I noted a few days back that the most important structural change that China needs to make to get through its present troubles is to sort out the bankruptcy law. Or rather, the cultural phenomena around the idea itself, for the worst part of the Chinese economy is in the State Owned Enterprises. These SOEs are propped up by endless cheap loans from the state controlled (and often, local authority) banks to cover their ongoing losses. Many of them are, in effect, zombie companies and really do need to be closed down and their productive assets reallocated. And the way we do that is through the bankruptcy process. But we've now someone one upping me: the claim is that China itself needs to go bankrupt!
China will have to go bankrupt to survive!
It is, of course, a cheeky piece of hyperbole in search of a headline. The basic point is much the same as mine:
The severe damage that China is currently suffering is not necessarily what it may appear to be. It’s actually these “zombie” companies that are degrading the economic fabric of the nation; they are the failing businesses that the Chinese government is nevertheless keeping alive on artificial respirators. The easy money and low prices which have been inundating the system basically favour all sorts of inconsequential ventures, the most cost-effective management, and deficient distribution of resources. Despite this, these companies are still in business right now. Worse still is that they continue to use up resources to produce goods and merchandise at more or less considerable losses. The State and its banks have not stopped making cash injections, or – at the least – reallocating or restructuring loans in order to protect employment and the utility of the work being done.
This really is where the problem is. A useful pencil sketch of how China has grown in recent decades is that they've not stopped planning and being Marxist Leninist about everything. Rather, that they've restricted such clod-hopping economic policies only to that state owned part of the economy. They've stopped banning people from doing things outside that system. The huge growth in GDP has really come from that private sector which has been, instead of being directed and encouraged, simply allowed to grow. And, as someone who has had dealings with companies in that sector, that's almost certainly the most viciously free market economy on the planet right now.
The part of the economy which isn't doing well is that SOE sector: exactly where government has retained control. And that control is really exercised through the banks. Interest rates are kept deliberately low and then the deposits of the state owned banks funneled, at those low interest rates, into these SOEs. They are, at best, only marginally profitable and large numbers of them are hemorrhaging losses. Losses which are covered by yet more of those cheap loans. This is of course a waste of capital: most of them are never going to be able to reorganise into something profitable. Given that growth is going to be slower in future (at least growth in basic commodities is) there's simply no way that the place needs to be making more cement and more steel than the rest of the world put together just as a couple of examples. So the factories that are doing so are the walking dead, those zombies.
Better by far that they be closed down and those assets go off and do something else. Yes, even if the capital invested in furnaces and so on is all just dead money. There really is something called opportunity cost. What could those loans, what could that labour, be doing elsewhere which adds value to the economy rather than losing money where it is?
Much is made of the way that China needs to avoid the middle income trap. That first stage of building an economy isn't so hard: but trying to get from where China is now to the front rank of economically developed nations is much more difficult. To the point that only four or five nations have managed it in the last 60 years or so. And at the heart of how you do do it is making sure that the mistakes, the failures, are cleared away and resources go off to do something more appropriate. This is where Japan stalled in the 90s, not allowing companies that should go bust to do so but propping them up. And according to a number of observers is the point at which Japan started to fall behind.
I've said this before and will no doubt say it again, but bankruptcy is the defining feature of capitalism. How, and how quickly, do we clear up the failures so as to make room for other attempts at doing better?
And the lovely thing about this is that putting companies through bankruptcy actually increases GDP. No, really: think about how GDP is constructed. It is not a measure of output at all. It is a measure of value added. And losses at a company are of course value subtracted: thus losses reduce GDP. Closing down a loss making company is, contrary to what many think, actually an increase in GDP. And that's before we even get to what those resources might produce which adds value once they are freed from their current shackles.
If I were in charge in China (and no, I do not recommend giving me control of an economy, really, no) I would be polishing up that bankruptcy code and pushing a good few of the SOEs through it. Once the lower levels of the bureaucracy get that message, that this is what to do, then we'd see a scouring of that SOE sector and, in time, a boost in growth in the economy.
