The Beginning of the End of Excess Capacity

24 Aug 2016

If you do not change direction, you may end up where you are heading – Lao Zi


  • Contrary to conventional wisdom, Beijing’s policy is not the primary force for cutting excess capacity. The central government does not have firm control of the local authorities, as many observers have assumed, that it could just order them to shut down firms and factories as it wants.
  • Arguably, market forces are the primary driver, without which government policies alone will not get reforms too far. Crucially, if government policies are pushing in the opposite direction from market forces, its reform effort is unlikely to be successful.
  • Initial evidence shows that market forces may be aligning with Beijing’s policy objectives to cut excess capacity. However, the short-term result may not be a sharp rise in unemployment, as many would expect, but deterioration in household income growth.

Many observers often think that resolving China’s excess capacity problem is a matter of government policy and political will. This line of thought ignores the realty that Beijing does not really have firm control of the local governments that it could simply order them to shut down factories.

Over the last three decades, political power in China has been decentralised considerably, with Beijing giving the provincial and municipal governments an increasing amount of autonomy to experiment with economic reforms. They have been granted direct control over resources, such as land, energy, finance and raw materials, and permission to develop local infrastructure. As a result, local government spending accounted for an average 71% of total public expenditure between 2000 and 2014, much bigger than the 46% share in the US.

The good intention backfires

The purpose of decentralisation was to encourage regional competition to achieve efficient gains and high GDP growth. Local party bosses knew that their career paths depended on their region’s economic performance and, hence, worked hard to boost growth. This political objective of chasing high growth rates at all cost propelled China to become the world’s factory and the second largest economy in the world after the US.

However, decentralisation has led to substantial waste, manifested in a large local government debt (almost 40% of GDP in 2014, which was 2.5 times the size of the central government debt). It has also created a huge rent-seeking mechanism and spurred large scale corruption, with local officials striking deals with businesses by providing preferential treatments in the forms of tax breaks, cheap credit and land sold at below-market prices in return for bribes.

Nevertheless, such arrangements facilitated the entry of hundreds of thousands of private firms into market, adding to production capacity of the gigantic state firms. The party went on for more than 30 years under the old supply-expansion development model, in which economic agents build/invest/produce first to expand supply and create jobs that, in turn, create demand to absorb the supply. The model began to break down when President Xi Jinping took office in 2013 and changed the country’s policy objective to achieving growth quality through structural reforms. This means no more swift demand growth to absorb all that excess supply that economy has built up, laying bare the excess capacity problem.

The costs of decentralisation have become enormous obstacles to rein in the local powers such that many central government reform initiatives, including cutting excess capacity, have not trickled down to the local levels. The bad news is that Beijng does not have the effective control to order plant closures. The good news is that market forces may be aligning with policy intention to cut excess capacity. Beijing is now talking about shutting down “zombie” state companies in six over-capacity sectors in iron & steel, coal, cement, aluminium, shipbuilding and flat glasses. It is focusing first on the iron & steel and coal industries by setting three-year targets for production cuts.

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