China Briefs

An interview with David Hoffman, Managing Director of the Conference Board’s China Center

March 07, 2018

David Hoffman, Managing Director of the Conference Board’s China Center, and head of the Conference Board in Asia, recently conducted an interview with Europe’s World Finance Magazine. David’s answers illuminate the nature of China’s momentous economic transition and provide valuable insights for MNCs struggling to adjust to China’s “new normal”.  We re-print David’s conversation below, for the benefit of our members:

Q: Why is the shift from a manufacturing-driven economy to a service-driven economy so important for China's continued economic development?

The important shift is from “investment-led” growth (including investment in manufacturing “physical plant”) to “consumption-led” growth. China is structurally over-invested – in many cases acutely so: in manufacturing capacity in many sectors, and in both infrastructure and real estate capacity in some regions (i.e. bridges to nowhere, ghost cities, etc.). In an over-capacity situation, investment generates low, if not negative, productivity growth. Think of an unoccupied, newly constructed industrial park sitting idle. This is the fundamental problem. Over investment is dragging on productivity growth, and unproductive investment yields debt build up. If the investments eventually prove to be unviable commercially, this then turns into bad debt. Consumption-driven growth is more sustainable because capacity better calibrates to bottoms-up demand, versus a top-down plan.

 Q: Why is SOE reform so important in this strategy?

SOEs are the primary agents of the government’s investment-led growth “addiction”. They are allocated credit to invest to drive growth even if the investments are risky or aren’t commercially viable. After all, investment – even if it involves digging a hole and filling it up again – creates GDP growth. If the investment is unproductive, however, it only creates a one-off GDP boost. It is suspected that more and more of China’s ever-increasing investment is of this one-off nature. Because SOEs don’t have balance sheet accountability, in that they’re backed by the State and can’t go bankrupt, there is an intrinsic moral hazard in SOEs leading China’s investment drive. The only way for money losing SOEs to survive is to continue borrowing, to continue investing, to continue building capacity; new borrowing then evergreens the old loans, and new loans are taken for more investing, and so forth.

 Q: How can industrial overcapacity be addressed?

It must be consolidated-out through forced mergers and/or planned production controls and equipment/facility de-commissioning; or it must be resolved through the market processes of bankruptcy, liquidation and scrapping. China’s “supply-side structural reform” program is taking the first approach. There has arguably been some progress in steel and coal, but it’s just a scratch on the surface in terms of how much capacity cutting needs to eventually happen. Many firms that would otherwise go bankrupt are reportedly being kept artificially alive via significant fiscal and credit resources to sustain essentially furloughed operations. But this diverts these important financial resources away from elsewhere in the economy and society where they could be used more productively and beneficially. In parallel, policy efforts are promoting the Belt and Road Initiative (BRI) internationally to effectively create demand for Chinese capacity and, in doing so, hopefully avoid painful capacity-reduction altogether. This is a long shot. Some BRI projects, even many, may very well be successful. But there is no way the project set can be sizably successful enough, in the required near- to medium-term timeframe, to soak up the requisite Chinese over-capacity before the capacity effectively becomes obsolete. Eventually, the painful processes of capacity reduction must be faced: debt write offs, employment retrenchment, asset re-pricing and associated wealth destruction, etc. 

Q: What risks does protectionism present?

Protectionism hurts everyone, and trade wars most of all. But, given the huge importance of manufactured output to China’s economy, and all of the supporting infrastructure and labor that underpins it, China has much at risk from trade actions that impact its export sector.  

Q: Beijing is increasing its efforts to reduce risky debt, why is this important?

Debt servicing costs drag on corporate performance, impacting the abilities of firms to invest in expansion, innovation and people. In parallel, non-performing debt constrains the amount of bank lending and government financing that can flow to maximally productive and beneficial purposes in the economy and society. Risky debt – i.e. where ultimate ownership of the debt and its liabilities are unknown – can have catastrophic, collateral, wealth-destruction consequences on healthy market players, hence wiping out positive economic activity. 

Q: Final thoughts?

We mustn’t forget that China is amidst a momentous economic transition; one that will require deep structural adjustments if it is to put the Chinese economy back on a sustainable path. These adjustments lay before us, as they have largely been forestalled by elevated levels of credit expansion and fixed asset investment these last several years. Contrary to today’s prevailing thinking, a soft landing has not been achieved, even despite the stabilization and slight uptick that occurred in 2017. Looking forward, it’s hard to see how many of these adjustments won’t be disruptive if not painful for markets. Importantly, given the China-sized scales involved, and the surge of China’s global business activity, the adjustments will necessarily impact both China and global market conditions for multinational business and financial investors. Most near-term scenarios are biased toward the downside, although certainly not for all sectors. The good news is that market shake-outs – as typical of creative destruction cycles, even those with “Chinese characteristics” – should yield better operating conditions over the longer-term, especially for competitive firms. At this critical juncture, executives need to understand the gamut of potential China exposures facing their companies – both positive and negative – so that they can position their companies to exploit associated opportunities and mitigate risks.