As Beijing relies on fiscal spending to boost its economy, a growing fiscal deficit and ballooning public-sector debt will weaken China's long-term economic prospects. Economic growth spurred by increased government spending is unsustainable and creates distortions that will cause imbalances in production structures.
It is bad enough that this will bring low-quality growth due to the inefficiency and corruption associated with government spending. All this pump-priming has also proved ineffective, as shown by the return of deflation.
Although the State Statistics Bureau indicates that fixed-asset spending was up by almost 26 percent in the first five months of the year over the same period last year, most of the spending on fixed assets reflects capital expenditures by the government and state-owned enterprises (SOEs). Consequently, the central government or its supplicants account for more than two-thirds of investment in the country, and such spending outpaces GDP growth by a factor of three.
China has been fiscally stimulating the budget for the past five years, and this year the budget will be around 310 billion yuan (US$37.5 billion), leaving a public-sector deficit of more than 3 percent of GDP.
Then there are problems on the revenue side that will mean that Beijing will face increasing financial strains. After substantial gains over recent years, central government finances have begun to deteriorate. While government expenditures experienced a year-on-year increase of 23.9 percent in the first quarter of this year, tax revenues rose by just over 3 percent.
These large and growing deficits add to existing public-sector debt. When contingent liabilities, including recapitalizing the banks and fulfilling pension obligations, are added to existing government debt and bad debts held by SOEs, the total is around 70 percent of GDP.
It appears that China's leaders are embarking on a dangerous gamble. They are undertaking a typical political ploy of inflicting long-term costs to capture short-term gains that will prove to be illusory. Public-sector deficit spending imposes a burden on future generations of taxpayers that will be required to pay for today's follies.
The tendency for Beijing's leaders to spend beyond their means reflects a range of new pressures, including the hopes of smoothing the political transitions in the Communist Party leadership expected later this year. They also hope that public spending will break a nagging deflationary cycle and avoid further slowdowns in growth. Communist Party chiefs also want to enact high-cost social welfare programs and reform the banking sector.
Economic theory suggests that deficit spending might work if the problems it seeks to ameliorate are cyclical and temporary. But China's economy is suffering from long-term and structural problems that require radical and massive restructuring. Clearly Beijing has misdiagnosed the problem and is treating it incorrectly.
How effective is deficit spending in reviving economic growth? China need not look far for an example of the problems that arise from using deficit spending to correct structural problems. Since Japan's bubble economy popped, most of the country's additional public-sector expenditures have been financed by deficits. Government spending during the 1990s exceeded ?800 trillion, five times more than fiscal expenditures in the US during its restructuring in the 1980s. Despite these massive expenditures and expansionary credit policies, Japan's average economic growth in the 1990s was about 1.1 percent.
Tokyo's outstanding debt rose from 56 percent of GDP at the beginning of the 1990s to about around 130 percent. Many credit-rating agencies put the figure much higher.
All this bad news in Japan is the outcome of a government too stubborn or afraid to implement the necessary policies to force radical restructuring of the economy. By following this same path of timidity and lack of resolve, Chinese leaders are likely to have a hand in further deterioration in their economy.
Some similarities exist in the restructuring required for these two economies. In both Japan and China, small and medium-sized enterprises were starved of capital while some industrial behemoths were kept alive. Not until the
government changes its policies to allow a new entrepreneurial class to provide the basis of future growth will incomes rise and unemployment fall.
Despite high levels of personal savings in both countries, the allocation of these funds is grotesquely inefficient. Neither Japan nor China has a well-
functioning domestic capital market, with most borrowing directed through the banking system.
An obvious problem with bank lending is its vulnerability to political pressures. Indeed, the politicization of decisions on capital formation is at the core of the problems in both countries. Both need domestic stock and bond markets that are wider and deeper. Since capital markets require greater transparency and accountability, massive failures tend to be less likely.
Restructuring needs to be aimed at more than merely cutting costs -- which only resolves temporary difficulties. Proper restructuring requires a dynamic perspective that involves deep reform of management practices and government involvement in the economy. China and Japan need nothing less than changes in their corporate and political cultures to encourage the kind of entrepreneurial initiatives that can resolve their economic woes.
Christopher Lingle is professor of economics at Universidad Francisco Marroquin in Guatemala and global strategist for eConoLytics.com.
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