The IMF’s Il Houng Lee, Murtaza Syed, and Liu Xueyan have published a very interesting and widely noticed study called Is China Over-Investing and Does it Matter? In it they argue that there is strong evidence that China is overinvesting significantly. According to the abstract:
"Now close to 50 per cent of GDP, this paper assesses the appropriateness of China’s current investment levels. It finds that China’s capital-to-output ratio is within the range of other emerging markets, but its economic growth rates stand out, partly due to a surge in investment over the last decade. Moreover, its investment is significantly higher than suggested by cross-country panel estimation.
"This deviation has been accumulating over the last decade, and at nearly 10 per cent of GDP is now larger and more persistent than experienced by other Asian economies leading up to the Asian crisis. However, because its investment is predominantly financed by domestic savings, a crisis appears unlikely when assessed against dependency on external funding. But this does not mean that the cost is absent. Rather, it is distributed to other sectors of the economy through a hidden transfer of resources, estimated at an average of 4 per cent of GDP per year."
The article is well worth reading because it makes a very strong case, perhaps a little late, for what many of us have been arguing for the past seven or eight years. China’s investment rate is so high, we have argued, that even ignoring the tremendous evidence of misallocated investment – and unless we can confidently propose that Beijing has uncovered a secret formula that allows it (and the tens of thousands of minor government officials and SOE heads who can unleash investment without much oversight) to identify high quality investment in a way that no other country in history has been able – there is likely to be a systematic tendency to wasted investment.
How much overinvestment?
One of the implications of the study is that households and SMEs have been forced to subsidise growth at a cost to them of well over 4 per cent of GDP annually. My own back-of-the-envelope calculations suggest that the cost to households is actually 5-8 per cent of GDP – perhaps because I also include the implicit subsidy to recapitalise the banks in the form of the excess spread between the lending and deposit rates – but certainly I agree with the IMF study that this has been a massive transfer to subsidise growth.
This subsidy also explains most of the collapse in the household share of GDP over the past twelve years. With household income only 50 per cent of GDP, a transfer every year of 4 per cent of GDP requires ferocious growth in household income for it just to keep pace with GDP, something it has never done until, possibly, this year.
The size of the transfer makes it very clear that without eliminating this subsidy – which basically means abandoning the growth model – it will be almost impossible to get the household and consumption shares of GDP to rise if China still hopes to maintain high GDP growth. The transfer of wealth from the household sector to maintain high levels of investment is simply too great, and this will be made all the more clear as the growth impact per unit of investment declines.
Another implication of the IMF study is that to get into line with other equivalent countries at this stage of its economic take-off, China would have to reduce the investment share of GDP by at least ten percentage points and perhaps as much as twenty. Aside from pointing out that the sectors of the economy that have benefitted from such extraordinarily high investments are unlikely to celebrate such a finding, I have three comments. First, after many years in which China has invested far more than other countries at its stage of development, one could presumably argue that in order to get back to the "correct” ratio, investment should be lower than the peer group, not equal to the peer group. In that case investment has to drop by a lot more than ten percentage points.
Second, even if China had kept investment at the "correct” level, as measured by the peer group, this would not imply that China has not overinvested. I haven’t been able to dig deeply into the comparison countries, but the study does list them, and a very quick glance suggests that many of these countries, after years of very high investment, themselves experienced deep crises or "lost decades”.
How much would growth have to slow?
My third point is more technical. If Chinese investment levels are much higher than optimal (assuming the peer group average is indeed optimal), of course the best solution for China is immediately to reduce investment until it reaches the right level. The longer investment rates are too high, the greater the impact of losses that have eventually to be amortised, and the worse off China is likely to be.
But it will be very hard for China to bring investment down as a share of GDP by ten full percentage points very quickly. Let us assume instead that China has five years to bring investment levels down to the "correct” level, and let us assume further that the "correct” level is indeed ten percentage points below where it is today. Both assumptions are, I think, dangerous because I am not convinced that an investment level of 40 per cent of GDP is the "correct” level for China going forward (I think it must be much lower) and I don’t think China has five years to make the necessary adjustment without running a serious risk of a financial crisis.
But let us ignore both objections and give China five years to bring investment down to 40 per cent of GDP from its current level of 50 per cent. Chinese investment must grow at a much lower rate than GDP for this to happen. How much lower? The arithmetic is simple. It depends on what we assume GDP growth will be over the next five years, but investment has to grow by roughly 4.5 percentage points or more below the GDP growth rate for this condition to be met.
If Chinese GDP grows at 7 per cent, in other words, Chinese investment must grow at 2.3 per cent. If China grows at 5 per cent, investment must grow at 0.4 per cent. And if China grows at 3 per cent, which is much closer to my ten-year view, investment growth must actually contract by 1.5 per cent. Only in this way will investment drop by ten percentage points as a share of GDP in the next five years.
The conclusion should be obvious, but to many analysts, especially on the sell side, it probably needs nonetheless to be spelled out. Any meaningful rebalancing in China’s extraordinary rate of overinvestment is only consistent with a very sharp reduction in the growth rate of investment, and perhaps even a contraction in investment growth.
In fact I think over the next few years China will indeed undergo a sharp contraction in investment growth, but my point here is simply to suggest that even under the most optimistic of scenarios it will be very hard to keep investment growth high. Either Beijing moves quickly to bring investment growth down sharply, or overinvestment will contribute to further financial fragility leading, ultimately, to the point where credit cannot expand quickly enough and investment will collapse anyway.
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.