This is part II of an edited extract on China's optimal investment level. Part II (Taking stock of China's investment frenzy, June 14), which focuses on the differences between the two models of investment, can be found here.
I believe that in the past two to three years there has been a significant and welcome shift in Beijing’s attitude towards maintaining growth, and that this shift implicitly represents a shift from the capital frontier model of optimal investment levels to the social capital model. Keynes famously reminded us that “even the most practical man of affairs is usually in the thrall of the ideas of some long-dead economist,” and I would argue that in this sense models do matter. The economic model that we implicitly use to justify policy can result in hugely different policies with hugely different outcomes.
The surge in debt of the past few years has created tremendous concern, but I would argue that this concern would not be justified if investment levels in China were still too low. In that case any credit-fueled increase in investment would likely have resulted in a net improvement in China’s debt servicing capacity, in which case, with government debt at well below 25 per cent of GDP, rising debt would not be a concern.
But if investment is being misallocated, if investment levels are higher than China’s ability to absorb and exploit capital stock, then it should not be surprising at all that debt capacity is becoming a problem. In fact, as I have argued for many years, this is simply an automatic consequence of additional investment in the investment-driven growth model. Debt, in this case, must be rising faster than debt servicing capacity, in which case Beijing’s true debt level is not the nominal debt level but rather the nominal debt level plus estimates of contingent liabilities likely to rise as a consequence of wasted investment.
Let me not overstate my case. The fact that China’s debt is rising much more quickly than China’s debt servicing capacity is consistent with my implicit model – which claims that the optimal amount of capital stock in China is a function of China’s relatively low level of social capital, and that Chinese investment has far exceeded its optimal level – but it doesn’t prove it. The fact that debt may be rising faster than debt servicing capacity is not necessarily inconsistent with the capital frontier model. After all, as the US amply proved in the 19th century, even countries in which additional investment is economically justified can still run into debt problems and even crises.
Neither model has been proved. China may have too much capital stock, or it might not have enough, in which the current debt worries may simply reflect bubble conditions in the credit market. The policy implications of the two models, however, could not be more different.
If you believe that China can and should continue to increase investment until capital stock per capita approaches US or Japanese levels, then clearly China should continue to invest, and it should invest more in the poorer regions than in the richer ones. Everyone, even among the remaining China bulls, agrees now that Beijing must change some of its credit allocation conditions, but the old growth model will continue to be the right one according to the capital frontier model. There is no need to change the capital allocation process significantly and there is no need to liberalise interest rates.
What is more, according to this model, China’s very low consumption share of GDP mainly reflects the extraordinary growth in GDP. As high investment levels are maintained, it will simply be a question of time, and probably a short time at that, before the household income share of GDP, and with it the household consumption share, begins to surge. GDP growth can remain at 7-10 per cent for at least another decade.
If you believe, however, that China’s very low level of social capital has long ago made its investment strategy obsolete, the consequences and implications are radically different. It suggests that China has overinvested beyond its capacity to utilise these investments economically, and so there are hidden losses on bank balance sheets created by the failure to write down physical capital to its true value. In this case Chinese growth cannot help but drop significantly as these losses are finally recognised and as investment levels are sharply curtailed.
What Beijing must do, in this case, is to ignore GDP growth rates and focus on household income growth rates, which anyway are what should really matter. Rather than continue to increase investment in manufacturing capacity, infrastructure, and real estate, Beijing should find ways to curtail investment growth sharply and to allocate what capital is invested to small and medium enterprises, to service industries, and to the agricultural sector, all of which are sectors whose growth at the expense of the current beneficiaries of high investment growth (SOEs, local and municipal governments, national champions, etc.) are likely to imply improvement in China’s social capital. Doing this will also require significant changes in the legal, social, financial and political institutions that constrain China’s ability to absorb capital efficiently.