For corporate China, the music has stopped playing. Profits of China's industrial companies in aggregate could fall this year for the first time in more than a decade, threatening job losses that will make the necessary transition to consumer-driven growth difficult to achieve. Firms are struggling under the burden of investment excesses, suddenly high real interest rates and slowing global growth.
The problem here is government policy. Beijing engineered a spectacular stimulus in the wake of the financial crisis but misguidedly aimed it at investment and exports. Investment as a share of output was already exorbitant at 41% in 2004, yet went up to 46% in 2011. Just to compare, Japan's investment rate peaked at 36% and Korea's at 39% during their boom eras.
The stimulus, and all that investment in general, may have helped many capital-intensive businesses start projects, but what after that? With so much capital being invested, the marginal unit of investment was probably getting wasted. It made companies inefficient, which explains their losses.
This marginal unit matters for efficiency and hence growth, but the China bulls won't tell you that. They argue that China's capital stock is low, both relative to output and even more so relative to its huge population. But the amount of capital in China doesn't tell us anything. What matters is the flow of capital, and where it's flowing to.
The fundamental flaw in China's economy is that it doesn't serve its consumers. The flipside of its high investment rate is low consumption, down to 35% of output in 2011, from 45% a decade ago. This gets economic theory backward: We produce in order to consume and we invest in order to be able to produce more. A country cannot increase its investment relative to output forever.
Ultimately, China's economic strategy is a dead end because, after a while, such investment becomes unprofitable. A point comes when companies cannot sell the extra products made possible by the extra investment. Their profits slump, as we see in China today.
If this weren't bad enough, companies have to contend with other adverse changes too. China's massive monetary injection after 2008 produced such a burst of inflation that it made its way into labor markets. Wages have risen 43% since 2009 and unit labor costs in dollar terms 22% since 2007. This has wiped out China's cost advantage in world markets. Plus, the yuan is no longer undervalued against the dollar.
Besides the vise of excessive investment and rapid wage inflation that have squeezed corporate margins, real interest rates shot up as Beijing tightened starting late 2010, in response to the economy's overheating. The global recovery also floundered and deprived China of the market its investment-led model needs for growth.
In this environment, private companies have reassessed their need for investment and are likely to slash capital expenditure further. Beijing eased monetary policy a bit in the late summer, but that has helped only large state-owned enterprises—which don't create new jobs—and perhaps contributed to a slight industrial expansion that data this week point to. Capital-goods exports to China from Korea and Taiwan have also picked up pace in the past couple of months.
However, if Beijing eases financing conditions dramatically to go for state-driven muscle-bound development, as it did in 2009, it still won't help. The government debt burden is much higher than official figures suggest, when you include the hidden liabilities in the state-owned banks. Beijing doesn't have much scope for stimulus before debt becomes excessive.
Moreover, large capital outflows have undermined bank liquidity, making it harder to use the banks to finance expansion. Activity could perk up in coming quarters if the government pushes more investment, but the prospects for growth further down the line will be undermined even more.
Those among the China bulls who acknowledge wasteful investment still suggest the consumer will take up the baton, and ensure decent growth. But if companies are to slash investment, consumer incomes will be hurt as unemployment rises and wage growth wanes. That risks a demand deflation spiral, which is sure to increase the debt burden and sharply slow down growth, not to mention stress the financial system.
So the likely scenario China will see over the next few years is the share of consumption rising, but with overall growth weakening to at most 5% a year, as the investment share falls. A rising share of consumption won't drive strong growth and help China stay close to its previous rates of expansion, as the bulls like to think.
Such a slowdown may be good for China in the long run as economic policy becomes more rational. If Beijing stops mollycoddling state firms, reforms to ensure that investment is efficient and that the share of household income in output rises, and cuts red tape, growth in China will be on much sounder footing. As for businesses, they will need to reorient themselves toward consumers. Chinese people will welcome higher growth of their incomes and consumption much more than "roads to nowhere."
But all this will only take place if Beijing reforms in earnest, and loosens controls on interest and exchange rates significantly. That's a big "if" for the Communist Party.
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