Most economists and policymakers agree that infrastructure investment more than exports drove China’s double-digit growth over the past decade. It is not an uncommon development path for emerging economies that do not rely on natural resource exports. China’s sheer scale makes it look an unique achievement, and it is, but in quantity rather than kind. Now close to 50% of GDP, investment is 10 percentage points higher on that measure than the ratio typical of Asia’s emerging economies in the run up to the Asian financial crisis.
The scale of China’s domestic savings has, however, let the country run such high levels of investment without becoming reliant on external funding. This has let it avoid what tripped up so many other emerging economies going down this path, not just Asian nations in the 1990s but even more painfully Latin American ones in the 1980s, a banking and/or foreign exchange crisis once foreign investors start to question the returns on their capital and realize that the cost of financing such high rates of investment had been mispriced.
It has not, however, let China avoid the underlying questions of whether the return on its capital spending is sub-par, and, if it is, whether that is distorting the cost of capital to the detriment of the broader economy and Chinese as a whole. A recently published IMF working paper, with the refreshingly to-the-point title, Is China Over-Investing and Does it Matter?* addresses those questions head on. In short, its answers are yes and yes.
That China hasn’t hit an external debt crisis, say the authors, Il Houng Lee, Murtaza Syed, and Liu Xueyan, the first two from the IMF’s China office, the third from the National Development and Reform Commission,
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 percent of GDP per year.
The burden of that cost, the authors believe, falls on households and, to a lesser extent, small and medium sized enterprises. The financial system effectively makes them subsidize the main vehicles of investment large, state-owned enterprises (SOEs). In other words, social welfare could be improved by increasing consumption at the expense of investment.
Meanwhile, China now requires ever higher investment to generate the same amount of growth. Absent a dramatic surge in productivity rates or exports, the authors estimate that investment would have to account for 60%-70% of GDP to sustain current growth rates. That would be both expensive and dangerous in terms of the potential threat to domestic stability.
It also suggests that, as most economic policymakers if not all within the Party recognize, the current growth model has run its course. Investment growth has to be moderated and consumption promoted. The policy implications for the new leadership, which has a more traditional SOE-centric state-capitalist cast of mind than the outgoing one, are self-evident.
*Is China Over-Investing and Does It Matter? By Il Houng Lee, Senior Resident Representative, China office, IMF; Murtaza Syed, Deputy Resident Representative, China office, IMF; and Liu Xueyan, Senior Fellow, Institute of Economic Research, National Development and Reform Commission of China. IMF Working Paper No. 12/277.