In the May 10 issue of my blog I referred to a very interesting IMF paper written by Il Houng Lee, Murtaza Syed, and Liu Xueyan. The study, “China’s Path to Consumer-Based Growth: Reorienting Investment and Enhancing Efficiency”, attempts among other things to evaluate the efficiency of investment in various provinces within China. I argued in the newsletter that the paper supported my contention that China has overinvested beyond its capacity to absorb capital.
This argument is in opposition to claims made by many analysts that China has not overinvested systematically, and that in fact, with much less capital stock per worker than advanced countries like the US or Japan, China has a long ways to go before it begins to bump up against the productive limits of investment. For example in a September 3, 2012, issue of Asia Economics Analyst, Goldman Sachs makes the following point:
China is often criticised for investing too much and too inefficiently, and for consuming too little… However, focus on the investment/GDP ratio risks confusing flows and stocks and we believe is not the right metric for assessing whether a country has invested too much. For that, we also care about the capital stock rather than the investment flow—on this metric, on a top-down approach, China still has a long way to go — its capital stock/worker is only 6 per cent of Japan’s level and 16 per cent of Korea’s.
The Economist has also made a similar argument.
Because China’s capital stock per capita is so much lower than that of much richer countries, claim Goldman Sachs, the Economist, and many others, Chinese investment levels overall are still much lower than they optimally ought to be. While it is of course always possible for China to misallocate individual investments, which everyone agrees is a bad for growth, these analysts strongly disagree with the claim that China has overinvested systematically.
Since the newsletter came out I have had a number of conversations with clients who wanted to pursue a little further the issue of how to think about an optimal level of capital stock per capita. In my central bank seminar at Peking University we recently spent a couple of sessions hashing this out in a way that we found very useful, and I thought it might be helpful to summarise those discussions in order to explain a little more schematically how I think about this issue.
The two models of investment
To begin this discussion it is worth remembering what the IMF paper suggested about investment in China. The abstract of the paper is:
This paper proposes a possible framework for identifying excessive investment. Based on this method, it finds evidence that some types of investment are becoming excessive in China, particularly in inland provinces. In these regions, private consumption has on average become more dependent on investment (rather than vice versa) and the impact is relatively short-lived, necessitating ever higher levels of investment to maintain economic activity. By contrast, private consumption has become more self-sustaining in coastal provinces, in large part because investment here tends to benefit household incomes more than corporates.
If existing trends continue, valuable resources could be wasted at a time when China’s ability to finance investment is facing increasing constraints due to dwindling land, labor, and government resources and becoming more reliant on liquidity expansion, with attendant risks of financial instability and asset bubbles. Thus, investment should not be indiscriminately directed toward urbanisation or industrialisation of Western regions but shifted toward sectors with greater and more lasting spillovers to household income and consumption. In this context, investment in agriculture and services is found to be superior to that in manufacturing and real estate. Financial reform would facilitate such a reorientation, helping China to enhance capital efficiency and keep growth buoyant even as aggregate investment is lowered to sustainable levels.
In contrast to claims cited above suggesting that Chinese investment levels are too low, among other things the paper argues that although investment levels as measured by capital stock per capita are obviously lower in the poor inland provinces in China than they are in the richer coastal regions, in fact investment in the former areas may be less productive than investment in the latter areas. This implies that the regions with less capital are also less able to absorb additional capital efficiently.
Should this be a surprise? For those who argue that China is poor because capital stock per worker in China is much lower than in the advanced countries, and that China should aggressively increase investment to close the gap, the findings in this paper ought to be surprising. If the further an economy is from US levels of capital stock the more appropriate it is to increase investment, then investment in the poor inland regions should have a higher return than investment in the richer coastal regions.
But whether or not the findings of this and other similar studies should surprise us depends on how we decide what the optimal level of capital is for any economy. I would argue that there are basically two different models for thinking about how much investment is optimal:
1. The capital frontier constraint
One model suggests that the most advanced and capital-rich countries have developed, perhaps through trial and error, the appropriate level of capital investment given the state of technology, trade, and managerial organisation, and they effectively represent the frontier for investment.
According to this model it is pretty easy to figure out what an appropriate investment strategy is for a developing country – more investment is almost always good. Because in this model what separates poor countries from rich countries is primarily the amount of capital stock per worker, poor countries should always increase their capital stock until they begin to approach the frontier. Until they do, an increase in capital stock automatically causes an increase in workers’ productivity that exceeds the cost of creating the capital stock, and so the country is economically better off because the benefit of investment exceeds the cost of investment. This model implicitly underlies claims made by many analysts that because China’s capital stock is much lower than that of the US, Japan or other rich countries, it is meaningless to say that China is overinvesting in the aggregate.
2. The social capital constraint
The other model suggests that for any economy there is an appropriate level of investment or capital stock per worker that depends on the ability of workers and businesses in that economy to absorb additional capital stock. I am going to call this ability to absorb capital stock “social capital”.
The implication is, then, that the higher a country’s social capital, the higher the optimal amount of capital stock per worker. The fundamental difference between rich countries and poor countries, in this case, is not the amount of capital stock per worker but rather the institutional framework that gives workers and businesses the ability to absorb additional capital productively. Advanced economies are understood simply to be those economies that are able to absorb high levels of investment productively. Backward economies are constrained in their abilities to do so.
What determines the level of social capital? Lots of things do. The right institutions matter tremendously, but because there is no easy way to quantify what the “right” institutions are, we tend to ignore their importance in favor of more easily measurable factors, such as broad measures of capital stock. I would argue, however, that economies are much better at absorbing and exploiting capital if they operate under an institutional framework that creates incentives and rewards for managerial or technological innovation (which probably must include clear and enforceable legal and property rights), encourages the creation of new businesses and penalises less efficient businesses, perhaps at least in part by institutionalising methods by which capital can quickly be transferred from less efficient to more efficient businesses, and maximises participation in economic activity by the whole population while minimising distortions in that participation.
*This is part one of a two-part piece. The second part, on whether China will be able to reach an optimal level of investment, can be read here.
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.