Exclusively from Michael Pettis newsletter:
For years I have been arguing that the Achilles heel of the Chinese growth model is the unsustainable rise in debt that comes as a necessary consequence of capital misallocation fueled by bank lending. Capital misallocation, I argued, was the nearly inevitable consequence of high investment growth over many years in a system in which price signals are severely distorted and there is political incentive to maximize economic activity in the near term. If capital misallocation is funded by debt, the increase in debt is necessarily unsustainable.
These should have never been considered surprising revelations since the historical precedents for investment-led growth “miracles”, of which there are many, are pretty clear. Still, it was only in the past two or three years that the problem of wasted investment was widely acknowledged, although even here not universally. A number of China bulls that fought most strongly several years ago against the idea that China was misallocating capital on a grand scale are still fighting the good fight.
I mention this because of an article that came out in last Friday’s South China Morning Post about China’s investment in the electric car industry. The electric car industry was often Exhibit A in the argument that Chinese investment was in the aggregate rational and economically sensible. This industry is clearly the industry of the future, the China bulls argued, and China’s massive investment in the technology, which would allow the country to dominate one of the key sectors of the future, showed why it was mistaken to complain about capital misallocation. This kind of investment was actually very clever stuff.
I have to confess I was never comfortable with this argument, although criticizing investment in the electric car industry was always a little like punching a six-year-old child. It is really hard to do it without looking like a heel, and inevitably someone points out that since the electric car industry is clearly the industry of the future, and since China is getting an early lead, it follows that this is a very smart investment for China.But remember, even if the first two points turn out to be true (and if it is so obvious, why doesn’t everyone else do it?), the third doesn’t obviously follow. The point is not whether or not electric cars will one day be an important business, and certainly not whether electric cars are a “good thing”. What matters as far as this debate is concerned is
- Whether the total economic costs of investment are less than the total economic benefits, and
- Whether there is a mismatch in the timing of costs and benefits.
The first point determines whether the investment is ever wealth enhancing, and the second determines whether or not in the medium term there is a worsening of the underlying imbalance. This means that in discussing whether or not capital is being misallocated it is not enough to assert that electric cars will one day be an important technology.
Electric cars?
My problem with Chinese investment in the electric car industry had nothing to do with my superior knowledge of the prospects for the industry (I have none). It had mostly to do with my basic instinct that risky high-technology ventures are not best funded and directed by companies, industries and policymakers who are historically weak in the technology sector, especially when they have no shareholder or budget constraints and have almost unlimited access to heavily-subsidized capital. This seemed to me a recipe for wasted investment.
This is why the SCMP article interested me:
Beijing is having a serious rethink over its ambitious electric vehicles policy. The central government has assembled the top experts and policymakers on electric and hybrid cars at a meeting in Wuzhen, in Zhejiang province, this week. One expert attending the meeting said the government was increasingly concerned about problems in the industry, including its cost-effectiveness, technological difficulties and the uncertain benefits to the environment, according to the 21st Century Business Herald.
It said Beijing was reconsidering its support for pure electric cars and may rethink how to spend the 100 billion yuan (HK$122.6 billion) fund set up to develop green vehicles – perhaps by shifting resources to hybrid cars.
Beijing is soon to release the final version of its long-awaited green car development plan, which has been under drafting by the Ministry of Industry and Information Technology since 2009. But there is now growing debate as to how to make best use of funding set aside to help develop the next generation of cars.The central government announced its ambitious plan to develop a new generation of green vehicles – focusing on pure electric cars – two years ago. However, in July, Premier Wen Jiabao wrote a long article in the Communist Party’s mouthpiece Qiushi magazine in which he said he was confused by the latest developments and the future of electric cars. He also criticised the lack of co-ordination and planning of local authorities and warned against committing resources to premature technologies. “Whether electric cars will be a mature product, we don’t know,” he wrote.
A few days after this article appeared, BYD, the main maker of electric car in China saw its stock soar by 26% in a day. Here is what an article in South China Morning Post said was the reason:
Shares in the Warren Buffett-backed BYD soared 26 per cent to a three-month high yesterday on hopes that new policies to steer mainland car buyers towards electric vehicles would help turn around slumping sales at the Shenzhen-based manufacturer of petrol and electric cars.
The rally came after the weekend publication of a directive signed by four government ministries encouraging 25 pilot cities, including major markets such as Beijing and Shanghai, to “actively study” exemptions for electric cars from license plate lotteries and auctions, as well as a host of other purchase restrictions.
The only way to make electric cars economically viable in China, in other words, is to put into place administrative measures that divert buyers, but as any economics student can tell you, these kinds of administrative measures simply shift resources from one sector of the economy to another without creating wealth. In fact because they force consumers to choose something that they otherwise wouldn’t, they actually reduce overall wealth.
It is hard for me to be very optimistic that the success of electric cars in China will increase the wealth of the Chinese people. It seems to me that investment in high-prestige areas like electric cars, solar panels, and so on for technologically backward countries with low worker productivity may be a little like investment in the space program or in the Olympics. They may have positive political and even psychological returns, but on a strictly economic basis they reduce overall wealth and exacerbate domestic imbalances.
In that case for all the importance the industry might have one day, debt levels in China must continue to rise unsustainably. The key to determining their economic impact of any investment must be the two points that I posit above.
First, the additional wealth that it creates for the economy must exceed the debt servicing cost to the economy of the investment, and of course the debt servicing cost must be the “true” debt servicing cost, in which interest rates are implicitly raised to an economically justified rate, and not the heavily subsidized rate that simply transfers part of the cost to the household sector. If it does not, the domestic imbalances are exacerbated and debt rises unsustainably.
Second, even if over the long term the benefits justify the cost, if they do not so over the short and medium term, then the imbalances are exacerbated for some period before they are resolved. In and of itself this shouldn’t matter if we are concerned about long-term growth prospects, but in the case of an economy with serious domestic imbalances and the risk that these imbalances may derail the economy, it will matter. To get to the long-term you have to go through the short and medium term, and disruptions in the short and medium term may eliminate the longer-term benefits.
Of course the question of whether or not China is misallocating capital can be endlessly debated because it is very hard to prove except in retrospect. I would argue that there are several reasons why we should believe that capital has been wasted on a large scale for many years. The first reason is simply historical precedents, something which unfortunately rarely enters into most economic analysis. No country in history that has had anywhere near the growth in investment as China has not had a serious problem in subsequent years, in which debt rose to crisis levels and growth ground to a stop.