Effectiveness of central planning can be a double edged sword

by Vested Team
September 7, 2022
9 min read
Effectiveness of central planning can be a double edged sword

In this blog, we discuss the effectiveness of China’s central planning, which can serve as a double-edged sword. In doing so, we touch on the accelerated adoption of solar technologies, how China missed the scientific and industrial revolution, and finally close with the current economic deterioration due to the real estate bubble and China’s continual pursuit of its zero-Covid policy.

The effectiveness of central planning

When a country as large and determined as China puts its mind to accomplishing an objective, it can be extremely effective. Folks that live in the western world are often in awe at the determination of the Chinese and the outcome. During the course of its existence, China often showed a single-minded top-down approach in aligning political and fiscal resources in achieving strategic goals. 

In other words, while the West, in particular the US, debates, China builds. But this efficiency can be a double-edged sword. If the goal is correct, then the outcome can be world-changing. But if the goal is wrong, the outcome can be severe

Here are examples where the effectiveness has the intended consequences (clean energy investments) and unintended consequences (missing the scientific and industrial revolution). 

Intended consequences: China’s clean energy investments

More than a decade ago, China made it a strategic imperative to be a global photovoltaic (PV) powerhouse. The imperative prompted local governments to offer cheap land, while state-backed banks gave favorable loans for solar projects. Fast forward 12 years and China’s share of solar panel manufacturing has reached 80% of the global supply and is projected to hit 95% for some aspects of PV making. 

Figure 1: China has increased its share of PV manufacturing over the past decade. Image is from the IEA

In the process of achieving this, they have also decimated the US panel-making industry (see Figure 2 below).

Figure 2: China became dominant in solar panel manufacturing. Source

China is not just investing in the manufacturing industry, it is also aggressively investing in electricity generation capacity. In the past three years alone, it has added more solar power capacity than the US, UK, and Europe combined (see Figure 3), and its investment in this sector is not waning. In 2022, China tripled investments in solar projects as compared to the same period in 2021.

Figure 3: Net solar PV capacity additions from 2018 – 2020. Image is from the IEA

These massive-scale investments have had ripple effects at the global level. The cost of solar power has dropped faster than even the most optimistic predictions from a decade ago. Every year, the cost of solar energy declines by an average of 15%, which is almost 6x faster than the average prediction made in 2010. In the past decade, the cost of electricity for utility-scale photovoltaic (PV) systems went down by 88%. Much of this cost reduction is driven by increased economies of scale, particularly due to the massive expansion in manufacturing capabilities in China.

The net outcome is good for the world’s effort in transitioning to renewable energy but disastrous for domestic production in other countries. China is replicating this strategy in other sectors too: wind generation, nuclear power, and semiconductor. 

The rate of investments in nuclear energy is particularly striking. While the US, France, Germany, and Japan have reduced investments in nuclear power in the past decade (for context, the US built only one nuclear power plant in the past 20 years), China’s nuclear power production has quadrupled. In its attempt to achieve carbon neutrality, China plans to build 150 reactors in the next 15 years, with a price tag that is expected to be about $440 billion, funded by cheap capital from state-sponsored banks. Strategic projects such as these typically have an interest rate of 1.4%, much lower than ~10% typically seen in developed nations. With this low cost of capital, nuclear power costs in China can be about one-third that of in the US and France

Unintended consequences: Why did the scientific and industrial revolutions not happen in China?

The scientific and industrial revolution began in the West in the 16th and 17th centuries. Some argue that this is because the West had strong navies, gunpowder, the printing press, and vast energy sources (in particular coal). 

But China had access to these resources centuries before the West:

  • It is home to the oldest coal mine in the world (the Fushan mine, which was started around 1000 BC). By the 10th century, the coal mines in China were more advanced than in other countries in the world at the time. 
  • China also discovered paper, the printing press, gunpowder, and the compass (essential for sea travel) centuries before the West. 
  • By the 1400s, China had the largest fleet of ships in the world. The fleet, called the “Treasure Fleet”, was not only the largest but also the most advanced at the time. Some ships were 120 meters long (6x the length of Christopher Columbus’ flagship vessel, the Santa Maria). In the early 15th century, China, under the Ming dynasty, was a preeminent naval superpower that was able to trade and project its influence as far as Southeast Asia, India, and Africa, decades before Columbus was even born. 
Figure 4: Zheng He and the Treasure Fleet. Image is from National Geographic

So what happened? Even though China appeared to have the same ingredients as the West centuries earlier, the country was unable to lead the scientific and industrial revolution.

Unfortunately, by 1525, all Treasure ships were destroyed by the Chinese government. All sea faring voyages ceased and records of maps were burned. Trade between China and other countries became restricted. 

There are many theories that try to explain the Chinese government’s reasons for stopping the sea voyages. Angus Deaton, a Nobel Prize-winning Princeton economist, believed that China did so because of politics. At that time, China had a singular political bureaucracy; the emperor and his court, worried about the threats from the merchant class, decided to ban ocean voyages. 

Just like that – China’s growing influence in the world was reversed. By closing itself from the world, China lost its technological advances.

In this example, the singular efficiency of one bureaucracy resulted in possibly one of the greatest missed opportunities. Once the emperor decided that seafaring was unfavorable, the ships and the naval officers had nowhere to go. 

Contrast this to the experience of Christopher Columbus:

  • In 1484, Colombus tried to sell his idea for an Indies voyage to establish new trade routes to the King of Portugal, who rejected him. 
  • Columbus then took his idea to the Catholic monarchs, who ruled Spain at the time. They too thought that his idea was impractical. But for fear of Columbus selling his idea to a competing monarch, they paid him an allowance to further develop the idea (perhaps these ancient monarchies were the first VCs and Columbus the first entrepreneur in residence ?). 
  • Columbus kept trying to raise funds for several more years. He kept going back and forth between the Spanish and the Portuguese. It was until he threatened to bring his idea to the French that Columbus won the agreement from the Spanish monarchs.

As you can see, Columbus had options. Unlike China, Europe at the time was a fragmented region competing with one another. This allowed for the migration of talent and competition of ideas. Yes – it can be messy and inefficient, but this competition of ideas (in free markets), as history has shown, allows humanity to bubble up the best ideas. 

Now let’s shift our attention back to modern-day China.

Efficacy of central planning can be a double-edged sword

So perhaps the efficiency of central planning is good when the desired outcome is easily observed and planned for. But the efficiency has the potential in snuffing out upsides too. Today, China’s grappling with the outcomes of the policies that it pursued in recent years with great consequences. 

Effectiveness in filling GDP gap with construction has led to a real estate bubble

This central planning approach carries on in modern China. In most countries, GDP is the output of economic activities. In China, this equation is reversed. GDP growth is set as a nationwide target that needs to be hit by local governments. Local governments support the central policies by providing cheap land and friendly financing terms via state banks. If economic activities by the private sector are not sufficient to hit the GDP target, the local governments then bear the responsibility for bridging the gap

These gaps are typically filled by the construction sector that is fueled by cheap credit from state-sponsored banks. This is how the country has been able to hit and beat its GDP target like clockwork. As a result of this practice however, China has been over-building. It’s really hard to appreciate the scale of construction that China has committed to. Between 2011 – 2013, China used more concrete than the US used between 1901 – 2000. 

In recent decades, however, the Chinese economy has become unable to just grow via debt-fueled construction. Between 2008 – 2019, total debt from government, households, and businesses, increased by 1.8x, from 169% of GDP to 306%, Yet, the GDP growth rate decreased from 10% to 6%.

Using real estate as a bridge for GDP gaps worked for many years until they stopped working. With the same single-mindedness, China turned its attention to tackling this debt crisis head-on. It set up new policies to restrain the ability of the real estate sector to raise more debt. This too worked with great effectiveness in slowing down real-estate speculation and growth of bad debt. However, this also created a sector-wide liquidity crisis. For the past year, some of the largest real estate firms have been unable to pay their debts and are having difficulty completing construction. 
In China, buyers typically pay for their homes before they are completed and delivered. Real estate firms use this cash to develop new projects. Now that these firms have halted developments, the buyers are boycotting, and have stopped paying their mortgages. The boycott spread fast, affecting approximately $296 billion worth of property development.

Figure 5: Image is taken from here, with data from here

There’s no solution to the current situation as of yet. The central government has proposed several solutions, which include pushing banks to restart lending to developers again and creating a central bank-backed fund to finance ongoing constructions, essentially reversing the credit restrictions policies instituted in 2020.

But even if the liquidity crisis can be resolved, many of these homes are now worth less than they were 2 – 3 years ago. The real estate bubble has popped and confidence in the sector is at an all-time low (Figure 6 below). 

Figure 6: Real estate slump in China has persisted for more than a year. Source

Considering that real estate is the primary investment vehicle for many Chinese, this crisis has caused a decline in wealth, known as the wealth effect, the notion that people feel richer when their assets are rising, so they spend more and stimulate the economy.

Effectiveness in pursuing zero-Covid policy is threatening China’s economic growth

In addition to tackling the real estate bubble, China is also pursuing a zero-Covid policy. The government apparatus is effective in lockdowns and mass testing; no other country in the world could close a Disneyland without prior notice, temporarily locking down 34,000 visitors on a Sunday and could impose a lockdown in a city of tens of millions without much warning. The latest lockdown is happening in the city of Chengdu, a city of 21 million inhabitants. 

But the effectiveness of lockdown does not translate to the effectiveness of containing the outbreak. Covid has mutated several times, and each new variant is more contagious than its predecessors. So far, 41 cities, responsible for about one-third of China’s GDP, are currently in the midst of outbreaks.

The combination of the above factors has significantly dampened China’s economic growth. Its economic numbers are below target. Unemployment is near a record high, and currently, one in five Chinese youth is unemployed. 

But the greater threat here is not an economic slump, but rather the ticking population bomb. Due to economic pressure and the one-child policy (which led to gender imbalance: in 2019, China had 30 million more men than women), the country has observed long-term marriage decline. In 2013, there were 13.3 million marriages per year. In 2021, 7.6 million, a 43% decrease. 

And now, when the economic situation is increasingly uncertain, and the Covid lockdown is prolonged, families are increasingly delaying having children, at a time when the country needs them to do so the most. 

Figure 7: Chinese population forecast. Source

 

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