Chi on China: China’s Supply-side Reform is not What You Think

25 May 2016

I hope everyone that is reading this is having a really good day. And if you are not, just know that in every new minute that passes you have an opportunity to change that –  Gillian Anderson

SUMMARY

  • Do not expect China’s supply-side reform to resemble that of the US-UK style in the 1980s with massive layoffs and bankruptcies. Today’s reform is even different from its own form in the late 1990s, when Beijng closed tens of thousands of state firms and cut millions of jobs.
  • China’s macroeconomic objective of supply-side reform has shifted from closing down companies/plants and cutting jobs to improving operating efficiency of state companies, subject to the constraint of minimising the reform’s negative impact on employment.
  • The economic effect of closing down “zombie” firms is smaller than many observers have expected, so Beijing still means business in its structural changes. Blanket implicit guarantee is gone. But inherent in the reform process is an incentive problem which distorts Beijing’s decision-making.

Due to the scale of China’s system, it will not be possible for Beijing to pursue a “shock therapy” to cure its structural illness like the Regan-Thatcher reform style of the US-UK in the 1980s which resulted in massive bankruptcies and unemployment. Given today’s weak growth momentum and sensitive political environment, China cannot even afford to repeat the same state-sector reform effort that it implemented in the late 1990s.

Rather, supply-side reform today is aimed at improving the state-owned enterprises’ (SOEs’) operating efficiency through mergers and acquisitions, public-private partnership or mixed ownership, job-retraining, early retirement etc. The trouble is that this approach may address the flow of the new excess-capacity problem but not the stock of the old problem, and there is an incentive incompatibility problem behind the process.

Reform in the good old days
China went through some serious supply-side reform in the late 1990s and early 2000s when former Premier Zhu Rongji sold off and closed more than 60,000 inefficient SOEs and cut more than 30 million jobs. This was impressive because at that time China was a closed economy with little foreign exposure. So there was no threat of foreign capital flight and a currency collapse.China could have gone for using heavy fiscal expansionary measures to avoid a sharp economic downturn while buying time for a “soft” and gradual deleveraging of the corporate sector with no aggressive capacity shake – outs and job losses.
However, Premier Zhu chose a tough route to tackle the inefficiency problems. He did go the Keynesian way by expanding fiscal spending considerably to prevent GDP growth from contracting . But it also followed the Austrian discipline by taking the painful decision to close down inefficient state firms (Chart 1) and lay off millions of state workers. As a result, the share of loss-making SOEs in the industrial sector fell dramatically (Charts2), and profits of the industrial sector improved throughout the 2000s (Chart 3).
Download to read more