China's Economic Ascendancy?

A point of reckoning for State direceted, investment-led growth?

The question mark at the end of this title underscores a Chinese economy that has entered what could well be the toughest phase of its extraordinary rise. By now, China’s cyclical and structural growth challenges are well known — the debt-intensive property crisis is at the top of the cyclical bucket and the most serious structural problems include demography, productivity, and consumption. In conjunction with external pressures on China’s long powerful export-led growth impetus, the question mark seems more than appropriate.

Putting it another way, has China reached the point where the sources of growth and development are exhausted?  Last week, I took the contrary view that there could well be more to come from  Chinese fixed investment. Yes, China has, by far, the highest investment-to-GDP ratio of any major economy in the world.  But I argued this was necessary to build up its still deficient capital stock: China is at the low end of a cross-country comparison of capital-to-labor ratios, still in need of significantly more investment to boost the lagging capital endowment of its vast workforce that is so essential for productivity enhancement.   

Of all the pieces I have written recently on China’s growth challenges, this one has generated the highest volume of reader feedback, a sampling of which can be found here.  The focus has been on two issues: first, many have taken exception to my pushback on one of the key pillars of the Western fixation on the China disaster scenario, that an overhang of excess investment can only end in tears; second, there are widespread concerns over the mix of Chinese investment that is inherent in State-dominated decision making, implying that the problem lies more in the misallocation of investment rather than in China’s  aggregate capital endowment. In other words, lagging capital endowment was thought to be less of a concern than the hopeless inefficiency of a State-directed investment process.

Fair point — but to a point. I vividly remember my first visit to Shanghai, Pudong in 1998, at the time the largest urban construction project in the world. Andy Xie, Morgan Stanley’s newly hired China economist, said to me as we were driving through Pudong, “Look around, this is Chinese GDP.”  Figure 1 puts some numbers on that observation.  It measures China’s capital-to-output ratio, a gauge of how much of its fixed capital stock is required to produce a unit of GDP. [Note: This is slightly different than the flow version based on investment-to-GDP ratio, or the “incremental capital-output ratio”.] The sharp upward sloping line indicates that China has had to draw on an ever-greater stock of capital per unit of output to sustain its economic growth miracle. It underscores the inherent inefficiencies of China’s high-investment economy.

The Pudong example was, of course, only a hint of what was to come.  With China’s economic impetus having shifted in recent years from efficient private sector enterprises back to relatively inefficient, debt-intensive SOEs, there has been a further dramatic erosion of overall investment returns.  As a result, after drifting up steadily in the early phase of the reform period (1980 to 2000), China’s capital-output ratio subsequently soared, doubling from 2002 to 2019.

This inefficiency of Chinese capital accumulation stands in sharp contrast to the relative capital efficiency of major developed economies.  This is also evident in Figure 1, which compares China’s capital-to-output ratio with those in the United States and Japan.  Relative to China, the modest updrift in the Japanese ratio, is barely discernible.  Long criticized for its own high-investment overhang, Japan’s capital efficiency metrics are, in fact, far superior to those in China.  Moreover, China’s soaring capital-to-output ratio stands in even sharper contrast with the downdrift in the US, where capital efficiency has been on an improved trajectory for most of the post-World War II era.

But it’s not that simple. In one key respect, Figure 1 is an apples-to-oranges comparison — it draws a contrast between the capital efficiency of a large developing economy (China) and those of two large, developed economies (the US and Japan). It turns out there are compelling reasons to expect different investment return profiles for developing and developed economies.  Economic development strategies invariably feature heavy emphasis on infrastructure and low-income housing, investments with low financial returns but high social returns, that skew capital-to-output ratios to the upside.   China, for example, has led the way in the hard connectivity of its infrastructure gambit — roads, bridges, airports, modern ports, and, of course, a world beating high-speed rail network. The same can be said of China’s urbanization strategy, a key pillar of rural-urban migration that boosts personal income and raises the growth potential of discretionary consumer purchasing power. To be sure, while urbanization drives the demand for low-income shelter, the property crisis speaks to a China that has obviously overdone investment in new housing, exacerbating the inefficiency of a soaring capital-output ratio.

As Figure 2 below illustrates, China is not alone as a large developing economy with a rising capital-to-output ratio.   Shown is a comparison of capital-to-output ratios for China and the other BRICS nations (Brazil, Russia, India, and South Africa) plus Taiwan.  Except for the Russian Federation where the ratio soared in the early years after the demise of the Soviet Union and then sunk back to levels prevailing elsewhere in this sample of large developing nations, capital-to-output ratios for the other BRICS economies have all increased markedly in recent years; the same has been the case in Taiwan. To be sure, the rise in the Chinese ratio has outstripped the others since 2012, as China has increased the investment intensity of its faltering economy.

How do I square the circle between the negative results on capital efficiency with the more upbeat conclusions I stressed last week on the sustained high-investment potential implied by China’s lagging capital endowment?

First of all, these two characterizes of China’s capital-intensive growth model very much hang together – in effect, they are two sides of the same coin. They speak to a large developing economy that, as modern growth theory suggests, is still in need of need of a sustained period of high investment to boost the lagging capital endowment and productivity of its large, increasingly urban workforce. 

But the results on the soaring capital-to-output ratio alongside a declining real internal rate of return on the capital stock (Figure 3) raise serious questions about China’s investment decision making process — namely, should it be driven by the State or the market?  As argued above, it is not uncommon for developing economies to support low-return investments in infrastructure and urbanization-driven shelter in the early stages of their development.  But those trends have their limits: Chinese urbanization, for example, currently stands at 65% of its population with an upside widely expected to top out at around 80% by 2035;  similarly, China’s state-of-the-art high-speed rail network now covers more than 46,000 km connecting 31 of its 33 provinces, making it close to fully operational. The hope is that as development progresses and nations like China close in on those limits, the mix of investment should shift away from low-return infrastructure and property, allowing the capital-to-output ratio to come down.  As can be seen in Figure 2, hints of that are already evident in the post-2012 Taiwan experience.

This raises a by-now familiar theme in the China growth debate — the need for a shift from the long-standing emphasis on quantity to a focus on quality. The days of open-ended investment — the quantity fixation — are drawing to a close as China now reaches middle-income status. That raises the toughest question of all: Who is best equipped to manage a more discriminating, return-driven, investment process — the State or the private sector? Ultimately, China’s economic ascendancy will be stymied if it doesn't answer that question with a keener eye on the quality of economic growth.