International Herald Tribune
Philip Bowring: Better use of China's profits
MONDAY, JULY 31, 2006
HONG KONG As the yuan inches up again and China's government talks tougher about restraining credit, the question looms of how to rein in China's galloping economy and reduce international imbalances. The solutions that some have suggested focus on credit growth and the exchange rate, but that focus is too narrow.

Scant attention is paid to two interrelated issues that are arguably at least as important, both to China's domestic economy and to foreign trade: corporate profits and fiscal policy.

Corporate profits are booming but because companies are failing to pay out dividends, profits are creating their own imbalances. China's fiscal policy, for its part, is characterized by excessive discipline - the mirror image of what is happening in the aging developed world - and by big price distortions that favor goods-producing and exporting industries.

Much has been written about overheated fixed-asset investment - now more than 40 percent of gross domestic product. Likewise, there is no shortage of warnings from local as well as foreign commentators about too rapid credit growth, which is said to be behind the excesses in construction and manufacturing investment, and fears of another surge in nonperforming loans.

Almost unnoticed, however, is the fact that most fixed-asset investment is being financed not by credit but by retained earnings and new equity. For sure, credit is growing too fast because interest rates are low, liquidity is high and banks tend to turn a blind eye to restraining central guidelines when state-owned enterprises and other influential bodies come calling. Market forces and credit assessment are still lacking in the banking sector. But this is only half the problem.

Because of a remarkable rise in profits, retained earnings now account for more than half of capital spending. Only 27 percent comes from the banks - though the bank contribution to real estate investment is much higher.

Overall return on capital for the once derided state-owned enterprises rose from 2 percent in 1998 to 12.7 percent in 2005, and for other enterprises, from 7 percent to 16 percent. Corporate-sector savings now account for a massive 20 percent of gross domestic product.

In most countries, investment increases naturally tend to follow profit booms. But that is more than ever the case with China because of the growth obsession of all Chinese enterprises, public and private. Cash generated from operations is quickly earmarked for new investments and then topped up with additional bank loans.

There is nothing wrong with healthy profits, but in China the owner of much of the capital - the government - gets little return from dividends. That, in turn, restrains government revenues, which partly explains why so little cash is available for education, health and other social spending, or to redress regional income imbalances. Revenue is low as a percentage of gross domestic product, and much anyway is dedicated to fixed-asset investment. A fiscal deficit of only 1 percent of gross domestic product is also very conservative given the rate of growth of the economy.

While China doesn't need more fiscal stimulus, a policy to push for dividends from state-owned enterprises and spending on social needs would do much to rein in economic excesses and reduce domestic imbalances. If state- owned enterprises paid out 50 percent of profits as dividends, government health and education spending could be nearly doubled, according to the World Bank. Manufacturing and construction investment would be lower, but probably wiser.

State-owned enterprise profits may already have already peaked, because of excess capacity, rising interest rates and rising commodity prices, in which case asset investment will slow naturally, but government action on dividends would help.

So, too, would government policies to price more realistically energy, water, land and other inputs into manufacturing - and in ways that would reduce rather than encourage pollution. The same applies to export and foreign investment incentives. Any shift away from goods to services production tends to cause imports to rise faster than exports and thus rein in the trade surplus. Such a shift need not damage the overall growth rate and might even help create jobs and improve income distribution.

Beijing is aware of these issues, which have been pushed by the World Bank and others. But as with interest rates and the yuan, China's government is cautious in changing policy direction. That's a pity, because bolder moves are needed if the very serious risks from simultaneous domestic overheating and external imbalances are to be reduced.