China's Capital Allocation Remains Highly Inefficient

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Includes: FXI, PGJ
by: Peter Fuhrman

Capital is not a problem in China. Capital allocation is.

Expansionary credit policies by the government has created a boom in bank lending. This rising tide of bank credit is also lifting Chinese SMEs. Through the first half of this year, loans to SME have increased by 24.1%, or 2.7 trillion yuan ($400bn). All that new lending, though, has not substantially altered the fact that bank lending in China is still directed overwhelmingly towards state-owned companies. So, while lending to SME rose by nearly a quarter, that equates to only a tiny 1.5% increase in the share of all bank loans going to SME.

State-owned banks and state-owned companies are locked in a mutual embrace. It’s not very good for either of them, or for the Chinese economy as a whole. Faster-growing, credit-worthy private companies find it much harder and more costly to borrow. Over-collateralization is common. An SME owner must often put up all this company’s assets for collateral, then throw in his personal bank accounts and property, and finally make a cash deposit equal to 30% to 50% of the loan value.

China isn’t the only country, of course, with inefficient credit policies. Japan’s banking system still puts too much cheap credit in the hands of favored borrowers. But, the problem is more damaging in China that elsewhere, for two reasons: first, many of China’s best companies are small and private. They are starved of capital and so can’t grow to meet consumer demand. Second, the continuing deluge of credit for state-owned companies distorts the competitive landscape, keeping tired, often loss-making incumbents in business at the expense of better, nimbler and more efficient competitors.

In other words, China’s credit allocation policies are actually stifling overall economic growth and inhibiting choice for Chinese consumers and businesses.

State-owned banks everywhere, not just in China, have the same fatal flaw. They like an easy life, which means lending to companies favored by their controlling shareholder, not those that will earn the greatest return. They can turn a deaf ear to profit signals because, ultimately, profit isn’t the only purpose of their labors. They allocate credit as part of some larger scheme, in China’s case, maintaining output and employment in the country’s less competitive, clapped-out industries.

There’s a regional dimension to this too. China’s richest, most developed areas are in the South, particularly the powerhouse provinces of Guangdong, Zhejiang and Fujian. The economy here is driven by private, entrepreneurial companies, not the state-owned leviathans of the North. As a result, a credit policy that discriminates against private SME also ends up discriminating against the parts of China with the highest levels of private ownership and per capital wealth.

That’s not sound banking, or sound policy. The good news is that the situation is changing. SME are gradually taking a larger share of all lending. The change is still too slow, too incremental, as the latest figures show. But, with each cautious step, the private sector, led by entrepreneurial SME, gains potency, gains scale and gains more of the resources it needs to provide the products and services Chinese most want to buy.