The Chinese economy has been suffering from diminishing marginal returns on investment and deteriorating financial efficiency (with each additional unit of new loan generating a lesser amount of successive GDP) for many years1. This is a clear evidence of excess capacity destroying economic values. Ironically, China’s excess capacity is not a result of too much investment, as conventional wisdom has it. Evidence shows that China overall is still under-capitalised. How could excess capacity coexist with under-investment?
China is still under-capitalised…
In terms of capital stock accumulation, China is a late comer. Its capital stock per worker is significantly less than the major economies and its Asian peers (Chart 1). China only started building up capital in the late 1980s while most of the other major economies started in the 1950s (Chart 2). The data also shows that the speed of capital accumulation rose exponentially after 15 to 20 years into the building-up process.
China’s capital accumulation has just started to accelerate and the pace is not as aggressive as that in South Korea, Singapore, Germany or the UK (Chart 2). Even after 30 years of catching up, the gap between China’s capital-to-worker (or per-capita capital) ratio and that of the major economies remains large (see Chart 1). Another indication of China’s under-investment is its railway network density, defined as metres of railway length per squared-kilometer of area. It is lagging behind the major economies, including India which has a lower per-capita capital stock (USD44,077 versus China’s USD86,901 in 2014) but a much bigger railway network than China (Chart 3). All this suggests that China still has a lot of room for catching up. At this stage, China is still under-capitalised.
…but also suffers from excess capacity
China’s under-investment has happened despite more than 30 years of reckless state-owned enterprises (SOEs) expansion. The SOEs’ investment has been supported by easy access to state bank credit and favouritism, including heavily-subsidised state land. They build/invest/produce NOT according to demand conditions but to expand supply so as to create jobs that, in turn, create demand. This is the supply-expansion model that has been driving China’s growth for over three decades.
When President Xi Jinping came to power in late 2012, he set out to change this growth model through slower growth structural reforms. Swift demand became history. Rationally, as demand weakens, firms make the necessary adjustment by producing and investing less. But the SOEs have not. The structural change in the growth model has exposed the inherent excess supply problem in the old model.
Decades of investment-led lopsided growth funded by cheap state-bank credit and preferential government policies have channelled most resources to a few giant inefficient state industries, which Beijing has now identified as coal, iron & steel, aluminium, shipbuilding, flat glass and cement, allowing them to build up a significant amount of debt while starving the private sector of credit. These six excess-capacity industries have liability-to-asset ratios significantly higher than the industrial sector’s average of 55% (Chart 4). Their excess capacity has been manifested in the sharp fall in their capacity utilisation ratios below the 80% normal level (Chart 5). This is unlikely to be just a cyclical phenomenon because there is a structural decline in both Chinese and global demand after the 2007-09 Great Financial Crisis (GFC).
The high debt ratios of these excess-capacity industries are the key contributor to the high corporate-sector debt ratio, which stood at almost 160% of GDP in 2015. The combination of high debt and over-capacity has pushed many firms into losses. Indeed, the share of loss-making firms in the six excess-capacity industries is twice the industrial sector’s average (Chart 6).Download to read more