International Law

Chinese Investment and Overcapacity

By Stan

Funny, I can almost see the eyes rolling and heads nodding off just by typing that headline.

Wake up! This stuff is important.

Every once in a while, it’s a good idea to revisit some of the macro issues that are causing problems here in China. Lack of consumer demand as a structural problem is finally beginning to be understood by the mainstream media out there (it’s been a topic of discussion for many years now in some circles).

However, the linkage between the banks, investment, and overcapacity (also a longtime topic) is seldom set out carefully to explain the challenges Beijing faces in righting trade imbalances, particularly during a time of global recession.

I find that this FT article does a good job. I read it, thinking that it was almost as good as Michael Pettis’ blog. Turns out he penned this FT column as well, and since it’s confined to Op/Ed space, there is less detail than I’m used to reading on his blog. Anyway, here’s the important bit:

US banks are cutting off consumer lending as they contract, but Chinese banks are actually increasing their lending to the manufacturing and infrastructure sector in order to generate growth and employment. Although the employment effect of this lending will contribute to total global demand if it takes workers off the unemployment queue, the consequent increase in production may easily overwhelm it, so that China will continue to export huge amounts of overcapacity into a world struggling with collapsing demand.

Demand is the big problem, but instead of funneling money into the hands of consumers or expanding targeted spending programs, liquidity is being pumped into the system. This wouldn’t be a big deal if those funds were allocated well, but the banking system here is a work in progress, and a loan might just as well go to construction of another luxury hotel or steel factory instead of something really productive. Jobs will result, but overcapacity in many industries (esp. manufacturing) will also get worse.

Which leads to trade problems. What does overcapacity get you? Well, cheap exports. What is the last thing that the U.S. and EU want to see these days when they are faced with populist uprisings (I mean that in a political sense)? Cheap Chinese products hitting the shelves.

Looks like a recipe for disaster, which is why the Ministry of Commerce and others in Beijing have been railing against protectionism so vociferously this month. Pettis, and presumably the FT, a reliable voice for free trade, has the right answer:

But trade war is not the solution. Threatening China with trade sanctions if it does not rapidly reduce the rising overcapacity it is forcing on to the rest of the world will not work. There is very little Chinese policymakers can do in the short run without causing a collapse in the export sector and a rise in unemployment so rapid that it could lead to social instability.

The world must recognise that China can adjust, but it cannot adjust immediately. It will take several years to do so, and will require significant changes in both its financial system and in its development model.

This is going to be a tough sell. In the U.S., you have surging populism and a Democratic Party-controlled legislature. China will emerge, yet again, as an easy bogeyman in the coming months.

I have a feeling that it will come down to the deft political skills of the new Obama administration to thread the needle here and keep everyone just happy enough to keep protectionism from rising to unacceptable levels. That probably means that Secretary Clinton, Secretary Geithner and others will need some tangible deliverables/concessions from China that they can take back to the U.S. Congress to placate the populists.

My thinking is that if Clinton can make progress on the climate front, or perhaps with North Korea, this might generate a reasonable amount of goodwill to hold the wolves at bay. Remember that the U.S. in 2010 will have another Congressional election, and the populists will be ready.

Update: Greg Mankiw offers some sage counsel in the NY Times against protectionism.

Full post as published by China Hearsay on February 18, 2009 (boomark / email).