Misreading China's Investment Problem

Unmasking a popular myth about the Chinese economy

It has become conventional wisdom that China’s investment problem is in a league of its own. A recent article by Greg Ip in The Wall Street Journal is the latest example of this groupthink.   With the investment share of China’s GDP in uncharted territory, goes the argument, the precarious state of an unbalanced Chinese economy is about to go from bad to worse. 

At first glance, the numbers tell a compelling story in support of this thesis. IMF estimates put total investment at 42.5% of Chinese GDP in 2024.  That’s fully ten percentage points above the investment share for the broad collection of emerging and developing countries (32.3%) and nearly double the investment share of advanced economies (22.3%). It’s also nearly ten percentage points above the investment share of the so-called BRICS countries  (i.e., excluding China, a 22.8%  average for Brazil, Russia, India, and South Africa).

While these statistics are correct, they mask several key aspects of the Chinese investment story that draw the basic conclusion of the coming investment collapse into sharp question:

• First, there is the important difference between stocks and flows.  Gross investment is a flow that is included in the GDP accounts. But that is very different than the stock of productive capital which ultimately drives productivity and an economy’s longer-term growth potential. As we shall see below, China’s unique status as a high-investment economy — the flow — is not matched by its low ranking of its capital endowment — the stock.

• Second, total investment is a broad concept covering many activities, from infrastructure and manufacturing capacity to commercial buildings and residential property. The problem lies more in the mix of such investment than in the sum total of such outlays.

• Third, most pundits focus on “gross” investment in making the case for China’s imbalances.  Yet that includes the portion of spending that must be allocated to depreciation — the replacement of worn-out or obsolete capital stock. In judging the macro excesses of an economy’s investment share, it is far better to focus on “net” investment, or gross investment less depreciation; that is the portion of total investment spending which is dedicated to the physical expansion of the capital stock.    

In what follows, I will focus mainly on the first point in assessing the excess-investment critique of China’s growth model. The place to start is with an understanding of economic growth. I won’t bore you with the simple equations of a basic Solow growth model — the mainstay of economic growth accounting and macro productivity analytics.  But it is relatively easy to demonstrate that in a stylized economy with two factors of production — labor and capital — labor productivity (output per worker) is a function of the capital endowment of an economy’s workforce, what economist call the capital-labor ratio.  This is consistent with a large body of research that links productivity growth to the innovation enabled by new technologies that are embodied in the capital stock. Ergo, to the extent that labor productivity drives an economy’s longer-term potential — a generally accepted principle of economic growth theory — the stock is far more important than the flow in assessing the imbalances of China’s so-called excess-investment economy.

The chart below examines China in this context. It measures the dispersion of capital-labor ratios for a sample of 21 countries in 2019 (latest data available). As can be seen, China is at the low end of this comparison, with an average capital stock of some $124,500 per worker (using PPP metrics expressed in constant 2017 US dollars). China’s capital-labor ratio is not only well below that of the developed countries in this sample, but it also falls short of that in Singapore, South Korea, Russia, Malaysia Mexico, Brazil, and even Indonesia.  Significantly, China’s capital endowment was less than 40% of that in Taiwan in 2019. It did beat out India, the Philippines, and Vietnam.

These striking disparities are an outgrowth of an incredibly weak starting point in the early days of the People’s Republic of China. In 1952, China’s capital-labor ratio was just under $1,500 per worker.  That was less than one-third of the 1952 ratio in India, about 10% of that in Brazil, and considerably smaller fractions of capital endowment of the other countries in our sample.   By 1990, the Chinese capital-labor ratio had risen by nearly fivefold from that prevailing in 1952 but was still only about 4% of that in Russia.

[Note: The Penn World Tables are the single best source for assessing cross-country comparisons of incomes, output, input, and productivity; the latest version (version 10.01 released in January 2023), which covers some 183 countries, is produced by the Gronigen Growth and Development Centre (Netherlands) based on the pioneering growth accounting framework of the late Angus Maddison.]

This underscores a critical feature of China’s growth challenge.  Coming out of the Revolutionary period of the late 1940s, China’s capital stock was de minimis compared with that of other nations — developing and developed, alike.   In the early days of the PRC, growth in capital endowment picked up somewhat, averaging 4% per annum over the 1950-80 period; however, Mao-era instability during that timeframe — notably the Great Leap Forward and the Cultural Revolution — limited meaningful economic progress.  It wasn’t until the Deng era’s reforms and opening up of the 1980s that capital accumulation moved into high gear, with growth in China’s capital-labor ratio post 1980 more than doubling to nearly 9% per annum.

That brings me to an important conclusion on China’s high-investment economy:  China needs rapid capital accumulation to boost the productivity of its vast workforce and propel overall economic growth. Recall that investment, the flow, is the essence of incremental additions to the capital stock over a succession of many years.  In other words, the capital accumulation driven by net investment (the third bullet point above) is the means toward increases in the capital stock that are so essential for long term economic prosperity. Since 1980, China has been making good progress toward that  end, but still has a long way to go before its capital endowment on is on a par with the low end of advanced economies.  The only way for China to achieve that is by consistently running a high-investment economy for many more years to come.

Consequently, the problem for China is not a high investment share of its GDP but the wrong mix of investment (the second bullet point above). There is little doubt that China has spent far too much on residential construction in the past decade, if not longer. But this is now being corrected by an ever-deepening property crisis — a painful, but necessary, way of shifting the mix of investment toward more productive segments of the economy, such as advanced manufacturing, infrastructure, and the commercial construction required of an expanding services sector.

Apart from the lingering excesses of a long and arduous fix for its vastly overbuilt property sector, China’s high-investment economy is less of an overhang of an unbalanced macro structure and more an important source of its longer-term growth potential. It is the means toward the end — a key pillar of a high-income society. The trick for China is to make the right investment in the right place, and boost productivity in doing so. Only then can China sustain the more rapid growth in personal income generation that it needs for the consumer-led rebalancing that I have been preaching about for nearly twenty years.

On a deeper level, I believe this misreading of the Chinese investment challenge is yet another example of where the western critique of China is wide of the mark.  With the Chinese economy now experiencing its most serious growth problems in decades, the consensus has embraced the long-awaited China-collapse scenario.  As Greg Ip and countless others have pointed out, the feared implosion of a seemingly outsize investment overhang has become an important part of that tale.  For reasons outlined above, I believe those fears are overblown.

Dating back to my Wall Street days, I have long been mindful of the pitfalls of consensus thinking. It’s a lesson I think about a lot today. Just as the Chinese leadership has embraced the notion that the “East is rising, and the West is declining,” China’s adversaries in the West now expect the opposite.  As I argued in Accidental Conflict, false narratives on both sides of the US-China relationship are a potential recipe for strategic miscalculation that could end very badly.  

Next week: China’s Economic Ascendancy