A prediction about China's future growth

The newspapers are filled with stories about Chinese entrepreneurs facing capital constraints. Since these people are not politically connected, they can only borrow money at very high interest rates. In contrast, State Owned Enterprises (SOEs) have an easy time borrowing at very low interest rates. The key macro question here is whether any of these SOEs have used the money they received from the State wisely? There is a nasty moral hazard issue here. Do the SOEs have strong incentives to produce quality products that people want to buy?

I anticipate that there are two possible outcomes here. Under scenario #1, the SOEs go broke and the State learns from its past mistakes and stops bailing them out and China's industries evolve into a "free market" system rather than a mixed system featuring SOEs and for profit firms. Under the scenario #2, the SOEs are bailed out again and again and in aggregate this subsidization drags down the whole system.

So, the wise leaders of China will face a choice. To continue to grow at 9% a year, they will have to let the SOEs die and this will cost them money and their friends at the SOEs will be sad.

Macroeconomists are in deep thought about capital misallocation across sectors. Here is a recent example that includes relevant references.

If politics distorts who gets the money, then less productive people may be handed more capital. This is not the key to growth.

So, the leaders of China face a choice. Do they prioritize growth or nepotism?