China’s Twin Challenges

LONDON This month’s monetary-policy statement from the People’s Bank of China (PBOC) contained a striking statement: “If endogenous momentum is inadequate and returns on investment low, growth must rely on debt to a great extent.” Those words highlight the twin challenges – real and financial – that the Chinese economy now confronts.

On the real side, China needs to achieve a transition away from unsustainable investment-led growth. Even before the 2008 crisis, China’s investment rate of 41% of GDP was extraordinarily high. But by 2010-2011, it had soared to 47%, as the authorities unleashed a real estate- and infrastructure-construction boom aimed at offsetting the threat to exports and employment arising from advanced-country deleveraging.

The plan worked, with employment in construction industries rising from 28 million in 2007 to 45 million in 2013. But much wasteful investment has inevitably followed: massive apartment blocks in second- and third-tier cities that will never be occupied, and heavy industrial sectors, such as steel and cement, that suffer from chronic overcapacity. From 2007 to 2013, as average returns on investment fell, China’s incremental capital-to-output ratio – the units of investment needed to achieve each additional unit of GDP – doubled to six.

As China shifts to a more sustainable consumption-led growth model, it needs better investment – and less of it. Limited progress has already been made on this front: investment as a percentage of GDP has fallen slightly to 46% in 2014, while growth in retail sales and consumption have outpaced GDP growth. But with household consumption still below 40% of national income, China has a long way to go.