Analysis of the Problem of Overcapacity in China: Relevant Policies, Theories and Case Studies

By Zhang Junkuo & Zhao Changwen Research Team of the Development Research Center of the State Council (DRC)

Foreword

An important problem that has arisen during China's economic development in recent years is the excess overcapacity in some industries. With a slowdown in China's economic growth since the second half of 2011, the profit margin of industrial enterprises above designated size has fallen significantly, the number of loss-making enterprise gradually increased, and the scope and severity of overcapacity further expanded. In this connection, the Central Economic Working Conference held in December 2012 suggested that readjustment of the industrial structure should focus on tackling the problem of overcapacity. In October 2013, the State Council issued Instructions on Tackling the Problem of Excess Overcapacity. In the "Decision on Some Major Issues Concerning Deepening the Reform Comprehensively" made at the Third Plenary Session of the Eighteenth CPC Central Committee, it was pointed out that it was necessary to "establish a sound and long-acting mechanism to guard against and cope with overcapacity". In December 2013, the Central Economic Working Conference noted that consistent efforts should be made to carry out the decisions and arrangements of the central leadership to deal with overcapacity. These moves indicate not only the central leadership's high concern about addressing the issue of overcapacity but also the complex nature of this problem.

The complexity of solving the problem of overcapacity is first reflected in the diversity of causes. The problem of overcapacity in China is different from other countries in terms of its development stage, institutional mechanism and development mode. As regards development stage, since the implementation of China's reform and opening-up, especially from the start of the new century, China has witnessed a catch-up stage of rapid growth and the speedy economic growth has offered broad investment opportunities and rich investment returns, attracted various kinds of capitals for increased investment, and even given rise to a "wave" of over-investment in certain industries. This is the market factor triggering overcapacity. With regard to institutional mechanism, competition and decentralization among China's local governments have led to a healthy race for development along with an impulse for over-investment. During the international financial crisis, some excessive relaxed macro-economic control measures made enterprises feel that there was a swift demand. Furthermore, the inappropriate and uncoordinated industrial policies have also crippled the efforts to deal with overcapacity. In view of development mode, China's extensive economic growth has remained basically unchanged. Faced with increased market demand, enterprises depend more on increasing scale than on boosting efficiency, which also causes a lot of industries to keep expanding capacity.

Though overcapacity is prevalent, there is a huge difference as to the severity of this problem among industries, with quite a few industries such as household appliances and apparel industries facing a less serious problem. Based on our analysis, the problem of overcapacity is severe in the following three types of industries: the first type involves heavy chemical industries. The local governments hope to attract key investment through these industries whereas their products possess a high degree of homogenization, including iron and steel, cement, electrolytic aluminum, and plate glass industries. The second type involves strategic emerging industries that enjoy excess preferential policies, including wind power equipment manufacturing, polysilicon, and photovoltaic cell industries, with the photovoltaic industry given more favorable policies. And the third type involves industries that suffer a plunge of market demand owing to factors arising from home or abroad, including ship building and photovoltaic industries. Overcapacity has done relatively serious harm to China's economic development and posed the following potential risks: First, there is a risk of the further development and massive outbreak of overcapacity. Because of the large-scale investments in previous years, the production capacity of many industries is still in a process of rapid growth. For example, the capacity of iron and steel plants under construction is around 150 million tons, that of the cement industry around 560 million tons, that of the electrolytic aluminum industry around 10 million tons, and that of the plate glass industry around 123 million weight cases. If new capacity is also counted in, the rate of capacity utilization of all industries would drop dramatically. Meanwhile, China's economic development has entered a relatively higher stage and the contribution by service sector to economic growth has surpassed that of industry and many heavy chemical industries are about to reach their peak value of development. Therefore, if we do not tackle overcapacity to promote structural readjustment, transformation and upgrading in advance, the problem of overcapacity may further worsen in several years, which might result in an eruption of various problems and the risk of a "hard landing" for China's economy. Second, the sustained overcapacity may bring about a vicious competition and benefit decline among enterprises and even cause socio-economic risks of widespread bankruptcy. Judging from the situation since 2013, although widespread bankruptcy of enterprises would not happen for now, there is an increased number of potential problems in iron and steel, chemical engineering, and coal industries. Third, overcapacity could give rise to the buildup of risks and deterioration of market order. On the one hand, in the real economy, as a number of low-efficiency enterprises, while enjoying preferential policies and regional protection, are reluctant to withdraw from the market in time whereas top-quality enterprises are unable to fairly participate in market competition. Under the context of overcapacity, it might lead to the distorted effect of "the bad money driving out the good", and the normal structure and order of the real economy market is disrupted. On the other hand, the reason why such problems as enterprises' withdrawal from the market and unemployment would not loom up within a short period in some of the industries with overcapacity is that the enterprises (local state-owned enterprises in particular) have borne their proper share of responsibility. These big enterprises "rob Peter to pay Paul", i.e. rely on profitable operations to compensate for insufficient capacities, thus internalizing socio-economic risks. Such practice can only for a little while mask the socio-economic risks that are likely to be triggered by overcapacity, but the operational risks of enterprises continue to accumulate. In a sense, overcapacity is the "bubble in the real economy". On the surface, real enterprises seem to be running normally while the truth is that they are simply benefiting from the "bubble" performance. Once it bursts, huge systematic risks would follow, causing a grave negative impact to the entire socio-economic development.

Based on the understanding for now, although the essence of tackling overcapacity is to bring into full play the decisive role of market in resource allocation, the government can never "govern with a hands-off attitude" but should "better play its role". The primary job of the government is to create conditions for market to function better, especially to redress overcapacity triggered by institutional factors.

In the short run, the key to tackling overcapacity lies in two aspects. First, efforts should be made to improve and implement the policy issued by the central leadership to "digest, transfer, integrate, and obsolete a batch of excess capacities". Second, a policy system for enterprises' withdrawal from the market should be established and improved. One, the primary way for substandard enterprises to withdraw from the market is to set up and strictly enforce the standards regarding environmental protection, energy conservation and quality. Two, the government should call off unfair preferential policies in whatever regions and industries so as to promote fair competition through which good enterprises stand out while those lacking in competitiveness are sifted out. Three, by improving the enterprise withdrawal mechanism, the society could be stimulated to provide subsistence assistance for bankrupt enterprises so as to cut down the cost of withdrawal. Four, the administrative means of directly setting objectives to restrict capacity should be reduced as much as possible.

In the long run, the major way is to establish a long-acting mechanism to guard against and deal with overcapacity by taking deepened reform as a starting point. The primary task is to carry out the requirements put forward at the Third Plenary Session of the Eighteenth CPC Central Committee with regard to establishing fair, open, and transparent market rules, especially the decision on "implementing unified market supervision, eliminating and repealing all sorts of regulations and practices that impede a nationwide uniform market and fair competition, as well as prohibiting and penalizing the illegal implementation of preferential policies" with a view to guiding local governments to propel economic growth mainly by improving the quality of services and strengthening the construction of the soft market environment rather than by resorting to preferential policies. At the same time, efforts should also be exerted to promote the market-based allocation of public resources, to separate government administration from the management of enterprises and state assets, to transform the functions of the government and to improve the assessment system.

This book contains the research findings by the research team of the Development Research Center of the State Council over one year. During the research, the team has received valuable assistance from government research offices and local development research centers in Hebei, Henan, Jiangsu and Zhejiang provinces and Shanghai municipality, from industry associations related to iron and steel, building materials, nonferrous metals and photovoltaic materials, as well as from over 100 enterprises. We would like to take this opportunity to express our sincere appreciation for their kind assistance.

It is sincerely hoped that dear readers would not hesitate to make comments and stint your criticism to this book.