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Why China’s local governments may have outsized role in overcapacity conundrum

Why China’s local governments may have outsized role in overcapacity conundrum
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China’s overcapacity so ‘deeply rooted’ at local levels that analysts say its ebbs and flows have underpinned economy for decades

With a degree of carte blanche in guiding and funding industrial expansions, China’s local governments have played an outsized role in propagating the country’s overcapacity conundrum, according to specialists in economic development and trade.

Amid heightening accusations from the United States and Europe that China’s excess capacity has strangled their own manufacturing sectors – especially in the new-energy realm – Beijing has recently begun taking a harder line in pushing back.

Just a few months ago, China’s top leaders acknowledged that “overcapacity in some industries” was a major economic challenge to tackle this year. And in March, President Xi Jinping warned against a “headlong rush into new projects” in China’s drive for “new quality productive forces”.

But in recent weeks, the official message has shifted sharply, with allegations that the West was “hyping up” the issue with a “trumped-up narrative” rooted in protectionism, and that “so-called overcapacity is a sham”.

Xi now contends there is no such thing as “China’s overcapacity problem”. And Beijing argues that, from a global perspective, there is actually a shortage of capacity in the new-energy sector.

Still, Beijing’s concerns and evaluations of unchecked manufacturing have been well documented over the past three decades, with acknowledgements that institutional and mechanism factors – including local governments’ excessive involvement – have long led to instances of overcapacity weighing on the economy.

“Overcapacity is deeply rooted in China’s economic system,” said Joerg Wuttke, president emeritus of the European Union Chamber of Commerce in China, who first visited the country in 1982 and has witnessed its rise over the last 40 years.

“The system goes like this: China has a plan, and then puts a lot of money into this. And then China tries to keep the foreigners out to give the Chinese companies a chance to grow in size. Then every province wants to have the same thing – the same steel, aluminium, chemicals, cars and batteries,” he explained. “And you have, all of a sudden, this incredible growth in capacities.”

But despite such outsized growth, Wuttke said, the biggest players rarely go bankrupt, largely due to their state-backed status or designation as domestic “champions” in their respective industries, and this exacerbates the matter.

China has seen ebbs and flows of overcapacity since it began shifting from a purely planned economy to a market-oriented economy – a roughly 20-year transition that started in 1978.

The first wave, involving consumer products such as televisions, occurred in the 1990s amid a strong growth spurt in the manufacturing sector as it catered to pent-up consumer demand.

China’s overall production capacity has become bigger, thus putting more pressure on the West

Professor Tao Ran

After becoming a member of the World Trade Organization in 2001, China saw its overcapacity shift to capital-intensive industries such as steel and cement, as rapid economic growth triggered investment sprees in the real estate sector. Now Beijing is taking steps to help local-level authorities buy unsold homes, including by vowing US$41.5 billion in funding to clear the excess housing inventory.

And slowly but surely over the past 15 years, the new-energy industry – including electric cars, batteries and solar panels – has become awash with excessive supply, led by private firms. And this has left domestic manufacturers with little choice but to sell their wares overseas, drawing backlash from Western governments that are looking to protect their burgeoning new-energy industries.

“After China acceded to the WTO, its massive industrial capacity was indeed designed to cater to the whole world, especially the US and Europe,” said Tao Ran, a professor with the School of Humanities and Social Science at the Chinese University of Hong Kong (Shenzhen), who specialises in China’s economic transition and has closely followed land reform and urban development.

“Of course, China’s overall production capacity has become bigger, thus putting more pressure on the West,” Tao added, noting that the fierce competition among domestic firms, coupled with government subsidies and loosened environmental regulations, indeed increased their production capacity, leaving foreign firms little room to compete.

Prominent industry insiders have also publicly spoken on how insufficient downstream demand became a worrisome issue among authorities at city and provincial levels where the industrial chain for electric vehicles helped drive regional economic engines in recent years. And the effects, in turn, helped power the national economy.

For local governments around the world, the appeal of attracting manufacturing investment typically involves increasing employment and tax revenue, while China’s local authorities tend to have deeper motivations to shore up their respective economies in order to gain political promotions, many Chinese scholars have argued.

And a tax-regime reform in the country, which took place from 2012-16 and shifted away the business tax burden on companies to value-added tax on consumers, also added to local governments’ incentives to attract more manufacturing investment, as more tax revenue generated from these firms could be retained at local levels after the reform, according to Tao.

Meanwhile, the policy toolboxes of Chinese local governments have always been bigger than those of their foreign peers.

Previously, local authorities could lower land prices – by reducing the acquisition compensation for farmers – curtail labour costs and relax environmental constraints. In the past decade, many shifted to so-called government guidance funds – investment vehicles for China’s private equity market that are used to direct capital to some strategic emerging industries such as semiconductors. And the source of such funding largely relied on borrowing from banks, Tao said.

“If the industry in the end fails to develop, the banks will be the ones that eventually lose money,” he added.

And with Beijing sounding the alarm and urging action to curb worrisome debt levels among local governments amid a property slump and the nation’s uneven economic recovery, investments from government guidance funds have also slowed down.

“As there has been serious overcapacity, and no more money to set up the [guidance] funds, projects in some places may inevitably be left unfinished, which means the money has been poured down the drain,” Tao said.

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