Xi Jinping's Turn Away from the Market Puts Chinese Growth at Risk
It used to be said that when the United States sneezes Canada catches a cold. Now China is sneezing and many economists fear that its weaknesses are contagious for the rest of the world.
China's problems are variously attributed to weak domestic demand, to a natural maturing of its economy, and, of course, to its tariff war with America. These factors appear to be eroding China's previous outsized contribution to global growth, rattling markets, and leading some multinational companies to downgrade their earnings forecasts.
But even if the trade dispute with the United States is solved, China's role as the locomotive of global economic growth is threatened by a far more fundamental factor—President Xi Jinping's rollback of the market-oriented reforms that served China so well for 35 years.
The adoption of market-oriented reforms under Deng Xiaoping and other leaders, starting in 1978, allowed private companies to flourish. Initially such businesses were illegal, but they were soon legitimized and later recognized as an essential element of a mixed economy. As a consequence, they gained increased credit over time from a state-dominated banking system.
These reforms allowed private companies to make a disproportionately large contribution to China's stellar output, employment, and export growth. This enabled it, in time, to become an economic superpower.
When Mr. Xi became general secretary of the Chinese Communist party in the autumn of 2012, many analysts expected him to build on this impressive legacy. Indeed, only a year later, he presided over an important party meeting that endorsed a far-reaching reform program. This stated that "the market must become the decisive force in the allocation of resources."
However, Mr. Xi has since largely abandoned this approach in favor of concentrating on his anti-corruption campaign. He has also repeatedly emphasized the role of state industrial policy and state-owned companies, despite overwhelming evidence that the latter are inefficient.
Even after receiving various direct subsidies, the Chinese ministry of finance acknowledges that more than two-fifths of these state companies persistently rack up losses. They are kept afloat with massive increases in bank credit that are almost entirely responsible for the increase to record levels of leverage in China's corporate sector.
Because of Mr. Xi's repeated admonition that state-owned companies should be bigger, the government has organized multiple mergers of large enterprises in particular industries. This ill-advised consolidation has reduced competition, weakening the incentive for innovation and cost control.
Predictably, the return on assets of the largest state-owned companies has fallen by more than half since the merger mania began. At the same time, the productivity of private companies has increased, and in the industrial sector is now almost three times that of their state-owned counterparts.
While these unwieldy state behemoths soak up a larger and larger share of bank credit, they are doing so mostly at the expense of more productive private companies. The share of bank lending to the private sector has shrunk by 80 percent since 2013. Despite the rapid growth in credit overall, the absolute amount of bank lending to private companies has also fallen sharply.
This has reversed a long-term trend—the share of investment undertaken by private companies first plateaued and then fell in recent years. Similarly, whereas private industrial companies had previously expanded their output at twice the pace of their counterparts in the state-owned sector for more than a decade, since 2017 the situation has reversed.
This reflects both the squeeze on the bank credit accessible by private companies and the more recent crackdown on the shadow banking system, which had previously been a source of credit as bank loans started to dry up. The failure of the state to protect private property rights has also played a significant role, undermining the trust and confidence that many entrepreneurs have in the system.
The combination of the precipitous decline in the return on assets of state-owned enterprises, which control about $30 trillion in assets (the equivalent of well over twice last year's GDP), and declining investment by private companies is dragging down China's average annual growth by an estimated 2 percentage points.
Perhaps Mr. Xi accepts this as the price of maintaining a state sector that he believes is an important element in sustaining political control. But without a return to a more marketed-oriented economic policy, even if bilateral trade disputes with the United States are resolved, the likelihood is that China's growth will slow further—with unpleasant consequences for the global economy.
Nicholas R. Lardy is the Anthony M. Solomon Senior Fellow at the Peterson Institute for International Economics and author of The State Strikes Back: The End of Economic Reform in China?