How will China Address its Surplus?


High income economies have surplus savings and it is shifted to financial assets.  China (and Asia more generally) have underdeveloped capital markets.  Its surplus is manifested in industrial capacity far and away more than it can absorb.  How it deals with the surplus is among the largest challenges for policymakers and investors.

Nothing fails like success, we are often old half seriously.  Yet we argue that the most formidable challenge for market economies is not this is or that weakness or defect that can be reformed away.  Rather, like some individuals we may know, the biggest weakness of capitalism arises from its greatest strength.  Capitalism has unleashed our species creative and productive forces like no other system.  It has conquered scarcity, reducing labor devoted to providing the essentials of life, like food and shelter.

The US, and to a lesser extent Europe and Japan, have built extensive financial markets.  The savings, which are not needed to produce goods and services, are transferred to the financial sector where they are invested paper assets.  The flexibility of the capital markets also served as shock absorbers so the real economy did not have to as much.  If the price of money (interest and exchange rates) could adjust, unemployment and growth would not have to, so ran the logic.

Indeed, following the double dip economic downturn in the early 1980s, there was an extended period that some economists dubbed the Great Moderation.  The business cycle was not repealed, but it had a smaller amplitude and shorter duration, and the new flexibility of the capital markets arguably played a critical role.  However, as Minsky’s work suggest, stability generates instability.  Financial innovation, increased leveraged that was facilitated by deregulation, and gaming of the remaining regulations, plant the seeds for eventual downturn.

In this context, the Great Financial Crisis demonstrated that shifting the volatility from the real economy to the financial markets can create a feedback loop and the volatility of the latter than impact the former.  The policy response has been to strengthen the regulatory environment.  The ink on Dodd-Frank, for example, was hardly even dry, before the push back began.  Many observers are concerned that the way out of the Great Financial Crisis was to create new asset bubbles, like in equities and bonds.

The Fed is still warehousing more $2 trillion of US government bonds.  Financial institutions are required to hold larger capital buffer, which also removes capital from the market.   The US housing market remains effectively nationalized as GSEs own the bulk of US mortgages.  The surplus savings problem has not been fully addressed.

China, like most Asian countries, purposely underdeveloped their capital markets.  The market for goods was understood as more important.  While the amount of financial assets is growing, Asia, including China cannot absorb all its savings, so it exports some.  The PBOC is sitting on more than $3 trillion of foreign assets.

However, China’s surplus capital is also still invested in plant and equipment.  This results in surplus capacity or China’s ability to produce more goods than for which there is effective demand.  What China does with this surplus is one of the key economic challenges of our generation.  Exporting the surplus risks a protectionist backlash, as we are witnessing.  The One Belt-One Road initiative can absorb some the surplus.

One of the strategic solutions to China’s surplus capacity will be industrial rationalization through mergers and acquisition.  This is being underscored by officials at the Boao Forum being held in the Hainan Province.   The head of the State-Owned Assets Supervision and Administration Commission noted that “Some of the central state-owned enterprises in certain industries at too fragmented and have low efficiency.  We support companies that are willing to come together on their own.”

Several sectors, including power, coal, and shipping have been identified.  There has already been consolidation in property firms, smelters, electric appliances, including air conditioners and breweries.

Half of the third of a century after the Civil War (1865-1900) were marked by crisis and panics, and crashes.  The war years saw a large build in industrial capacity, and after the war, the transcontinental railroad, created a national market and revealed the excess capacity.  The US experienced a large consolidative wave at the end of the 19th century/early 20th century.  The rationalization of industry led to the creation of giant corporations (think US Steel) that permit to project its power on the international stage.

A M&A wave in China is underway and will be extended.  The consolidation and concentration will create giants that intensify competition in global markets.  The US, Europe and Japan are critical of China’s trade practices, but even if China truly addressed these, it would still pose a dramatic challenge.    The size of the US domestic market allows its national businesses to have a global footprint.  The same will likely be true for China.  It gigantic domestic market means that China ” national champions” will also walk tall in the world economy.

The US, Europe and others can seek to slow down the rise of China.  They can curb Chinese businesses acquisition of their companies, restricting its ability for direct investment.  Persistent challenges of its practices at the WTO can continue and escalate.  However, precisely because of its large domestic market, it is unlikely to block or reverse China’s ascent.

The surplus savings that is chasing paper assets is a potential source of instability in the US, Europe, Japan, and many other high-income countries.  It was this instability was the source of the global disruption in 2008-2009.  The breakdown contributed to the European crisis in 2010, as creditors stopped recycling their savings by buying the debtors bonds.   China’s surplus is manifested in its industrial capacity, which is daunting.  Whether it exports its surplus output or consolidates it domestic industries to create national behemoths, the economic challenge is not going away anytime soon.

That means that policymakers and investors need to recognize the challenge posed by China is a marathon not a sprint.  This is an important difference.  From game theory, we learn that the longer the game, the more incentives there are to cooperate.  A one-off or short-term game lends itself to defection and poor outcomes.