BEIJING – China’s economy slowed unexpectedly in the second quarter of this year. Just as unexpectedly, most data released since July suggest that China’s growth has stabilized. Markets, not surprisingly, have breathed a collective sigh of relief. But should investors still be nervous?
Currently, the most severe problem confronting Chinese authorities is overcapacity. For example, China’s annual production capacity for crude steel is one billion tons, but its total output in 2012 was 720 million tons – a capacity utilization rate of 72%. More strikingly, the steel industry’s profitability was just 0.04% in 2012. Indeed, the profit on two tons of steel was just about enough to buy a lollipop. So far this year, the average profitability of China’s top 500 companies is 4.34%, down 33 basis points from 2012.
Some say that today’s overcapacity is a result of China’s past overinvestment. Others attribute it to a lack of effective demand. The government seems to come down in the middle.
On one hand, the authorities have ordered thousands of companies to reduce capacity. On the other hand, the government has introduced some “mini-stimulus” measures, ranging from exemptions for “micro firms” from business and sales taxes to pressure on banks to increase loans to exporters.
The authorities’ official line is that China’s growth model requires less investment and more consumption. But not all Chinese economists agree. They argue that capital stock is the key factor for growth, and that China’s per capita capital stock is still low relative to developed countries, which implies considerable scope for further investment.
To be sure, capital accumulation is a driving force of economic growth, and catching up with developed-country income levels implies that China must increase its capital stock in the long run. But what is at issue is not the size of the capital stock, or even the level of investment; the problem is the growth rate of investment, which has been significantly higher than that of GDP for decades.
According to official statistics, China’s investment rate is approaching 50% of GDP. Given absorption constraints, capital efficiency has been falling steadily amid increasing deadweight. If environmental damage caused by breakneck investment growth were taken into account, China’s capital efficiency would be even lower.
Human capital and technological progress are as important to economic growth as physical capital and labor, if not more so. If resource allocation is skewed toward physical capital at the expense of accumulating human capital – for which adequate consumption is indispensable – economic growth would be more likely to slow than rise. So China should reduce the growth rate of investment and increase that of consumption, allowing the investment rate to settle at a more sustainable level.
Of course, it is not entirely untrue that China’s overcapacity reflects a shortfall of effective demand. But where can effective demand come from?
Again, China’s steel industry provides a telling example. Despite China’s lack of a comparative advantage for steel production, it has built approximately one thousand mills, with output accounting for roughly half of the global total. As early as 2004, China’s government tried to clamp down on overinvestment; and yet output increased dramatically, from 300 million tons that year to a billion tons in 2012, owing to strong demand generated by investment in infrastructure and real-estate development.
China’s investment consists of mainly three broad categories: manufacturing industry, infrastructure, and real estate. In late 2008 and 2009, at the height of the global financial crisis, stimulus-fueled infrastructure investment sustained output growth. In 2010, investment in real-estate development replaced infrastructure investment as the main driver of growth. Today, both infrastructure and real estate are important drivers of China’s growth.
China does need more infrastructure investment – particularly in power and water utilities, transport, and communications. But the pace of investment must take financial constraints fully into consideration. More important, China can and should invest more in social infrastructure such as schools, hospitals, retirement homes, and so on.
However, real-estate investment is another story. It is difficult to judge how serious China’s property bubble is and when it might burst. But one thing is certain: China has invested too much in real-estate development.
With per capita income at less than $6,000, homeownership in China is roughly 90%, compared to less than 70% in the United States. Average floor space per capita is 32.9 square meters, while median floor space per family in Hong Kong is just 48 square meters. China has 696 five-star hotels, with another 500 on the way. Five of the ten tallest skyscrapers under construction worldwide are in China. In my view, this is madness.
China’s economy is being held hostage by real-estate investment. On one hand, China should not try to eliminate overcapacity by maintaining the high growth rate of real-estate investment. While investment in social housing should be welcomed, real-estate investment, currently running at 10-13% of GDP, is already far too high. On the other hand, if real-estate investment growth falls, overcapacity will be difficult to eliminate. This dilemma highlights the structural-adjustment challenge that China faces – and should give investors reason to hold their breath.
That said, there are two caveats. First, unlike other categories of investment, real estate investment does not increase productive capital stock. There is no fundamental difference between a house and an expensive durable consumer good. Second, in China’s statistics, the growth rate of gross fixed-asset investment is much higher than that of gross capital formation. This indicates that data on the growth rate of fixed-asset investment may have exaggerated the pace of capital-stock accumulation. Hence, while the Chinese government should be firm on reducing the dependence of growth on investment, it must exercise utmost care when doing so.