European steel workers gathered last week for a rally at the European Commission headquarters in Brussels to call for action against subsidized Chinese imports. (Francois Lenoir/Reuters)

China’s industrial overcapacity is “sucking the oxygen out” of its economy, fueling a dangerous buildup in bad loans and now exacerbating trade tensions with the West. Yet although the Communist Party has been aware of the problem for years, it has failed to tackle it.

Those are the findings of a new report by the European Chamber of Commerce in China that blames complacency, a lack of leadership and protectionism by local governments for China’s failure to address the problem.

“We have heard the same soundtrack for years — ‘We are aware of the problem, we are going to deal with this,’ ” said Chamber president Jörg Wuttke. “But the problem is getting worse. Now we are asking: Do you have the audacity to implement your policies?”

China’s state-owned heavy industry expanded too far and too fast during the boom years, in a borrowing and investment splurge. Now, as the economy slows, there is too much industrial capacity chasing too little demand. Many plants have been forced to cut back output and are struggling to pay back loans, but, instead of closing down, these “zombie” factories are being kept alive, at a huge cost to the economy and the banking system.

The government has made numerous attempts to limit industrial expansion and close down inefficient plants, but the effort has made very little headway, and the problem has intensified in recent years. The Chamber report is a follow-up to a similar report it issued in 2009, which identified the problem and laid out a series of recommendations to address it. Most went unfulfilled.

“After the global financial crisis, China unleashed the mother of all credit avalanches,” Wuttke said. “But double-digit growth turned decision-makers more complacent. They thought they could outgrow their previous overcapacity problems.”

As the economy “took off like a rocket,” China’s Communist Party put on rosy glasses, while the world’s political and business elite lined up to tell them “you are wonderful,” Wuttke said.

“You might lose touch with reality, hence it is more difficult to see this coming. You might underestimate the problems you are facing,” he said.

Managers at state-owned companies were complacent, too, he said, expecting that high growth rates were here to stay. “Very few have ever seen the cyclical developments with recession that we know in Europe and the United States.”

Today, Wuttke said, China’s pockets are no longer so deep that the country can buy its way out of the problem. Capital is flowing out of the country, debt is rising fast and an economic restructuring is overdue.

“The head winds are now there, and if they don’t act it will aggravate the financial crisis,” he said.

Wuttke’s comments are unusually forthright for a Western business leader in China. But he said there are many people within the Communist Party leadership who share a “very strong” frustration with the slow pace of reform.

One senior figure, he said, had “almost pleaded” with him to issue the second report on overcapacity, to help draw attention to the problem. “Sometimes they need outside voices to translate opinions inside,” he said.

Indeed, last week a senior economist within the system made another unusually frank call to arms. Zhu Baoliang, director of the economic forecasting division at the State Information Center, a think tank affiliated with China’s economic planning agency, told the South China Morning Post that the reform process was “almost in paralysis,” with little progress in key areas.

“Economic growth is slowing, fiscal revenues are shrinking, overcapacity is worsening and financial risks are on the rise. It’s really urgent now; reforms must proceed,” he was quoted as saying.

Wuttke said the senior leadership seemed more preoccupied with army and Communist Party reform, and with an anti-corruption drive, than with the economy. Some business leaders hope that President Xi Jinping will turn his attention in this direction during his second term in office from 2017, but Wuttke worries that the problem may have intensified by then and become harder to solve.

“We believe they have to act now and not wait,” he said.

At the center of a web of vested interests lie China’s powerful state-owned enterprises and the cozy relationships they enjoy with provincial governments and banks. One of the biggest problems is “local protectionism,” Wuttke said: Provincial governments depend so much on major industries for their tax revenue that they can’t afford to see them cut back — especially in areas where one or two industries dominate, such as the “steel city” of Tangshan, near Beijing.

Local governments also tend to resist cross-province mergers and acquisitions that might lead to industrial streamlining. A company headquarters moving to another province would take all its tax revenue with it.

Career incentives continue to reward local officials for high economic growth, while fear of unemployment and social unrest explains why many areas cling to old industries and lean on banks to roll over loans. Environmental rules are often poorly enforced for fear of adding more costs to already ailing industries.

Production as a percentage of capacity in refining, steel and cement is running at between 65 and 75 percent, the report estimates. In developed economies, anything below 85 to 90 percent would imply the industry was “bleeding cash,” Wuttke said.

Meanwhile, a surge in cheap Chinese exports of steel has stoked trade tensions with Europe. Just last week, thousands of steel workers marched in Brussels to protest the imports and to demand that the European Commission not grant China “market economy” status this year, a move that critics say would allow it to dump more cheap imports on Europe. The protests followed announcement of thousands of job losses at Tata Steel in Britain.

Wuttke said China’s overcapacity problem is spilling over to the rest of the world and could lead to more job losses and protectionist pressures in Europe. The answer, he said, was for the Chinese government to relinquish control of the economy to market forces, as it has promised to do.

“If the government is part of the problem, how can it be part of the solution?” he asked.

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