What exactly don’t investors understand about the phrase “command economy”?
I’ve been pondering that question as I watch global financial markets retreat on worries that economic growth in China is going to slow precipitously.
I just don’t think that kind of surprise is very likely given the nature of China’s economic system.
It’s not that I think China’s economic system—nor the people who run is–are perfect. For example, China’s leaders allowed a build-up of bad loans brokered by local governments that would be big enough to bankrupt many of those local governments and a majority of the country’s banks—in another system. In China’s system, however, the government can bury that bad debt—as it did after the Asian Currency Crisis of 1997—and engineer the re-capitalization of the country’s banks. (For more on this debt problem and China’s “solution” to it, see my post Move over Charles Ponzi and Bernie Madoff–China is running history’s largest financial scam .)
In fact, I’d argue that the Chinese economic system is generally bad at short-term economic decisions since the Chinese economy doesn’t provide either fast or accurate signals on pricing, supply, or demand.
And it’s often spectacularly bad at long-term economic decisions because, with no effective brake on government decisions and truly distorted feedback on the results of those decisions from the economy and the lower levels of government bureaucracy, wrong-headed policies can run for years and years as initial evidence of disastrous long-term consequences simply never filters up to top-tier decision makers.
But in a big swath of the middle-term China’s economic system does a spectacular job at making sure that nothing goes terribly wrong. Over a one or two or even three year period China’s unique combination of market and centralized command-style economics has the ability to make decisions far more quickly than most other economic/political systems and the brute power to mobilize a high percentage of the country’s resources behind that decision. And that’s exactly the time frame that includes current worries about China’s economic growth.
Right now I’ve got big doubts about, say short-term (a quarter or so) profits in China’s auto industry. In the long term I’ve got big doubts about China’s ability to solve its terrible demographic problem over the next 20 years.
But China’s ability to keep its economy humming at 8% to 10% a year for 2010 and 2011? Doesn’t keep me up at night. Especially because China has successfully reloaded its stimulus pipelines with enough cash to overwhelm any slowdown in just the way it did in November 2008.
In fact I’d say that current problems operate on a time scale that’s in the sweet spot for China’s economic/political system. These problems play to the strengths of the China’s economic system.
Let’s take a look at China’s Goldilocks’ worries—and at the short- and long-term where China’s system doesn’t work nearly so well.
To understand the draw backs of the Chinese economy in the short-term you don’t need to look any further than China’s auto industry. In 2009 subsidies and credits from Beijing boosted total auto sales in China by 45% from 2008 levels.
In the first half of 2010 sales growth dropped to a 30% annual growth rate.
And the rate looks like it is headed lower. Beginning in April car sales have dropped every month from the month before. In June, for example, sales dropped 5%. That took the annual growth rate down to just 14% from June 2009.
Now that’s volatility. And in a market with many features of a command-style economy volatility gets magnified because everyone jumps in the same direction on orders from the central government. And because there’s very little push back from market signals the initial response to the volatility and the eventual response can get, well, out of control.
For example, in response to the 45% growth rate in 2009 the auto industry in China went on an expansion binge. The top 14 automakers in China, many of them foreign, launched plans to reach a production capacity of 23 million vehicles by 2012—even though demand in China is projected at only 20 million vehicles by then. And that only measures plans by the big guys. China now has more than 100 domestic car companies.
In other kinds of economic systems banks would have pushed back against at least some of those expansion schemes. Financial markets might have pushed back against plans to raise all that capital. But in China in the short-run banks had been officially encouraged to make loans to car buyers with little or no effort to document incomes and banks and the financial markets had been officially encouraged to provide financing to car companies. Only in recent weeks has the central government itself reversed course and started to push back against the trend that it set in motion. Beijing has announced not just an end to some of the subsidies for buying a car but it has also promised an investigation into why it was so easy to get financing to start or expand a car company. (Gee, you think they’ll figure out who’s to blame?)
This isn’t an efficient economic system at work.
At the long-term end of the scale the damage can be much more extreme—because the forces that the command economy can bring to bear are given longer to run. China’s one-child policy, for example, was originally introduced in 1979. More than three decades later, the one-child policy has produced a history of often brutal coercion especially in rural areas, and seriously skewed China’s demographics. As the CIA World Factbook puts it, “One demographic consequence of the “one child” policy is that China is now one of the most rapidly aging countries in the world.”
In 2005 just 7% of China’s population was 65 or older. By 2020 23% of China’s population is projected to be 65 or older. According to projections in the United Nations Population Program’s medium scenario, the median age of China’s population will be 45-years-old in 2050. That would make China’s population as old in 2050 as the populations of developed and already old countries such as Norway or Finland.
Which is the source of what’s called Will China get rich before it gets old? problem. The per capita GDP of Finland was $34,900 in 2009. In 2009 China’s per capital GDP was just $6,600. (In both cases I’m using purchasing power parity figures that correct for differences in prices among countries.) It’s estimated that China’s official one child policy now affects only slightly more than one-third of the country’s population, but the country’s housing shortage, the need for many younger couples to take on the burden of caring for four parents, and, the gender imbalance that has resulted from the selective abortion of girls by families that wanted their one child to be a son now add up to an extremely effective unofficial birth control regime.
I don’t see a way to turn this long-term trend around. A failure to at least shift the demographic course, however, would have massive effects on everything from labor costs in China to the availability of China’s pool of savings to debtor countries around the world in coming decades.
The advantages that China’s command style economy has in dealing with middle-term problems are significant. In the middle-term China can mobilize huge resources to correct short-term mistakes that have resulted from slow or misleading signals from the economy back to government. For example, it would be more efficient in the short-term if China’s economy didn’t produce an over-abundance of unprofitable mining and natural resource producers. In the middle-term, however, raising the national tax on these industries—combined with selective application of takeovers by state-controlled companies and a bankruptcy or two—can correct the problem. Chinese officials have indicated that the country is about to introduce such a policy. In the middle-term the government can switch incentives to get officials to stop lending to unprofitable companies. That’s a whole lot easier fixing a long-term problem that requires dismantling a national population control bureaucracy with an estimated 300,000 officials and local population committees in every village and neighborhood in China.
In the last few weeks I’ve posted repeatedly about the progress of Agricultural Bank of China’s initial public offering. (For more on that IPO see my post China’s stock markets pass a test: Agricultural Bank looks like it raised more than $19 billion ) That’s because this $20 billion plus offering is a critical part of China’s plan to keep its banks lending even as it forces them to put more aside as reserves. (For how that works and why it’s necessary see my post , see my post Move over Charles Ponzi and Bernie Madoff–China is running history’s largest financial scam .)
All the signs are now that China is going to succeed at pulling this off. The Agricultural Bank of China offering is set. And China’s other major—and already public–banks look like they will meet their goal of raising an additional $40 billion within the next few months. That will restock banks with plenty of cash for lending even though the People’s Bank of China has required banks to keep more in reserves against their loans. Beijing has set a target for 2010 of $1.1 trillion in new bank loans. That would be a 22% drop from lending in 2009 but that year set an all-time lending record.
$1.1 trillion in new loans for 2010 would be plenty expansionary, don’t worry. And it would keep China’s economy growing at an annual rate of 9% to 10%.
New bank lending in June came to $82 billion, according to an unidentified bank official quoted in the 21st Century Business Herald. At that rate banks won’t have any problem making that $1.1 target.
And China’s government has gone out of its way in recent weeks to point out that when Beijing officials talk about an end to the stimulus put in place in 2008, they’re really talking about a relatively minor slowdown in spending. On July 5, for example, the National Development and Reform Commission reported that China had $100 billion in investment projects planned for western China alone.
Let’s see: Banks that will lend billions when the national government tells them to, a government that can make the decision to spend billions in stimulus without endless debate, and a country with $2.4 trillion in reserves at the end of 2010—and an economic system that’s good at fixing exactly the kind of middle-term problems it now faces.
So why exactly are investors so worried about growth in China?
Watch Bloomberg’s video of Steve Roach re: China “must up the ante” on domestic demand. This is another way of saying that declining U.S. and European domestic demand will threaten China’s exporting economy (and threaten the hyped-up foreign investment in China).
Ya’ll be careful out there now, ya heah.
Having said all above subsidies, don’t even bother to think adopting that system in US. Because, like all government run programs, they all ran out money! The so-called Chinese reform or open-up policy has two elements in my opinion. One is to free private sectors, the other is to unload government responsibilities! That’s what happened in the past 30 years of reform. The government has gradually unloaded all its responsibilities except pre-college education which is free and mandatory, though benefits distributed before are still there. Like housing, pension, etc. BWT, Chinese people can pass their free housing units to their heir tax-free. Their pension is inflation adjusted.
Another reminder is that the Finland’s average income maybe $33K a year, but I highly doubt that with $33K a year, you can live well in Finland. (Northern Europe has highest living costs in the world, higher than Japan and US.) But you can live very well in most China with the same amount of money. That’s just one way to explain it.
Another way to explain it. Many months ago, I saw one report explaining how it adjusted the purchasing power by comparing how much a big Mac would cost in different countries. If that’s the method used, it’s useless for China. Because in China McDonalds and KFC are actually pretty expensive. Despite it’s popularity, each Chinese individual may not go there very often. But if you go to a local Chinese eatery, dumplings, steamed bums, wontons will cost much less and taste much better! In other words, they can eat pretty well without going to MCD or KFC, make the big Mac comparison useless.
Jim raised the question wither China will get old before it gets rich. Jim used the purchasing power justified income level comparison. I don’t know which will happen first, but I’d like to remind people these factors.
Firstly, $2.4 trillion left in the pocket is pretty darn good and I’ll take it any day! Last week someone said that national reserve is not a measurement of wealth. If so, what is it? A measurement of height? Or weight? Or pause? Tell me one dirt poor country that is piling mountains of cash in its reserve!
Secondly, westerners make critical mistake when it comes to evaluate Chinese income level or living standard. Keep in mind, Chinese people live highly subsidized life. Ever wondered if Chinese personal income is so low, how could they all have pretty decent education (illiteracy is only 4%. BTW, what’s America’s illiteracy rate?), their mortality rate is pretty low too and slums are not fixtures of Chinese cities. It turns out, education, healthcare and housing, even retirement are all highly subsidized. If you factor in these things which are all very expensive, the $30K or $40K or so personal income that rich westerners get will quickly disappear. Here are few examples are how these are subsidized in China:
(1) Education. Ever since the communists took over in 1949, all education is free including college and graduate school. In the last decade or so, colleges and universities are no longer free, however government subsidies still exist in many ways. Pre-college education is free and mandatory!
(2) Healthcare. Although China is not known for cutting edge medical advances, the basic care is always there. From immunization to other basic care for long time are provided to people for free or very low fees. That’s why their mortality rate is low and life expectancy is pretty long. (It’s the western life style that now are causing more health problems for Chinese.) Ever heard of China’s “bare feet doctors”? They are essentially nurses or midwifes type sent to rural areas by the government to handle the healthcare where access to doctors or hospitals is not easy. They took care of China’s rural population for very long time. Like healthcare in other countries, in the last couple of decades it really got out of control and got so expensive. China’s old system has collapsed but the new one is still being searched. Just like us, we have not solved our health problems. (Mark down my words. Obama care will only create more problems, not solve it.) Healthcare or elderly care is a challenge for China.
(3) Housing. Chinese aged 50+ are extremely likely live in housing given to them by their “work units” (2 or 3 bedroom apartments are common.) unless he/she has made a fortune and can afford live in much fancy places. Don’t forget, for long time all Chinese people belong to some kind of organization (“work unit” in urban, “commune” in rural), such organizations distribute everything including housing! It’s only in the last decade or so, the government started or intensified private housing development. Now the younger generation no longer can get free housing.
(4) Pension or retirement. To make it short, it’s a combination of both private insurance and government or employer sponsored system. It’s not perfect, but I think many people in this country would like to have it unless you work for government and can get a $100K a year for not working.
Sounds I am defending China or Chinese government. No. I am simply share what I learned. China’s personal income is particularly misunderstood even with purchasing power adjustment.
I’ll stick to the good’ol USA.
Hmmm….8% percent compounded for three years is 26%. With exports likely weakening, will internal consumption ramp-up to fill the gap? I honestly don’t know, but I wonder. And a company who is expected to grow at X rate that grows at X-Y rate is always severely punished. Be sure to factor in a margin of error.
If you knew a company which would maintain 8% growth (and I am talking true sales growth, not just cutting expenses to maintain 8% growth in EPS) for the next several years, would you buy their stock? All things being equal, you probably would.
Now you have a country filled with companies that will grow that much (and more, in some cases) over the next few years. The phrase “no brainer” comes to mind…
I am completely fine with China’s 8-9% growth rate, though the market will be VERY worried over anything less than 9%. You just have to say that the market is not always rational.
China’s “command economy” no matter how well it worked for China, it’s NOT recommended for US. The two countries are too different (political system, people, value, etc.). By now, you have to be a blind not to see how inefficient, ineffective and disconnected the government management is in this country. Market driven economy still is the best for America.
But market driven economy does not mean lawlessness. Americans like football. Many rules in football can be learned. For example, referee in football is a rule enforcer. So should the government be. Referee can impose very tough rules including kicking the rule breakers out of the game. That’s what the government should do, particularly in terms anti-trust. (If the government has done its job, we won’t have so many “too big to fails”. Industry that is dominated by few players is NOT a free market.) Despite that, referee is NOT a player, because he is not trained and does not have the necessary skills and strength to be one. Nor the government. (Just look how disastrous every enterprise that government has run. Don’t tell me GM is a good example.) It’s particularly important that referee does not pick the winner. He can only judge according to existing rules, but not pick one. Nor should the government. However that does not mean that weak team has no chance to succeed, because as part of the rules, weak team gets to draft players first next year. (I know big government vigilantes will call this anti-government again, but I call this defending America’s freedom.)
Another big difference is how the leaders are “produced”. That’s too big to discuss here.
China’s one-child policy is a very complicated issue. No matter how westerners view it, to the Chinese people it’s a matter of choice. Choice to have a better life or stay impoverished forever. If you ask ask Chinese about it, they would say this. Personally they all wish to have at least two children per family, but that will mean to DOUBLE their population which they believe will keep them poor forever. So, they made the choice to slow the population growth. I think the one-child policy is very widely supported by Chinese people despite what you hear from western media. Keep in mind, all minorities are exempted from the one-child policy. Rural areas are also permitted to have more than one, if the first child is female who would marry away later. (Though I suspect the rural policy might have been implemented later.) Further recently, I heard that even urban couples can have more than one under certain circumstances.
Aging is not China’s problem alone. No country has taken care it well so far.
Jim,
I don’t know whether you’re right or wrong about the faults in China’s economic system. What I do know is that, after the near collapse of our economic system, American economists are in no position to critique or offer advice on economic systems of other countries. You can talk on & on about the efficiency of American capital markets & banking, but I don’t see it. Don’t forget–Wall Street banks are the ones that invented & perpetrated the worst kind of fraudulent financing schemes. I would be surprised if Chinese banks are half as irresponsible with their bad loans.
Oops! Today’s trade deficit report, especially with China, just painted a fresh coat on the bullseye on China’s butt. Never discount what the U.S. manufacturing associations and manufacturing unions can get done (like sanctions against China) in an election year. What would THAT do to the Chinese exporting machine , on top of European contraction. Interesting times!
The Chinese bank lending smells much like ours did during the housing boom. Nothing to worry about here folks.