china - what needs to be done

China is unique compared to other developing/emerging economies in the world. While other such countries are always cash strived and undertaking any major infrastructural/ industrial project requires major mobilization of resources, China remarkably commissions and executes major infrastructural projects with ease and panache. However, practicality of those projects itself are irrelevant.
For instance, the Shanghai MAGLEV. Building the Shanghai MAGLEV cost the exchequer USD 1.2 Billion. It doesn’t seem such a large investment considering the fact that China invests 2.6% of its GDP (USD 125 Billion annually) on infrastructure. However, MAGLEV capacity utilization is 20% and at its current revenues, the project is not even going to recover its financing costs. Another example is the High Speed Rail network connecting the entire country. The ambitious project that is expected to cost USD 300 Billion is one of the largest infrastructural projects ever taken globally. By 2012, China plans to build over 8000 miles of high speed rail lines which surpasses that of the entire world combined.
The important question to ask here is – are these huge infrastructural projects economically viable? The short and sweet answer to that is – “It doesn’t matter”. Why because – mostly Chinese Banks finances these projects and the Government owns most of the Chinese Banks. When the Government wants to build, they ask the banks to finance. When the banks don’t have liquidity, the Government prints more money and liquidates these banks. So the entire notion of practicality and economic viability of these projects don’t form a criterion during decision making.
This raises question on the robustness and feedback mechanism of the financial system in China. An optimal financial system should draw savings and channelize them to effective investments efficiently. Although, China efficiently attracts savings into its banks and investments funds, its capital allocation process which includes decision making and funneling those funds are lacking efficiency and independence.
The same applies to capitalizing Chinese companies. Chinese State owned enterprises are known for their inefficiency and low profitability. While private enterprises contribute 50% to the country’s GDP, they have access to only 27% of loans from the financial system. The remaining loans fund SOEs and infrastructural projects. Thus, private enterprises in China have limited scope for expansion. Not surprisingly, 25 largest companies in Mainland are all public sector. This explains the vast non-performing loans in China’s banking system. A more efficient capital allocation process will also create higher returns on savings. Currently, Chinese financial assets earn only 0.5% after inflation. A more efficient financial system which gives 1.8% inflation corrected return, similar to that of Korea, will infuse USD 25 Billion into Chinese households and will increase domestic consumption.
An important succeeding question is - how can a financial reform be brought into the Chinese financial and banking system? This is a very tricky question to answer – particularly since there is so much scope of improvement in the Chinese Financial System. However, a few primary suggestions are:-
• Making key decision holders in the banking system accountable for their capital allocation. This will enable banking system to be independent of the political forces in the market.
• Easing rules to enable SMEs and private companies raise capital from the equity markets.
• Strengthening and coordinating the Chinese Corporate Bond markets. Banks should ideally finance SMEs and individuals while Corporates and Infrastructure projects fund themselves by issuing bonds.