Capital controversy

Chinas overinvestment problem may be greatly overstated

Apr 14th 2012 | from the print edition THE IMF says so. Academics and Western governments agree. China invests too much. It is an article of faith that China needs to rebalance its economy by investing less and consuming more. Otherwise, it is argued, diminishing returns on capital will cramp future growth; or, worse still, massive overcapacity will cause a slump in investment, bringing the economy crashing down. So where exactly is all this excessive investment? Most people point to the rapid growth in Chinas capital spending and its unusually high share of GDP. Fixed-asset investment (the most widely cited figure, because it is reported monthly) has grown at a breathtaking annual rate of 26% over the past seven years. Yet these numbers are misleading. They are not adjusted for inflation and they include purchases of existing assets, such as land, that are inflated by the rising value of land and property. A more reliable measure, and the one used in other countries, is real fixed-capital formation, which is measured on a valueadded basis like GDP. This has increased by a less alarming annual average of 12% over the past seven years, not that much faster than the 11% growth rate in GDP in that period.

The level of fixed-capital formation does look unusually high, at an estimated 48% of GDP in 2011 (see left-hand chart). By comparison, the ratio peaked at just under 40% in Japan and South Korea. In most developed countries it is now around 20% or less. But an annual investment-toGDP ratio does not actually reveal whether there has been too much investment. To determine that you need to look at the size of the total capital stockthe value of all past investment, adjusted for depreciation. Qu Hongbin, chief China economist at HSBC, estimates that Chinas

capital stock per person is less than 8% of Americas and 17% of South Koreas (see right-hand chart). Another study, by Andrew Batson and Janet Zhang at GK Dragonomics, a Beijing-based research firm, finds that China still has less than one-quarter as much capital per person as America had achieved in 1930, when it was at roughly the same level of development as China today. Some claim that a rise in the ratio of Chinas capital stock to GDP is evidence that new investment is becoming less efficient: a given increase in capital leads to a smaller increase in GDP. But a rising capital-output ratio is perfectly normal when a poor country shifts from agriculture to more capital-intensive industry. GK Dragonomics estimates that Chinas ratio of 2.4 in 2010 is well within the range of 2 to 3 seen in most countries. Another yardstick is the return on capital, which should be falling if there is huge spare capacity. Yet average industrial profit margins and the rate of return on capital of listed firms have been fairly steady over the past decade after adjusting for the cycle. Although many firms, particularly state-owned ones, benefit from cheap loans, the average real cost of borrowing across the whole economy is much higher, so this distortion is more likely to lead to a misallocation of investment than to excess overall investment. The growth rate in Chinas total factor productivity (TFP), a measure of the efficiency with which both labour and capital are used, has also been one of the fastest in the world. TFP growth has probably fallen in the past few years, but that largely reflects a spurt in infrastructure investments, which deliver modest immediate gains but will boost productivity over the next 20 or 30 years. Although sceptics dismiss many of these projects as white elephants, a report by BCA Research suggests that the countrys infrastructure is still lagging behind demand. The total length of railway track has increased by 50% since 1995, for example, but passenger numbers have doubled and freight traffic has increased by 150%. China has around 6% of the worlds total railway network, yet carries 24% of global freight volumes. And despite all the new property construction in recent years, there is still an overall shortage of housing in China. Roughly one-third of urban residents live in poor-quality collective housing. This means that many more houses need to be built. Again, the problem is misallocation of investment rather than oversupply. There is huge unsatisfied demand from people who cannot afford to buy at current prices, while a rising number of richer households own more than one home, often as an investment. Flawed figures? Chinas rising investment and falling consumption as a share of GDP are commonly portrayed as an economic anomaly. Yet this pattern is normal in a rapidly industrialising country. In a traditional agricultural economy farmers consume most of their income, but once industrialisation gets under way a rising share of national income goes to owners of capital, who invest it in factories and the like. Investment rises as a share of GDP, and consumption falls. During their peak periods of industrialisation, South Korea and Japan saw an even sharper rise in investment relative to GDP than China has seen over the past 20 years. As for that oddly high level in its investment-to-GDP ratio, one explanation is that Chinas statistical system (set up when it was a command economy) is better at recording investment

than consumer spending. Many think consumption (especially of services) is undermeasured as a share of GDP, and hence that investment is overstated. A report by Morgan Stanley suggests that Chinas true investment-to-GDP ratio may be up to ten percentage points lower than officially reported (ie, 38% rather than 48%). Given Chinas rapid growth, cheap loans and the big role played by state-owned banks, it is inevitable that capital has been wasted in some industries. But the evidence suggests that China has not seriously overinvested. That does not mean rebalancing is unnecessary. Under Chinas capital-heavy model of growth, owners of capital have been getting much richer than workers. The main reason for shifting from capital-intensive production to the more labour-intensive, consumer-friendly sort is not to sustain economic growth, but to reduce inequality. Workers could then enjoy more of the rewards of Chinas past investment.