Reserve Bank of India (RBI) Raghuram Rajan has flagged concerns about a slowing China and the perils of high indebtedness among several of its sectors that wield considerable influence over the economy. For India, indeed for the rest of the world, the level of action in the factory floors of China is of far greater consequence, given the economy’s size and its sway over the global economy. Exports from China fell 1.8% in April. Exports to the United States from the Asian giant, which for long has been the world’s factory, fell 9.3% year-over-year last month. A sputtering West is usually not good news for China and the numbers only reinforce this point. Mr Rajan, a former International Monetary Fund (IMF) chief economist and former Chicago University professor famed for his perceptive warnings about the global financial crisis of 2008, has cautioned that unused capacities in China’s manufacturing sector and high levels of debt can haunt the economy.
The problems of “over-capacity” and “over-leveraging” can have deadly consequences as both feed into each other. Over the last two decades China has excelled in the art, and science, of turning out high-quality goods from its mega industrial zones at costs that are a fraction of what the rest of the world could produce at. Low wage rates, aided by armies of young men entering the work force every year and collapsing technology acquisition costs, propelled it into the most preferred destination for the world to shop. Factories continued to add new capacity lines to fulfil voluminous export orders. Large capacities also helped companies reap economies of scale enabling them to keep the price low for long periods. The continuous capacity addition pushed the overall level of investment in China to 46% of GDP, sharply higher than emerging market peers. For instance, investment level in India is currently about 30% of GDP.
China’s banking system funded this massive investment activity. Banks did not hesitate to offer loans buoyed by the assumption that factories will continue to remain flooded with orders from across the world and, therefore, their cash-books will remain healthy enough to repay loans. The problem was, nobody was quite sure when to put a stop on creating more capacity in anticipation of an impending slowdown. Many companies raised funds from China’s costlier “shadow banking” sector in a mistaken zeal. So, when the twin problems “over-capacity” and “over-leveraging” struck, companies found themselves underprepared to deal with the cycle of bust. There are lessons India’s corporate and banking world should draw from this. Investment planning is a function of current and anticipated demand. It isn’t easy to anticipate boom and bust cycles. The current problem of mounting bad debts partly mirrors this. Indian companies are best advised to follow well-thought-out business plans and, importantly, avoid borrowing from unregulated “shadow banks”.