Author: Guiying Laura Wu, Nanyang Technological University
Why was real gross domestic product (GDP) per capita in China 40 times smaller than that in the United States 40 years ago? It has been argued that differences in aggregate total factor productivity (TFP) are the dominant source of differences in GDP per capita. It has been documented that growth in aggregate TFP has contributed to more than 70 per cent of per capita GDP growth in China. Crucial to increasing TFP into the future and shoring up growth will be addressing capital misallocation in China.
Evidence suggests that resource misallocation across firms performing at differing levels in an economy lowers its aggregate TFP. McKinsey Global Institute studies have found that in many less-developed countries such as South Korea, Brazil, Turkey and India the most productive firms within most sectors have productivity levels comparable with those in Western Europe and the United States but there is a long tail of low-productivity firms. If, therefore, resources could be reallocated from the low-productivity firms to high-productivity firms within a country, the aggregate output would increase, which would lead to an increase in aggregate TFP.
The efficiency of resource allocation offers a new perspective with which to understand cross-country income differences. Capital misallocation has been documented as a prevailing empirical phenomenon both in less-developed economies in general and in China in particular. The reallocation of capital within the manufacturing sector, for example, is a focal point in explaining the miracle of China’s economic development.
The importance of addressing capital misallocation in China raises a pertinent question: what are the underlying factors that cause capital misallocation? Two candidates have attracted increasing interest: capital market imperfections due to financial frictions and non-market distortions induced by government policies.
The evidence suggests that China’s corporate governance, accounting standards and investor protection systems are poor at best, while its banking system is not well developed and is to a large degree inefficient. This leads to substantial financial frictions. The Shanghai Stock Exchange and Shenzhen Stock Exchange have been growing rapidly since their inception in 1992, but their scale and importance are still not comparable with other channels of financing — in particular, the banking sector. In this environment, Chinese firms must rely heavily on retained earnings to finance investment and operational costs.
However, financial repression is far from uniform: Chinese banks, which are mostly state-owned, tend to offer easier credit to state-owned enterprises (SOEs) with less screening, higher lines of credit, lower interest rates and fewer collateral requirements. The Chinese stock market is disproportionately dominated by SOEs and large, semi-privatised SOEs. Not surprisingly, firms in the informal sector are subject to strong discrimination in credit markets. As a result, many successful non-SOEs do not use any channels of formal financing during development.
When it comes to policy distortions, a number of institutional factors must be considered. First, from a public finance perspective, a possible reason for the government to favour one firm over another is that the favoured firm contributes significant tax revenue. Second, a government may also distort capital allocation to pursue specific industrial policies.
It has been suggested that China practices a form of state capitalism in a vertical industrial structure: SOEs are explicitly or implicitly allowed to monopolise key upstream industries, while the downstream industries are largely open to private competition. Firms in upstream industries that are exporting can therefore expect to receive favourable policy distortions.
Third, the well-known trade-off between growth and stability facing the Chinese government has often been taken as an argument to justify policy distortions. To minimise social unease and reduce resistance to reform, the government may have a strong political motivation to maintain employment stability. For example, to avoid laying off workers or shutting factories during an economic downturn, the government usually asks state-owned banks to bail out loss-making SOEs.
Finally, an alternative hypothesis is that the government prefers firms with political connections. For example, Communist Party membership has been found to help private entrepreneurs obtain loans from banks or other state institutions. Firms with government-appointed or government-connected chief executive officers are also found to face much less severe financial constraints.
China’s remarkable economic development is thanks to both the development of the financial environment and economic reforms aimed at correcting overall policy distortions, though large and persistent capital misallocation still exists after 40 years of reform. The structural reforms that are particularly relevant to capital misallocation are mainly concentrated in the state-owned enterprise sector and the financial system. Reform in this area has the potential to drive a new wave of high quality growth.
Guiying Laura Wu is Associate Professor in Economics with the Division of Economics, the School of Social Sciences, Nanyang Technological University, Singapore.
This article is abridged from Guiying Laura Wu, ‘China’s economic development: A perspective on capital misallocation’ in Ligang Song, Yixiao Zhou and Luke Hurst (eds.), The Chinese Economic Transformation: Views from Young Economists, China Update, ANU Press, 2019.