China must avoid creating more problems with action on overcapacity

At the Central Economic Work Conference late last year, overcapacity was highlighted as a problem prioritised for action this year. So, just before the Lunar New Year, 12 ministries and state commissions jointly rolled out a plan to push for mergers in key industries including carmaking, steel, cement, shipbuilding, aluminium, rare earths, electronics, pharmaceuticals and industrialised agriculture.

Reports say as many as 19 sectors will eventually be affected, under plans that are still being finalised.

The worry about overproduction is twofold. One is the problem of waste, of course; the other is concern that the government may go overboard trying to tackle the excess capacity, thus hurting the economy even more. This worry is not unfounded.

Overcapacity has plagued the Chinese economy since the 1990s. Despite repeated government attempts to solve the problem, it has only got worse. One study concluded that the rate of utilisation of capacity last year was even lower than that in 2008, at about 70 per cent of pre-2007 levels.

In the past, the government has tried to curb excess capacity with administrative measures - such as by imposing market entry barriers, setting higher approval standards for projects and upgrading outdated production facilities - and the occasional financial policy.

By contrast, its latest plan stressed the use of market-based solutions while the government plays a guiding role. This is to be welcomed. But, by setting a target of 2015 for industrial consolidation, the government is raising fears that it may end up meddling in market operations to meet the deadline.

Some excess production is to be expected in a market economy. This is different from a planned economy, in which a supply shortage is common. Economists generally agree that some oversupply is a good thing in a healthy market - it can spur enterprises to innovate and improve. Yet, on the mainland, overproduction is not a result of normal market operations but of a government-led, investment-driven growth model.

Two broad categories of industries suffer from overproduction on the mainland: those driven by investment, such as steel, cement and aluminium; and those encouraged by the government to develop.

In the first category, overcapacity accumulates throughout an economic cycle. When the economy is heating up, exuberant investment leads to redundant projects. But when the economy cools, inefficient players that should have been forced out of business instead receive a lifeline from bureaucrats launching infrastructure projects as a stimulus. As a result, overproduction worsens.

In the second category, the government distorts the market by favouring certain industries with subsidies and other help, openly or indirectly. At the same time, local government officials trying to boost their performance records overpromote these industries, leading to market saturation in no time. This is the problem we see in China's renewable energy sector, such as wind farms and photovoltaic equipment.

The problem of overproduction can only be solved through the market. The government should do two things. One, it must stop intervening in the market, and abandon its investment-led growth model. Two, it must create fair market competition by setting clear rules, rationalising price signals and levelling the playing field.

This involves wider reform, by clarifying the convoluted relationship between government and market in China. The way local governments are evaluated should also be changed to prevent unhealthy competition.

In the short term, it is both practical and feasible to develop a healthy market and improve its workings. Take utilities such as water and electricity, the prices of which have been kept artificially low, with no heed to the environmental costs. The distorted pricing has enabled inefficiencies to persist. Thus, one immediate task is to rationalise the prices of resources so that they reflect the true environmental costs.

The merger plan encourages the consolidation of industries across regions to encourage the survival of the fittest. It sounds good on paper, but the reality is stark.

For too long, state-owned enterprises have used their access to cheap capital and land to squeeze out private enterprise. Worse, the administrative measures used in the past to tackle overproduction have usually ended up protecting the bigger players at the expense of private enterprise. So the latest merger plan must not be yet another way to suppress private enterprise.

Tackling the problem of overproduction is part of the larger task of restructuring the Chinese economy. It cannot be done overnight. While industry consolidation is to be encouraged, it has to be done through healthy market competition and not government intervention. Thus, to meet its own deadline of 2015, the government must nevertheless resist the temptation to interfere, and instead be guided by fact-based evidence on what's feasible.

Moreover, policymakers should keep in mind the framework for action suggested by the work report at the 18th party congress. The merger proposal is only part of a basket of reforms necessary to find a fundamental solution to China's economic ills.