Monday, November 24, 2014

Breaking China’s Investment Addiction

BEIJING – China’s economic growth model is running out of steam. According to the World Bank, in the 30 years after Deng Xiaoping initiated economic reform, investment accounted for 6-8 percentage points of the country’s 9.8% average annual economic growth rate, while improved productivity contributed only 2-4 percentage points. Faced with sluggish external demand, weak domestic consumption, rising labor costs, and low productivity, China depends excessively on investment to drive economic growth.

Although this model is unsustainable, China’s over-reliance on investment is showing no signs of waning. In fact, as China undergoes a process of capital deepening (increasing capital per worker), even more investment is needed to contribute to higher output and technological advancement in various sectors.

In 1995-2010, when China’s average annual GDP growth rate was 9.9%, fixed-asset investment (investment in infrastructure and real-estate projects) increased by a factor of 11.2, rising at an average annual rate of 20%. Total fixed-asset investment amounted to 41.6% of GDP, on average, peaking at 67% of GDP in 2009, a level that would be unthinkable in most developed countries.

Also driving China’s high investment rate is the declining efficiency of investment capital, reflected in China’s high incremental capital-output ratio (annual investment divided by annual output growth). In 1978-2008 – the age of economic reform and opening – China’s average ICOR was a relatively low 2.6, reaching its peak between the mid-1980’s and the early 1990’s. Since then, China’s ICOR has more than doubled, demonstrating the need for significantly more investment to generate an additional unit of output.

As the accumulation and deepening of capital accelerate growth, they perpetuate the low-efficiency investment pattern and stimulate overproduction. When production exceeds domestic demand, producers are compelled to expand exports, creating an export-oriented, capital-intensive industrial structure that supports rapid economic growth. But if external demand lags, products accumulate, prices decline, and profits fall. While credit expansion can offset this to some degree, increased production based on credit expansion inevitably leads to large-scale financial risk.

Thus, a combination of investment, debt, and credit is forming a self-reinforcing risky cycle that encourages overproduction. In the wake of the global financial crisis, Chinese banks were instructed to extend credit and invest in large-scale infrastructure projects as part of the country’s massive monetary and fiscal stimulus. As a result, China’s credit/GDP ratio rose by 40 percentage points in 2008-2011, with most of the lending directed toward large-scale investment by state-owned enterprises (SOEs). In the last two years, bank credit has become the main source of capital in China – a risky situation, given the low quality and inadequacy of bank capital.

Meanwhile, strong currency demand has led China’s M2 (broad money supply) to increase to 180% of GDP – the highest level in the world. The massive wall of liquidity that has resulted has triggered inflation, sent real-estate prices soaring, and fueled a sharp rise in debt.

Given that it is in local governments’ interest to maintain high economic-growth rates, many are borrowing to fund large-scale investment in real estate and infrastructure projects. The active fiscal policy adopted during the financial crisis enabled the rapid expansion of local official financing platforms (state-backed investment companies through which local governments raise money for fixed-asset investment), from 2,000 in 2008 to more than 10,000 in 2012. But, as local-government debt grows, Chinese banks have begun to regard real estate and local financing platforms as a major credit risk.

Likewise, with key industries facing overproduction and slowing profit growth, firms’ deficits are growing – and their debts are becoming increasingly risky. Indeed, the proportion of deficit spending among enterprises is on the rise, and the accounts-receivable turnover rate is falling. By the third quarter of 2012, industrial enterprises’ receivables totaled 8.2 trillion renminbi ($1.3 trillion), up 16.5% year on year, forcing many to borrow even more to fill the gap, which has driven up debt further.

According to GK Dragonomics, corporate debt amounted to 108% of GDP in 2011, and reached a 15-year high of 122% of GDP in 2012. Many heavily indebted companies are SOEs, and most of the new projects that they initiate are “super-projects,” with the return on investment taking longer than creditor banks expect. Indeed, some highly indebted firms’ capital chains may well rupture in the next two years, when they reach their peak period for debt repayment.

As a result, China’s financial system is becoming increasingly fragile. The expansion of infrastructure investment – which, according to some reports, exceeds 50 trillion renminbi, including highway and high-speed railway construction – will lead to the expansion of banks’ balance sheets. The investment loans and massive debts among local financing platforms, together with the off-record credit channeled through the “shadow” banking system, are increasing the risk that non-performing loans will soon shake the banking sector.

To reach the next stage of economic development, China needs a new growth model. Reliance on investment will not enable China to achieve stable, long-term growth and prosperity; on the contrary it may well inflict serious long-term damage on economic performance.

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    1. CommentedLeo Arouet

      Los retos de actuales y futuros que afrontará China. Entre las principales dificultades a las que tiene que afrontar tenemos:

      — Una creciente inestabilidad política: esto se da debido a una emergente clase media que reivindica para sí misma una mayor participación en la toma de decisiones y busca progresivas libertades. Y China se encuentra, ahora, en esta situación, donde las clases medias han visto cómo los ingresos y fortunas de una pequeña élite han aumentado, mientras que los niveles de vida de todo el resto se han estancado. Esto ha generado intensa movilización y protesta en contra de esta enorme desigualdad.

      — El segundo problema que enfrenta China es el insuperable nivel de degradación ambiental. La mayor parte del agua y aire están fuertemente contaminados. 320 millones de personas no tienen acceso al agua. El 70 por ciento de los ríos está altamente contaminado. Hace poco, una densa nube de humo y bruma oscureció varias ciudades como Pekín, Shangai, Chengdu y Zhengzhou, y que ha abarcado la mitad del país. En el 2012, la polución ha causado la muerte de 8,572 personas.

    2. CommentedMoritz G€d1g

      Often only investment and export are named to drive economies. Those who dare to talk about consume and the middle class are socialists. China and Germany are successful with this model but in the end it can not work for everyone nor forever.

    3. CommentedProcyon Mukherjee

      Michael Pettis has raised similar concerns that the pace of debt growth is far higher than the debt servicing capacity, but by citing the recent declarations by the Central Committee Secretary, he shows that there is still room to trust the shift in policy stances that is based on maintaining balance in economic growth and perseverance with market-oriented reforms in the face of multiple risks in the economy. The new helmsman of China’s ruling party is on record, "The government should continue its proactive fiscal and prudent monetary policies next year and improve the economy’s internal vigor and dynamic. The growth that we achieve must be tangible, not exaggerated growth, and should be efficient, of good quality and sustainable,” Xi said.

      If marginal ICOR is rising, which in true sense is a natural fallout beyond a threshold, it is an indication of the limits of over-consuming at a rate that is not sustainable; the impact on the commodity prices are already showing signs of visibility.