It's a bit of a counter to Martin Wolfe's "How China could yet fail like Japan", Financial Times of June 14.
China's investments are not as wasteful as the bears believe
Tom Holland
For years now economists, investors and newspaper columnists have been arguing bitterly whether China is on a sustainable growth trajectory or whether it is destined for an almighty crash.
Both sides can marshal some convincing-sounding arguments in favour of their views. But at its core the debate hinges on whether the heavy investment which has powered China's growth over the last few years will prove productive over the longer term.
If all those new roads, railways and airports turn out to have a multiplier effect, spurring local business activity and generating domestic demand, then China's recent investment binge will have been money well spent and the country's rapid growth will continue through the coming decade.
But if, as many observers fear, much of that investment has been wasted, with capital misallocated on a gargantuan scale, then it is likely China's economy is heading for a hard landing indeed.
The optimists say that China needs all that investment. They argue that China is a poor country developing from a low base. They say it must grow its capital stock, investing heavily in industry and infrastructure, if it is even to begin to play catch-up with the world's developed economies.
The pessimists counter that investment has run out of control. They say Beijing has kept interest rates too low, and that the ready availability of cheap capital has encouraged a boom in unproductive investment which has crowded out other forms of economic activity like private consumption.
As a result, China has become increasingly dependent on ever higher levels of investment to maintain its growth, with investment now making up almost 50 per cent of gross domestic product (see the first chart [above]), a far higher proportion than either Japan or Korea during their rapid growth phases.
And the more China invests, the worse its overcapacity gets and the more the economic return on its investments shrink, argue the pessimists.
The consequences of this waste can be seen everywhere, they say. Brand new steel mills and aluminium smelters operate at just a fraction of their capacity. Vast shopping malls sit empty. Villages with populations of a couple of thousand boast glittering 50-storey office blocks. Eight-lane highways that have never seen a car or truck peter out in the middle of the Gobi desert. And vast airport terminals forlornly await their first passengers.
Similar stories abound. But the problem with such anecdotes is that they are just that: anecdotes.
In any investment boom, there are bound to be some misconceived projects. And in an economy the size of China's, you are going to be able to find plenty of duds. But that doesn't necessarily mean all the country's investment is unproductive, or that overall returns on capital are deteriorating.
To settle the argument, we need an economy-wide gauge of how productive China's investment is.
John Knight and Wei Wang at Oxford University have had a crack at measuring the effectiveness of investment in the corporate sector.
If investment in new assets were as unproductive as the pessimists believe, they should have found that the ratio of corporate China's pre-tax profits to its net fixed assets had declined over recent years.
In fact, they found that investment efficiency has improved, with the ratio rising from just 3 per cent in 1998 to 16 per cent in 2006.
Still, that's unlikely to impress the pessimists, who could argue that the dates chosen misrepresent the trend, and that much recent investment has taken place outside the corporate sector anyway. What's needed is an even broader measure of investment efficiency.
The obvious one to look at is China's incremental capital output ratio, or Icor. In a nutshell, this measures how many yuan China needs to invest each year to produce an extra yuan of output in the following year. The higher the number, the less productive the investment, so if vast quantities of investment money were being wasted, we would see China's Icor number climbing over time.
But that's not what we see. The second chart [above] shows China's Icor, averaged over successive five-year periods. At around four, China's current Icor is on the high side - Japan and Korea both recorded an Icor of around three during their high-growth periods.
But there is no obvious sign of a rising trend, which indicates that the economic efficiency of China's investments is not deteriorating as the pessimists believe.
That doesn't mean a crash is impossible. But it does mean a hard landing is not the immediate danger that many observers believe.
