No Time to Delay the Marketization of Factor Prices

For China’s current investment dominant economic growth pattern, there are many criticisms pointing to the structure of ownership. In their opinions, domination of the economy by state owned enterprises (SOEs) caused the high investment rate while crushing the living space of private enterprises. In fact, the more important reason is the price regulation of factor markets instead of SOEs’ monopoly.

As we know, investment and consumption decision are made based on prices which reflects scarcity. Once governments regulate prices of factors, the factor scarcity signals can’t work, and such regulation will lead to the mismatch of investments.

Though large infrastructure construction is still indispensable in China, it does not mean that all the related investments are effective: The annual infrastructure investments in eastern areas are much higher than that of mid-west areas, and even incur investment quotas from the National Development and Reform Commission (NDRC). But we can also find that there are insufficient investments on infrastructures such as freeways in Jiangsu and Shandong etc., while that’s not the case in mid-west areas.

Why is the infrastructure investment in mid-west areas too much while insufficient in eastern areas? Obviously, interest rates of Local Government Financing Vehicle (LGFV) in each province do not reflect different risks of projects. In fact, under interest rate control and obviously financial repression, there’s no wonder of over-investment.

Let’s take a simple calculation, as the current 10 trillion yuan ($ 1.6 trillion) local government debts, additional 100 billion yuan have to be paid for one year if the interest rate floats upward for 1%. As the loan interest rate varies from 9% to 14% under the current “Trust-Government Cooperation” mode, any small rise of the interest rate would definitely heavy the debt burden of local government (According to the latest statistic, China’s local governments’ income is 5.5 trillion yuan by the end of Nov. 2012). Obviously, under such a situation, no matter how rich a local government is, it will still serious consider the feasibility of the investment projects.

The distorted resource distribution also appears in the competition of enterprises. Due to regulation in factor markets, SOEs have the systemic advantage to get cheaper resources, capitals, or get access permits compared with private enterprises. As a result, it seriously restricts China’s technical progress and creation.

Taking land as an example, according to the report “The Nature, Performance and Reform of State-owned Enterprises” made by the Unirule Institute of Economics (a famous independent thinktank in China), if the rent is calculated according to 3% of the price of industrial land, SOEs and their holding industrial enterprises should pay 2.6 trillion ($417.6 billion) land rent from 2001 to 2009, which occupying 63.6% of the nominal net profits of SOEs. Just as the state owned book stores “Xinhua Bookstores”,  the most import factor for its running well is that the land rent is almost zero. Correspondingly, there is continuous closing down of private book stores. For aspect of cost of capital, Unirule Institute’s reports shows that the actual interest rate for SOEs averages at 1.6%, while market interest rate was estimated around 4.68%. If SOEs got capitals with market interest rate, they should pay about 2700 billion yuan ($434 billion) in addition, which will squeeze out 68% of their nominal net profit.

Of course it has to pay price. Government regulation leads to distorted factor prices that not only depress household consumption but also create interest groups blocking reforms. Furthermore, the excessive capacity based on over-investment makes China can’t get rid of export-led economy. Hence, China has to maintain terrible policies in wages, environmental protection, export taxation and so on, which will increase its imbalances.

At the same time, the low deposit rate lead depositors to seek investment channels beyond banks, so it gives rise to the problem of usury. When investors can easily make money with money, they will not tend to invest on real economy. To say the least, those entrepreneurs who want to invest for company’s bigger development can hardly get loans from bank system, so they have to turn to usuries for financing. It is the main obstacle for the current economic transition.

In fact, only marketizing the factor prices can let the market system exert efficacy. Though the central government is strictly controlling the blind expansion of the “two high” industries  (high-energy-consuming and high-emission industries) , it is exactlly the result of disorted regulation in factor makets: If all prices go as the maket system running, such industries will eventually eliminated by the market for high costs and inefficiency.

Originally published on PHONEIX WEEKLY | 2012-12-30