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China's First Capitalist Economic Cycle

The Wall Street Journal, August 2, 2005

By JIM WALKER [Mr. Walker is chief economist at CLSA.]

China's real GDP growth is slowing. Last year's rate of 9.5% will likely fall into the 6-7% range in 2006. But a drop in growth as a result of a downturn in a profit-generated business cycle is not a bad thing in the long term. Such fluctuations show that China has joined the ranks of capitalist economies.
The current cycle is quite different from China's previous state-led booms in the 1980s and 1990s. Four features stand out. First, over the last decade the government began allowing markets to set prices for goods and services. Second, since 1999 the Communist Party has steadily introduced the concepts and institutions of private property into the Chinese economy. Third, with World Trade Organization membership the government introduced an "investment rulebook" into the national economy to make investment decisions more transparent and secure than ever before. Fourth, changes have been made to the capital markets with the formation of new, private-sector banks and the introduction of different forms of investment finance. China also has a relatively flexible national labor market for the first time ever.
The combination of these events, whether intentionally or not, has given rise to China's first capitalist economic cycle. The best way to understand China's current cycle is to turn to the analysis of Austrian economist Joseph Schumpeter (1883-1950). Schumpeter argued that "swarms" of entrepreneurs were the driving force for the boom-and-bust cycles of capitalist economies. Such swarms occurred when an invention or innovation set off a race for new products and services that resulted in new businesses sprouting up alongside existing companies.
Schumpeter held that entrepreneurial bursts of activity generate business-cycle upswings. After a while, increasing competitive pressure begins to shrink profit margins, leading to credit deflation and, eventually, a bust.
In China, newly introduced private property rights, along with other institutional changes, have given rise to Schumpeterian entrepreneurial swarming. This has increased confidence: confidence that the state will not confiscate one's property and confidence that an investment today will accrue future returns to the owner of the asset. This has also resulted in what has probably been the greatest creation of new businesses in history -- across almost all industries from tissue-paper production to semiconductor-chip manufacturing.
Every company in China faces hundreds if not thousands of competitors, with the exception of the few remaining markets that are still protected by the government, most of which are in heavy capital goods production. This is rampant capitalism, and it is excellent for growth. It is great for job creation. But it also entails depressing effects on profitability.
In China, it is this very phenomenon that will lead to slower growth. Profits have all but disappeared for large swathes of manufacturing industry, and when companies are struggling to make money in their core businesses they stop investing. Some companies will go out of business, leading investment to collapse. And with weakening or declining investment, economic growth falters. This is how endogenous cycles are generated in mature economies, despite the misguided efforts of governments and central banks to smooth them out.
Where does China stand today? On the one hand, there has been rapid and rampant business formation in the last four years. As Schumpeter argued, this shows up as distress for many producers shortly after it begins, especially those in industries that were previously shielded by the government from competition. Market share and profits are both under fire from a host of new sources of competition. Moreover, the expansion in productive capacity makes raising prices difficult, if not impossible. This is especially true in an economy with a predisposition toward prioritizing market share and only rudimentary notions of true profitability.
On the other hand, costs are rising in China, fast. It is already commonplace to see overall wage growth in the region of 10-20%. Herein lies one of the most surprising aspects of the current Chinese boom: the country has a labor shortage. The shortage is occurring at the skilled-worker level, particularly at the managerial level.
Time will solve much of this problem. China is churning out large numbers of well-trained scientists, engineers and business graduates. These represent the raw material for future middle, senior and executive managers. The problem is that China needs them now. The anecdotal evidence exists to suggest that this is one of the most serious bottlenecks in the continued rapid growth of the Chinese economy.
China's downturn will happen, it is only a matter of when. Net profit growth reported by the 1400 companies that make up the 'A' share markets for Chinese investors were up only 7% year on year in the first quarter of 2005. That is less than half the reported rate of nominal GDP growth. Conditions appear to be even worse among the unlisted companies in the manufacturing sector. And banks have turned conservative with respect to these companies, which implies that they believe customers to be in difficulty. There have also been reports of rising industrial company losses, as well as problems with companies meeting payment deadlines. When I visited China in May, for the first time I heard companies talking about competitors going out of business.
Over the next 18 months, Chinese GDP growth will disappoint many people. But the structural changes that generated the current upturn promise a bright future for long-term Chinese growth.

posted by Henry @ 2:28 PM