China hard landing series: Over-investment

Courtesy of Also Sprach Analyst.

One of the key arguments made against the idea that China can grow at high rates forever is that it has already been investing too much. In China’s national accounts, investment accounts for roughly half of total output, something almost unprecedented. The high rate of investment is not sustainable. And as investment is a large chunk of GDP, slowing investment inevitably means slowing economic growth as other parts of the economy, such as consumption and exports, are clearly not able to offset the slowing.

The chart below shows the comparison of investment/GDP ratio of a number of economies.  Where China now stands is almost unprecedented, with the exception of Singapore, which did reach those levels of high investment in the early 1980s before coming down significantly:

There are arguments against this, of course. The most compelling is the fact that China’s total capital stock does not appear to be too high. In fact, China’s total capital stock appears to be too low if measured on a per capita basis. The following chart from Goldman Sachs, showing capital stock per worker of various countries makes the point. China is clearly far behind other countries:

Some take this as a “proof” that not only has China not over-invested, but China should invest more. But this comparison is totally inappropriate, as China remains a pretty poor country compared with those in the top of the league in above table.

The next chart shows China’ capital stock as a percentage of GDP, also from Goldman Sachs.  This chart has totally changed the rankings. It is clear that although China’s capital stock as a percentage of output is not in the lead, it is certainly among the developed economies. In fact, it is greater than the United Kingdom, a country which is much richer than China on a per capita basis, and almost the same as the United States and Canada, which are, again, countries which are much richer than China:

This comparison is more appropriate. While the capital shock per capita comparison shows that there is huge room for even more investment, capital stock as a percentage of GDP shows that China already has quite enough of capital relative to its economic output.

However, a more fundamental problem to judge whether China has had enough of capital stock is not the volume of capital stock, nor the volume of it per worker/capita, not even the volume of capital relative to economic output. The more fundamental problem is the return on such investment. Another argument against is that despite the huge amount of investment being done, return on investment has not fallen very significantly.

There is, unfortunately, no easy way to accurately gauge the truth of this.  Not-so-up-to-date measures such as incremental capital output ratio (ICOR) has shown deterioration in the recent years, but optimists argue that it is still way below the level that Thailand reached right before the Asian Financial Crisis:

But circumstantial evidence also weighs against the argument that China’s returns have room to fall further. Clues we gather from various news reports, financial reports, and anecdotes paint a gloomy picture:

1. Many airports in China are losing money, yet China is building more anyway.  According to the FT:

China will build another 45 airports over the next five years, the industry regulator said on Thursday, raising fresh questions about the potential for overcapacity in the transport sector.

Li Jiaxing, the head of the Civil Aviation Administration of China, said that the new investments would take the total number of airports in the country to 220, even though most of the existing airports were losing money.

2. Railway investments are just doing as badly.  According to the first half account of the Ministry of Railways, the Ministry lost RMB8.81 billion in the first half of 2011, while total liabilities climbed to RMB2.526 trillion.

3.  Corporate profits (excluding banks) are almost collapsing.  On top of that, the detailed manufacturing PMI figures show an increase in inventory as manufacturing companies have clearly been producing too much and sales have been going too slowly.

4. One piece of outrageous anecdotal evidence said that inventory for the apparel industry is enough for three years or sales.

5. Steel companies’ profit for each tonne of steel has gone down to almost non-existent.

6. The New York Times has reported that unsold cars in China are rising, yet new auto factories are being built anyway:

Inventories of unsold cars are soaring at dealerships across the nation, and the Chinese industry’s problems show every sign of growing worse, not better. So many auto factories have opened in China in the last two years that the industry is operating at only about 65 percent of capacity — far below the 80 percent usually needed for profitability.

Yet so many new factories are being built that, according to the Chinese government’s National Development and Reform Commission, the country’s auto manufacturing capacity is on track to increase again in the next three years by an amount equal to all the auto factories in Japan, or nearly all the auto factories in the United States.

7. And, who can forget the over-building of real estate?

Sure, you might reply, but the economy is slowing, which contributes to slower sales, thus lower profitability of companies and rising inventories.

But, please remember: China was still growing at 7.6% yoy as of the second quarter.

How is it that an economy growing at 7.6% yoy is squeezing corporate profitability so hard?  How is it that an economy growing at 7.6% yoy feels like there is not enough demand for all the goods and services being produced? Even if we are all cynics and think that China’s GDP growth has been overstated by 2 percentage point, 5.6% yoy remains pretty decent and yet corporate profits are collapsing.

By contrast,  the US economy grows at 1.7% in Q2 (annualised) yet US corporate profits are at record high levels.

The answer is that China has been investing in too much productive capacity, which in turn produces too much stuff.  Put simply, China has invested so much that returns are marginal even at 7.6% yoy economic growth.  Returns on investment might have been good before the financial crisis, yet the collapse of external demand after the financial crisis and more recently in the persistent European crisis, have cut external demand significantly.  Meanwhile, domestic demand is not growing enough to pick up the slack.  Worse still, it is clear that domestic demand has been sustained by none other than investment itself.  Thus, it should come as very little surprise that IMF’s estimate put China’s capacity utilisation at just 60%.

There will be arguments about whether China has been investing too much or not. And the arguments will persist years after growth has slowed structurally and people start wondering what’s happened to China.  Of course, we are not saying that China should just stop building or investing in anything. Although I cannot think of anything, I’m sure that there must be something that China still needs to invest in. But there is little doubt that even though there are things that China should invest in, on the whole, the place has had quite enough for the moment. To be clear, if China continues to grow after facing the current challenge (albeit at a slower pace) into a rich country like the United States, capital stock will be much higher than where it is now.  But then, it is a question about what will happen in 50 or 100 years time, a time-frame that is relevant to almost nobody in terms of investment decisions.

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  1. Where China now stands is almost unprecedented, with the exception of Singapore, which did reach those levels of high investment in the early 1980s before coming down significantly

    It just shows you how deeply the RBA has bought into the China-will-boom-forever-story that Grenville used the Singapore argument.

    I mean how can you compare an city state of a few million people with a country of 1.35 billion? And as Zara points out, its not like Singapore’s investment boom was sustained for any length of time. Yet we are supposed to believe the Chinese construction mania will continue for many years to come.

  2. Zarathustra you really hit the hammer on the nail with alot of what you talked about. I just dont see how the bulls can keep saying that China will grow forever.

  3. Is this a wile e cote moment? It was like this for a while. Hence i am afraid that we could be talking not about landing. It is simply not landable. It can only end as a resetting crash, or as an orbiting zomby.

    • It’s great flying to the moon until you realise it’s too far and you launched without landing gear.

      • To avoid sounding like a doomster, I’ll add that maybe it’s all ok if the coyote has a glass half full onboard. 🙂

        But then, I can’t help but wonder, does it matter what’s in the glass?