The case of China, and every other case of an investment-driven growth miracle, suggests that the model cannot be sustained indefinitely because there are at least two constraints. The first has to do with the constraint on debt-financed investment and the second with the constraint on the external account, and one or both constraints have always eventually derailed the growth model.
To address the first constraint, in the early stages for most countries that have followed the investment-driven growth model, when investment is low, the diversion of household wealth into investment in capacity and infrastructure is likely to be economically productive. After all, when capital stock per person is almost non-existent, almost any increase in capital stock is likely to drive worker productivity higher. When you have no roads, even a simple dirt road will sharply increase the value of local labour.
The longer heavily subsidised investment continues, however, the more likely that cheap capital and socialised credit risk fund economically wasteful projects. Dirt roads quickly become paved roads, paved roads become highways, and highways become super highways with eight lanes in either direction.
The decision to upgrade is politically easy to make because each new venture generates local employment, rapid economic growth in the short term, and opportunities for what economists politely call rent seeking behaviour, while the costs are spread throughout the entire country through the banking system and over the many years during which the debt is repaid (and since most debt is rolled over continuously, this means effectively that the cost is repaid over the next 15 to 20 years).
It also seems easy to justify intellectually the infrastructure upgrades. After all, rich countries have far more capital stock per person than poor countries, and those investments were presumably economically justified, so, according to this way of thinking, it will take decades of continual upgrading before China comes close to overbuilding.
The problem with this reasoning of course is that it ignores the economic reason for upgrading capital stock and assumes that capital and infrastructure have the same value everywhere in the world. They don’t. Worker productivity and wages are much lower in China than in the developed world.
This means that the economic value of infrastructure in China, which is based primarily on the value of labour it saves, is a fraction of the value of identical infrastructure in the developed world. It makes no economic sense, in other words, for China to have levels of infrastructure and capital stock anywhere near that of much richer countries since this would represent wasted resources – like exchanging cheap labour for much more expensive labor-saving devices.
Of course credit risk is ultimately socialised – that is, all borrowing is implicitly or explicitly guaranteed by the state. Socialised credit risk means the lender does not need to ask whether or not the locals can use the highway and whether the economic wealth created is enough to repay the cost.
In fact the system creates an acute form of what is sometimes called the "commonwealth” problem. The benefits of investment accrue over the immediate future and within the jurisdiction of the local leader who makes the investment decision. The costs, however, are spread widely through the national banking system and over many years, during which time, presumably, the leader responsible for the investment will have been promoted to another post in another jurisdiction. With very low interest rates and other subsidies making it hard to determine whether investments actually reduce value or create it, the commonwealth problem ensures that further investment in infrastructure is always encouraged.
The problem of over-investment is not just an infrastructure problem. It occurs just as easily in manufacturing. When a manufacturer with privileged access to the banking system can borrow money at such a low rate that he effectively forces most of the borrowing cost onto household depositors, he doesn’t need to create economic value equal to or greater than the cost of the investment. Even factories that systematically destroy value can show high profits, and there is substantial evidence to suggest that in China the state-owned sector in the aggregate has probably been a value destroyer for most if not all the past decade, but is nonetheless profitable thanks to household subsidies.
And these subsidies are substantial. A mainland think tank, Unirule, estimated in 2011 that monopoly pricing and direct subsidies may have accounted for as much as 150 per cent or more of total profitability in the state owned sector over the past decade. I calculate that repressed interest rates may have accounted for another 400 to 500 per cent of total profitability over this period. Monopoly pricing, direct subsidies, and repressed interest rates all represent transfers from the household sector.
At some point, in other words, rather than create wealth, capital users begin to destroy wealth, but nonetheless show profits by passing more than 100 per cent of the losses onto households. The very cheap capital especially means that a very significant portion of the cost – as much as 20-40 per cent of the total amount of the loan – is forced onto depositors just in the form of low interest rates.
How? Because artificially lowering a coupon on a ten-year loan by 4 percentage points effectively represents debt forgiveness equal to 25 per cent of the loan. Lowering the coupon by 6 percentage points represents forgiveness of 35 per cent of the loan. Although most bank loans in China have maturities of less than ten years, these loans are rarely repaid and are instead rolled over for very long periods of time, so increasing the value of the implicit debt forgiveness. Low interest rates are effectively a form of substantial debt forgiveness granted, usually unknowingly, by depositors.
The rise of debt
Under these circumstances it would take uncommonly heroic levels of restraint and understanding for investors not to engage in value destroying activity. This is why countries following the investment-driven growth model – like Germany in the 1930s, the USSR in the 1950s and 1960s, Brazil in the 1960s and 1970s, Japan in the 1980s, and many other smaller countries – have always over-invested for many years leading, in every case, either to a debt crisis or a 'lost decade' of surging debt and low growth.
The second constraint is that policies that force households to subsidise growth are likely to generate much faster growth in production than in consumption – growth in household consumption being largely a function of household income growth. In that case even with high investment levels, large and growing trade surpluses are needed to absorb the balance because, as quickly as it is rising, the investment share of GDP still cannot increase quickly enough to absorb the decline in the consumption share.
This is what happened in China in the past decade until the crisis in 2007-08, after which Beijing had to engineer an extraordinary additional surge in investment in order to counteract the contraction in the current account surplus. As Chinese manufacturers created rapidly expanding amounts of goods, the transfers from the household sector needed to subsidise this rapid expansion in manufacturing left them unable to purchase a constant share of the goods being produced. The result was that China needed to export a growing share of what it produced, and this is exactly what it did, especially after 2003.
As long as the rest of the world – primarily the United States and the trade deficit countries of Europe and Latin America – have been able to absorb China’s rising trade surplus, the fact that domestic households absorbed a declining share of Chinese production didn’t matter much. A surge in American and European consumer financing allowed those countries to experience consumption growth that exceeded the growth in their own manufacture of goods and services.
But by 2007 China’s trade surplus as a share of global GDP had become the highest recorded in 100 years, perhaps ever, and the rest of the world found it increasing difficult to absorb it. To make matters worse, the global financial crisis sharply reduced the ability and willingness of other countries even to maintain current trade deficits, and as we will see this downward pressure on China’s current account surplus is likely to continue.
So China has probably hit both constraints – capital is wasted, perhaps on an unprecedented scale, and the world is finding it increasingly difficult to absorb excess Chinese capacity. For all its past success China now needs urgently to abandon the development model because debt is rising furiously and at an unsustainable pace, and once China reaches its debt capacity limits, perhaps in four or five years, growth will come crashing down.
Michael Pettis is a Senior Associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management. He blogs at China Financial Markets.