Lan Xiaohuan on China's Local Government Competition and Overcapacity
The Fudan University professor's How China Works: An Introduction to China’s State-led Economic Development, translated from his 2021 Chinese domestic bestseller, is now available in English.
Overcapacity is now the talk of the day when it comes to China’s economy, and Pekingnology today presents a brief excerpt from the recently published How China Works: An Introduction to China’s State-led Economic Development by 兰小欢 Lan Xiaohuan, Professor, School of Economics, Fudan University.
The book is translated from Lan’s 置身事内：中国政府与经济发展, a 2021 Chinese domestic bestseller with over a million copies sold, depicting the role played by the Chinese government in China‘s economic development. It explains how the Chinese government has gradually established and improved market mechanisms while promoting economic growth. The book particularly points out that the Chinese government not only governs the economy through policy guidance but also directly participates in the process of urbanization and industrialization as part of the market. It also introduces the specific mechanisms of government involvement in economic activities, which forms a bridge between economic theory and the reality of China.
Some institutions have free access to the book via Springer Link, where you can also purchase it.
Local Government Competition and Overcapacity
Preferential policies offered by local governments in order to attract investment help to lower barriers of market entry, which may result in excess investment and production capacity. This is one downside of China’s industrial policy that is often mentioned in policy debates, and the solar industry is often cited as a textbook example. Having a period of overinvestment and overcapacity is nothing surprising in itself and would likely occur in a market economy even without government interventions. Since investment is tied to the future and the future is always uncertain, the amount of investment chosen by the free market is unlikely to match exactly the future market demand. Industrial investment, given its long-term nature, is hard to reverse once the investment is made, therefore it is almost always too much or too few. When markets are optimistic, investment tends to overshoot, leading to excess capacity and falling prices. Many companies would go bankrupt, but the falling prices would stimulate more demand, which can once again stimulate a cycle of overinvestment. Periods of overcapacity are therefore normal as a supply and demand respond to each other in an everchanging market economy. It is precisely because of this overcapacity, companies have to work hard to increase their competitive advantage and survival chance, leading to continuing technology progress and efficiency improvement.1
In China, there are at least three more factors that can lead to overdevelopment of a given industry. To start with, a developing country, such as China, can see trends in developed countries. Certain products that become everyday items in developed countries first, such as color TVs, refrigerators or washing machines, are surely to catch on in developing countries later. The demand for such products will be huge and certain, and relevant production technology can be easily imported and copied. Meanwhile, the domestic market just begins to grow, and everyone has an opportunity, investment therefore floods into these sectors. Secondly, many preferential policies and subsidies from local governments in order to attract new investment, such as cheap land and loans, are often provided during the construction phase of a project. It takes time to build factories but local government leaders change frequently, if construction is not started quickly then these preferential policies and subsidies might be changed. Even worse, these preferential policies and subsidies might be given to a firm’s competitors. Even if the market situation changes after the factory has been built, it is always possible for firms to find some room to adapt by adjusting production volumes or prices. But if firms do not invest fast and early, many opportunities would be lost. The third reason is that local governments tend to follow industrial policies of central government. Even if a region is not suitable for a given industry, the local government may still try to invest in it because the investment would be politically correct, which would contribute to drive investment in overcapacity.2
Overinvestment may not always be a bad thing. In the early stage of economic development, overinvestment supported by local governments has at least two benefits. Firstly, local factories not only provide employment, but they also help to serve as training grounds for local workers, helping local peasants’ transition to industrial roles. Turning peasants into factory workers is a core part of industrialization, which requires a complete change in lifestyles and mindset. This transition cannot happen automatically and requires learning and training that can only be done in the factory. In the 1980s and 1990s, when township and village enterprises were growing quickly, a unified domestic market had still not formed. Countless small factories were built under the stewardship of local governments across the country, and their overall production efficiency and technical capability were very low. But these small factories provide local peasants with factory jobs, effectively a chance of “leaving the soil without leaving home”. In this way, peasants across the country became familiar with the operation of factories, and a huge force of industrial workers was trained. This process laid the foundation for China to take advantage of its labor force and become the world’s factory after entry into the WTO in 2001. From this perspective, the factory essentially assumed an educational function for the industrial economy and had a strong positive externality on the economy, and it should be subsidized and supported.
The second benefit of overinvestment is that it increases competition. Overcapacity has made price wars a norm for many products in China. Therefore, for a long time, innovation in cost reduction was the main type of innovation pursued by Chinese companies. In the West, this is often mocked as “copycat behavior”. However, functional simplification and cost innovation are very important. Many products in the West, such as automobiles or home appliances, have been upgraded over many years to satisfy the requirements of Western and richer customers, so the functionality tends to be complex and the price higher. But when these products are introduced to Chinese consumers for the first time, they are too fancy and too expensive. If sacrifices in terms of certain features and product quality can help to bring the price down, then it would expand the market demand. As consumers become more familiar with the products, and as they become richer, they will increase their demand for higher quality and more additional functionality. Therefore, it is not surprising that many industries in China have gone through the copycat and price war stages. And it is exactly in this stage of brutal competition that the industry is developing quickly, numerous small firms rise and fall fast, and resources and technologies are quickly concentrated in the hands of leading companies. Both technology and product improve rapidly. Take the home appliance industry as an example, domestic Chinese products start from being cheap and low-quality, upgrade fast to become high quality but still cheap, with reliable service and beautiful design. In a short period of about two decades, domestic brands started from scratch but managed to dominate the Chinese market. The same is true for many other consumer products.3
So, whether there is government support or not, the key is not overinvestment itself but to maintain competition. The fundamental advantage of a market economy is not an improvement in individual decision-making per se. No one can precisely predict an uncertain future, and in a free market there will be much more failures than successes. The advantage of a free market is that it ensures competition and through a process of trial and error, only the fittest or best-adapted companies survive.4 Therefore, industrial policies that are designed to support competition, rather than supporting specific companies, tend to be more effective at stimulating development.5 However, in practice it is difficult to avoid policies that only support specific companies. Even if an industry policy advocated by the central government is designed to target the entire industry and maintain competition among firms, when it is implemented at the regional level it necessarily benefits specific local companies. Local governments may choose to protect local companies from bankruptcy. But if these “zombie companies” cannot be eliminated, then the benefits of competition will be limited, and many resources will be misallocated and wasted. This is the main reason that many economists oppose industrial policy. In China, local governments have a strong preference for big industrial projects which stimulate investment and GDP growth. These big companies employ lots of people, and it becomes much harder to allow them to go bankrupt without disrupting social stability. So local government have strong incentives to intervene bankruptcy cases once big companies are involved, which could lead to ineffificient and unfair results. In the bankruptcy case of LDK, a former solar giant in Xinyu city of Jiangxi province, this problem is salient.
As mentioned earlier in the chapter, by 2011, LDK became the largest contributor to Xinyu’s public finances, paying 1.4 billion yuan in taxes which was equivalent to 12% of the city’s annual tax revenue. At the same time, the company created 20,000 jobs in the city. With the support of the local government, LDK received a large amount of credit from banks, far more than the total assets of the company. Starting from 2012, the company began to default on many of its debts. But local governments repeatedly injected funds into the company, and help persuade banks to rescue the company. In spite of all these efforts, the debt problem only got worse. By 2016, the total assets of LDK were valued at 13.7 billion yuan, but the total debt was as high as 51.6 billion yuan, and the company was bankrupt. However, the bankruptcy procedure was led by the local government, harming the interests of creditors. When creditors rejected the debt-restructuring proposal because the repayment offered is too low, the local court adjudicates in favor of the proposal against the will of the committee of creditors. This clearly violated the guidance from the Supreme People’s Court regarding legal practices in firm bankruptcy, and it received a great deal of attention in media, law communities and financial industry.6
Industrial policies must therefore have an exit mechanism. Such a mechanism can have two meanings. The first is that a subsidy policy itself needs an exit mechanism. For example, the solar electricity FiT subsidy mentioned above gradually declines over time, and all companies are aware that the subsidy will eventually be removed, therefore they need to continually reduce costs and improve efficiency to be competitive in the market. The second meaning is that there needs to be a channel for inefficient companies to go bankrupt. If inefficient firms cannot be driven out of the market, competition would be distorted. This involves not only industrial policy but also reforms of bankruptcy and restructure laws. In essence, it requires fundamental and market-oriented reforms of the allocation of production factors. However, enforcing efficient bankruptcy procedures has been a chronic problem for China’s economy. Creditor banks are reluctant to go through bankruptcy procedures because it will bring to light non-performing loans and losses. Local governments are reluctant to see firms, particularly big ones, go through bankruptcy procedures because the conflicts with unemployed workers and various creditors could be hard to control. In coastal areas of China where market economy is more developed, bankruptcy procedures are relatively easier and more transparent. For example, in the industry of solar power, the bankruptcy and restructuring cases of Wuxi Suntech and Shanghai Chaori proved to be more market orientated and creditor friendly than that of LDK. These two cases were listed by the Supreme People’s Court in the “Top 10 bankruptcy model cases for 2016”. However, in general, China still has a long way to go in terms of reforming its bankruptcy liquidation and reorganization laws.
The East is Read, a sister newsletter, recently shared another brief excerpt
Two years ago, Pekingnology translated a part of the original Chinese book
Again, some institutions have free access to the book via Springer Link, where you can also purchase it.
The impact of uncertainty on investment and the economic cycle is one of the important topics in economics. The related literature is vast. Readers can refer to Bloom (2014) for an excellent introduction to the topic.
The first factor is called the “tidal wave phenomenon”, as detailed in the paper by Lin et al. (林毅夫, 巫和懋, 邢亦青 2010). The second factor is known as the "Oi-Hartman-Abel" effect, that is, companies can benefit from expanding (in this case, building factories) and control risks by shrinking (in this case, reducing production volume after factories started to operate), see Bloom (2014) for an introduction. The third factor, or the phenomenon that local industrial policies are converging with industrial policy of central government, can be found in the paper by Zhao and Chen (赵婷和陈钊 2019).
Yip and Mckern (2016) analyze many cases of cost innovation by Chinese enterprises.
The idea that the core advantage of a market economy is not decision-making but the survival of the fittest comes from the late economist Alchian (1950). His article from seven decades ago is still wonderful to read today.
China’s industrial policies that are competitive in nature, such as industry-wide subsidies, tax breaks, and low-interest loans, have a positive effect on improving technology and efficiency of an industry, see Aghion et al. (2015).
For details, refer to an article from the 37th issue of Caixin Weekly in 2017, “Bankruptcy and Restructure of LDK”.