Equally unsafe to stand pat or move

Walter Russell Mead writes today at The American Interest about the difficulties paralyzing China.

When a company goes public and places its shares on the open market in an IPO, insiders who invested early on can reap large rewards because their pre-IPO investments now turn into shares that can be sold at higher prices on the stock market. In China, politically connected firms appear to receive special treatment: they get approval for IPOs based on misleading and false information, and they escape penalties when any problems appear. What this means in concrete terms is that while the insiders reap huge reward, the ordinary people who buy shares in these companies will watch their shares lose value as the companies fail to live up to expectations — because those expectations were based on false, misleading and incomplete data. The company doesn’t do well and share prices go down, or in a best case scenario go up but not as much as they should have as the original, politically-connected investors cash in and laugh all the way to the bank.

This is not only bad news for individual investors; it points to a central flaw in the Chinese economic model, a flaw that is taking an increasing toll. China’s capital allocation system has been so highly politicized that hundreds of billions of dollars in precious, irreplaceable funds have gone to investments that will not pay for themselves. Sometimes it is state-owned enterprises or local governments getting access to huge amounts of credit for political rather than economic reasons; sometimes it is private sector loans that are driven by policy rather than fundamentals (China regularly tweaks the cost and availability of credit to prop up housing prices by luring more investors to buy real estate); as we see here, it can be through a system that fails to screen IPOs properly.

...Meanwhile, after decades of policy-based lending, China is more of a bubble kingdom than a Middle Kingdom. We’re seeing housing bubbles, manufacturing bubbles, infrastructure projects that can never pay for themselves, malls that will never bring in enough revenue to cover the cost of construction, and whole regions (like the Northeast) where rust belt industries are on life support and state-driven lending for the construction of buildings that have no real commercial or residential use are the only things keeping the economy from tanking. There are so many bubbles, and they are so vital to the prosperity and thus to the political tranquillity of the country, that the government seems to have reached a place where it is equally unsafe to stand pat or to move.

China is at a political and economic impasse. The steps required to overcome the economic impasse worsen the political crisis and so, at the moment, China, despite its competent technocrats, its ambitious and activist president, and the extraordinary wealth it has created over three decades of astounding, world-changing growth, is paralyzed in the face of unfolding events. No wonder investors around the world are so worried.

Read more here.