lossmaking. By 2016, the share of lossmaking SOEs had declined slightly, to 45 per cent. Thus, roughly half of China’s SOEs for more than a decade have been unable to fully cover their cost of capital. Moreover, the magnitude of losses generated by lossmaking firms increased sevenfold, from RMB243 billion in 2005 to RMB1.95 trillion in 2016. As a share of GDP, these losses doubled, from 1.3 per cent in 2006 to 2.6 per cent in 2016.

The interesting question at the moment is how this crowding-out of the private sector evolves in response to the government’s campaign to rein in financial risks. Surprisingly, one of the big casualties has been investment by state entities: there’s been a sharp slowdown in infrastructure investment as the central government has tightened controls over local government fundraising. Mostly as a result, the non-state share of fixed-asset investment rose to 65% in the first half of 2018 from 63% in 2017.

But it would be unusual for tighter financial conditions to really benefit private-sector firms, which tend to be smaller and riskier borrowers than state firms. And there is indeed a great deal of official concern at the moment over small businesses losing access to credit.

(Also see this previous post for other references on the crowding-out of private-sector investment.)

 

SDR inclusion as commitment device

Chinese central bank governor Zhou Xiaochuan recently gave an interview to Caijing magazine, on the occasion of the first anniversary of the renminbi’s inclusion in the currency basket for the IMF’s Special Drawing Right, or SDR, alongside the dollar, euro, pound and yen. This obscure piece of financial infrastructure improbably dominated the headlines for a while, as China waged a public campaign for inclusion. But most people could not figure out why SDR inclusion meant so much to China, and in the end the world seemed to decide that it was mostly a symbolic victory in China’s quest for global status. We haven’t heard much about the SDR since.

Zhou, though, still seems to think that SDR inclusion was a big deal. And since he has for decades been one of the main figures driving the modernization of China’s financial system, his track record is not that of someone who just pursues empty pieces of symbolism. Zhou is already past the normal retirement age and probably will not be in office this time next year, so SDR inclusion is part of his legacy. In the long interview (Chinese text here), he gives what I think is quite a revealing justification:

The entry of the renminbi into the SDR basket will produce a “ratcheting effect” for China’s opening up. This is like the ratchet on the rope in a volleyball net; when the net is tightened the ratchet latches on to the rope, so once it is set in position it cannot go back, cannot reverse. In English there is an expression, “past the point of no return.” Of course, in economics and society there is no absolute “ratchet,” I don’t mean that it’s absolutely impossible for there to be a reverse, just that it is very difficult.

In China’s reform and opening up process, whether in attracting foreign investment, liberalizing foreign trade, reforming the exchange rate, entering the WTO, etc, there were often some small reversals in the middle, or kind of a stop-and-go. But once we took that step, it was very difficult to go back.

After the renminbi entered the SDR, both international institutions and financial markets are using the renminbi more and more; international investors are using the renminbi to invest in the domestic financial market; laws and regulations have been revised; traders and exporters are all using new procedures. If you want to go backward, it is difficult, and the costs are high.

Perhaps another way of putting this is that SDR inclusion is a commitment device. In addition to the practical concerns raised by Zhou, there would also be reputational costs to reversing exchange-rate and capital-account reforms. Since SDR inclusion is contingent on the IMF’s determination that the renminbi is “freely usable,” it could conceivably be reversed if the currency were to stop being freely usable. What future Chinese central bank governor will want to see headlines screaming “IMF expels renminbi from SDR”?

Of course, China over the past year has in fact been de-facto tightening capital controls by stepping up scrutiny of overseas M&A and slowing down approval of foreign-exchange transactions. But it has done so largely by using its regulatory discretion rather than changing formal rules. So perhaps the commitment device is working some.

It is telling though that this justification for SDR inclusion is about consolidating and defending past reforms, rather than advancing new ones, though Zhou clearly wants to see those as well.

Lagarde-Zhou

Christine Lagarde and Zhou Xiaochuan in 2016

 

My guide to the debate raging over China’s Northeast rust belt

Over the past week or so, an impassioned debate has broken out over what should be done to help China’s struggling rust belt in the Northeast. Justin Yifu Lin, perhaps China’s most famous living economist, sparked the debate when his think tank released a long (400+ pages!) report proposing an industrial policy strategy for Jilin, one of the three Northeastern provinces. The report’s recommendations were seemingly innocuous–develop more light industry, tourism, and agriculture-related businesses–but they nonetheless attracted vociferous online criticism.

Why? The summaries in the English-language press (see the SCMP and Caixin) give the impression that it’s a debate over whether government policies should promote light industry, or something else. If that were the case, this would be a typical academic tempest in a teacup. In fact, a lot more is at stake: the debate over what to do about the Northeast (aka Dongbei, aka Manchuria) involves fundamental differences over how to understand Chinese economic history and the development trajectory of countries and regions really develop. The debate over how to help such struggling regions is also one where conventional Western economic wisdom has little to offer, so the field is wide open. After doing some reading on both sides, here’s my guide to the debate (warning: this is a long post).

Continue reading →

Reinhard Bendix on the economic dilemma for nationalist politicians

Is there a connection between nationalism in politics and inward-looking, statist economic policies? The examples of China and Russia (and perhaps Turkey) in recent years suggest that there could be.

But where does this linkage come from? I recently stumbled across a 1987 article by the sociologist Reinhard Bendix, called “The Intellectual’s Dilemma in the Modern World,” in which he articulates this connection rather well. Here is the relevant passage:

There is a family resemblance between the Third World of today and the poor countries of earlier eras. In the sixteenth and seventeenth centuries, English intellectuals and other people reacted to the economic advance of Holland and the Spanish world empire. In the eighteenth century, German writers reacted positively or negatively to the economic and political advance of England and France. In response to the French revolution, German rulers proposed to do for “their” people–by a revolution from above–what the French people had done at great cost by and for themselves. Russian intellectuals during the nineteenth century took standards derived from Western European developments to form counterimages of czarist realities; and in the twentieth century Russian revolutionaries adopted programs and tactics derived from the French revolution and Marxist theory in their overthrow of the czarist regime.  …

Every idea taken from elsewhere can be both an asset to the development of a country and a reminder of its comparative backwardness–that is, both a model to be emulated and a threat to its national identity. What appears desirable from the standpoint of progress often appears dangerous to national independence. The revolution in communications since the fifteenth century has been accompanied by ever new confrontations with this cruel dilemma, and the rise of nationalism has been the response nearly everywhere. …

The division is deep over which path the country should follow. Perception of advances abroad are reminders of backwardness or dangers and weaknesses at home. Intellectuals attempt to cope with the ensuing dilemma: whether to adopt the advanced model and invite its attending corruptions, or fall back upon native traditions and risk their inappropriateness to the world of power and progress. This dilemma engenders heated debates and ever-uneasy compromises. People want their country recognized and respected in the world, and to this end they cultivate or revive native traditions. … But the desire to be recognized and respected in the world also calls for the development of a modern economy and government, and this effort at development focuses attention upon ideas and models derived from the advanced society of one’s choice.

I owe the reference to Elena Chebankova’s article “Ideas, Ideology & Intellectuals in Search of Russia’s Political Future” in the spring 2017 issue of Daedalus. She applies the Bendix dichotomy to the Russian situation as follows:

This cruel dilemma forces a split within the intellectual scene of second-wave industrialization states, of which Russia is part. Intellectuals of those countries inevitably face an uneasy choice between losing intellectual and cultural independence by admitting their backwardness and adopting the externally borrowed progressive paradigm, or reaffirming nativism and tradition by holding on to the previously chosen path.

The drama for Russian intellectuals is in the quandary of either adopting the ideology of individual freedom and bourgeois liberties, combined with embracing Western ontology, or clinging to the idiosyncratic centralized modes of governance that could conduct modernization and development, albeit in a risky alternative fashion.

The point is simple: economic policies that are perceived as pursuing convergence with “the West” can be difficult to reconcile with nationalist aspirations to have a country walk its own road. And to the extent that good economic policies actually mean “converging with the West,” nationalism can mean fewer good economic policies.

Of course this relationship is not a necessary one: there is no country that does not have some nationalism in its politics, and good economic policies do not actually have to mean (or be perceived as) “converging with the West.” Deng Xiaoping for one found no difficulty in reconciling his strong Chinese nationalism with liberalizing domestic markets and opening up to global trade. It also seems like Modi in India is managing to pursue a similar combination of nationalist politics with economic restructuring.

But countries with a socialist legacy perhaps face the dilemma more keenly — to a large extent the distinctive “Chinese way” or “Russian way” is, thanks to their history, socialism and the planned economy. And therefore appeals to nationalism can shade more easily into statist economic policies.

In any case, I found this old Bendix article surprisingly useful for thinking about these current questions. It is rather difficult to find online, so I’ve put a copy up on this site; you can download the PDF here.

bendix_reinhard.jpg

Reinhard Bendix

The divergence over the Great Divergence is narrowing

Stephen Broadberry, Hanhui Guan, and David Daokui Li have updated their impressive paper compiling estimates of Chinese per-capita GDP over about one thousand years (“China, Europe and the Great Divergence: A Study in Historical National Accounting, 980-1850“), with results that help shed light on one of the great debates in economic history: just when and by how much did incomes in Europe start to overtake those in China?

Our estimates indicate that Northern Song China was richer than Domesday Britain circa 1090, but Britain had caught up by 1400. Also, China as a whole was certainly poorer than Italy by 1300, but at this stage, it is quite possible that the richest parts of China were still on a par with the richest parts of Europe.

By the seventeenth century, however, China as a whole was already substantially behind the leading European economies in the North Sea area, despite still being the richest Asian economy. Even allowing for regional variation within China, it is clear that the Great Divergence between China and Western Europe was already well under way by the first half of the eighteenth century, before the start of the Industrial Revolution.

Although this clearly contradicts the early statements of California School writers such as Pomeranz (2000) and Wong (1997), it is broadly consistent with the later views of Pomeranz (2011), who accepts that his early claim of China on a par with Europe as late as 1800 was exaggerated, and is now willing to settle for an earlier date between 1700 and 1750.

We think this is encouraging, because it shows how engagement between researchers using primarily quantitative methods and those who tend to put more weight on qualitative methods can result in a new consensus that challenges the original position of both sides in a major debate.

The California School were right to claim that, taking account of regional variation, historical differences in economic performance between China and Europe were much less than was once thought. However, the early claims of the California School went a bit too far: China and Europe were already on different trajectories before the Industrial Revolution, as European economic historians have traditionally maintained. The Great Divergence did not begin as late as the nineteenth century.

But you don’t have to take their word for it; Kenneth Pomeranz himself has weighed in with a blogpost reviewing some of this recent research:

A recent paper by Stephen Broadberry, Hanhui Guan and David Daokui Li suggests that Britain must have overtaken the Yangzi Delta in per capita GDP by the first quarter of the 18th century. This is, of course, materially different from my claim in The Great Divergence that the Yangzi Delta had not fallen significantly behind until well into the second half of the 18thcentury, and maybe not until 1800…

I think it is noteworthy that a debate between an early and a late 18th century divergence represents a considerably different intellectual landscape than the one we would have if we relied on Maddison’s GDP numbers, or on the non-quantitative work of David Landes, Deepak Lal, and various others – or for that matter, on an earlier attempt by Guan and Li to estimate comparative GDPs, which had previously claimed that a huge gap already existed in the 15th century. …

Admittedly, that is far from the rough parity I had originally suggested at 1800, and would now be inclined to put at somewhere around 1750 instead; there are some plausible adjustments that I think would narrow the gap further, but that is not really the point for now.  Instead I would emphasize that despite continuing disagreements and continuing data problems – the latter of which will probably never be fully solved – we have made some progress in narrowing the range of plausible answers about when and how much divergence occurred in these terms.

On the whole I see this as an example of the virtues of quantification in social science: when disagreements are about empirically measurable quantities, rather than abstract principles, it should be easier to resolve them. But still, how often does that actually happen in economics?

broadberry-china-table

The debate over the alleged higher education glut in China

The latest issue of the Journal of Economic Perspectives has a good group of articles on issues in the Chinese economy; there’s a lot to talk about in there, but the piece on education by Hongbin Li, Prashant Loyalka, Scott Rozelle, and Binzhen Wu is particularly worth flagging. It touches on one of the hotter social debates in China over the past few years: whether the massive expansion of college education since 1999 has created an over-supply of graduates, or is just the beginning of the necessary transformation of the education system to meet the needs of a modern economy.

college-admissions

This debate is interesting not only because it is a very consequential one, but also because the two sides tends to use very different styles of argument. The case for the prosecution tends to rely more on close observation of current social phenomena in China (what you might call anecdotal evidence), while the case for the defense tends to rely more on economic theory. A good example of the argument for an education glut is a recent piece by Edoardo Campanella:

Education is never a bad thing in itself, but the move toward “mass universities” of the type that emerged in the West after World War II is occurring too fast. …

China, with a graduate unemployment rate of 16%, is producing more highly educated workers than the economy can absorb. The wage premium for workers with a bachelor’s degree has decreased by roughly 20% in recent years, and new graduates often must accept jobs – such as street cleaning – for which they are vastly overqualified.

As more Chinese students attend university, fewer are graduating from vocational schools, which teach the skills that the economy actually needs. In fact, the demand for qualified blue-collar employees is so high that in 2015 the country’s 23 million textile workers earned, on average, $645 per month – equal to the average college graduate.

Li et al. in the JEP piece note the same widely-reported factoids: that new graduates take a long time to find jobs, and their starting salaries are often of similar levels to manual laborers. But they counter with a combination of theoretical reasons not to be too concerned by these phenomena, and a more involved estimation of the financial returns to education:

In contrast to this common perception of too many college students, we believe that college expansion is a great policy achievement of China. If we assume that the demand for human capital is fixed in the short-run, then given the unprecedented increase in the supply of college graduates since 1999, it is not surprising that the return to college for young college graduates would decline for a time. However, in the long run, human capital investment can lead to investment in physical capital and skill-biased technological changes, which ultimately will increase the productivity of and return to human capital. In addition, regions and cities in developed nations that experience arguably exogenous shocks to the supply of human capital ultimately also experience increases in the productivity of skilled labor due to human capital spillovers. There is no obvious reason to expect that China’s case would be different in this respect.

Moreover, college expansion could well be a result of rising demand for human capital. Our analysis of data from China shows that the return to college education for the labor force as a whole has continued to rise despite the fast expansion of China’s colleges. In particular, the return for those with 5–20 years of work experience has risen from around 34 percent in 2000 to 41 percent in 2009. A possible reason is the rising demand for skilled workers driven by the influx of foreign direct investment and expansion of trade starting from the early 1990s. The high return to college education for experienced workers implies a high lifetime return (the 10-year lifespan return to college education for the year 2000 graduate cohort is as high as 42 percent), which explains why urban students flood into colleges in spite of the seemingly low short-term return.

My own impression is that the education-glut argument is more popular within China, perhaps because it can be more easily illustrated by tales of struggling new graduates. But the statistics that are usually used to support it seem questionable: if a recent college graduate is making the same wage in their first year of work as a migrant worker is making in their 20th, it’s not obvious that actually indicates the market is devaluing a university education. The proper measure is really the lifetime returns to education, and there seems little reason to doubt that today’s college graduates in China are going to have much higher lifetime incomes than today’s migrant workers without a degree. Perhaps the issue is that new graduates do not feel that the gap between themselves and manual workers is as wide as they expected it to be.

Li and his co-authors do point to some worrying evidence that the quality of higher education in China has in fact suffered as the number of students has massively expanded, an issue that Campanella also highlights. But while Campanella recommends making higher education much more restrictive and shunting most students into vocational education, Li and co. argue for decentralizing and deregulating higher education, so that universities are not mainly trying to meet government-set enrollment quotas but are instead competing to deliver a good educational experience.

A more serious problem than any over-supply of college graduates is likely to be the rather shocking under-provision of high school education for rural students, which the JEP article shows is weighing down the overall education level of China’s workforce.

Cormac McCarthy’s contribution to the theory of increasing returns

I really enjoyed this anecdote about the writing of W. Brian Arthur’s classic article on increasing returns from 1996:

As we are wrapping up the interview, he [Arthur] tells me an anecdote about the creation of that Harvard Business Review article. “I don’t know if you know the writer Cormac McCarthy,” he begins, “but I was very good friends with him at the time. I mailed the draft down to Cormac, who was in El Paso or somewhere like that. When I didn’t hear from him, I called him up and said, ‘Did you like my increasing returns article? It’s for the Harvard Business Review.’ There was kind of a silence on the line. And then he said, ‘Would you be interested in some editing help on that?’ Next time he’s in Santa Fe we spent four days on that piece. He took apart every single sentence, deleted every comma he could find. I said, ‘You can add that piece to your Collected Works, it will be somewhere in between Blood Meridian and All the Pretty Horses.’

“Let’s say the piece was better for all the hours Cormac and I spent poring over every sentence. The word got back to my editor at Harvard Business Review. She called me up, in a slight panic, and says, ‘I heard your article’s getting completely rewritten.’ And I said, ‘Yeah!’ She says, ‘By Cormac McCarthy? What did he do to it?’ And I said, ‘Oh, well, you know, pretty much what you’d expect. It now starts out with two guys on horseback in Texas, and they go off and discover increasing returns.’ And for a couple of seconds she was aghast.”

The full piece is from Fast Company, which has more on how the concept of increasing returns was used and abused by the technology industry in the years since its popularization. And indeed Arthur’s HBR article–it’s worth rereading–is extremely well-written, with many more simple, punchy sentences than are the norm for business or economics writing. It is hard to see any way to improve on the clarity of sentences like:

Increasing returns are the tendency for that which is ahead to get further ahead, for that which loses advantage to lose further advantage.

My guess is that McCarthy probably doesn’t deserve all the credit for the virtues of the prose, as Arthur is himself a very clear thinker and good writer (his book on technology is still one of my favorites). But everyone benefits from a good editor.