Cross-posted from FT Alphaville.
A new IMF working paper lays out what many China sceptics have been saying for years: the country has too much investment, and households are bearing the costs. Yes, you might have heard this many times on FT AV, from the likes of Michael Pettisand more recently, from George Magnus, but now it’s appearing in venues such as the IMF (even if the paper warns this ‘should not be reported as representing the views of the IMF’).
The paper concludes that the level of over-investment is in China is equivalent to about 10 per cent of GDP, and perhaps as high as 20 per cent. The cost to households averages at about 4 per cent of GDP over the past decade, it estimates, with another 0.2 per cent to SMEs, who have higher funding costs due to the ‘two-tier’ financial system that favours large companies.
One of the authors, Liu Xueyan, is a senior fellow in the Institute of Economic Research at China’s powerful National Development and Reform Commission. The paper ‘should not be reported as representing’ the NDRC’s views, either — yet it is another indication that China’s economic imbalance and the cost of correcting it are familiar topics to the country’s leaders*.
Stefan Wagstyl has a good overview of the paper at Beyondbrics, so we’ll just jump straight to the juicy bits: how bad could this be?
The paper’s authors say that China’s over-investment gives it a one-in-five probability of an economic crisis, based on a cross-country regression. However, they believe that is overstating the risk, because of China’s low reliance on foreign capital for its investment spree:
However, the trigger of a crisis, if ever, in China will likely be different from other countries. What distinguishes China from the rest is its self-reliance on the resources of investment. In large part, this is due to its high savings (Figure 8). However, various studies indicate that savings are arbitrarily high because of remaining controls in the financial sector that de facto entail a subsidy transfer from households and SMEs to large corporates. Whereas in other countries the high cost from excess investment has been exposed in the form of bank stress or foreign exchange market crisis, in China, it will likely be captured in, or triggered by, any one of the weak links of this implicit subsidy system.
We wonder if that conclusion over-estimates the cushion that China’s massive foreign exchange reserves provide against capital flight?
That scenario is still mostly hypothetical, however. China’s need to rebalance is a certainty — it’s really a question of when and how.
So, the paper says that over-investment is equivalent to 10 per cent of GDP, but it costs about 4 per cent of potential GDP.
That maths is pretty clear: rebalancing will inevitably require lower growth — another common Pettis refrain. The paper’s authors acknowledge it, too:
To the extent that elevated levels of investment during the post-crisis period in China were somehow abnormal and necessitated by the sharp external slowdown, the challenge now is how to return to a more “normal” level of investment without compromising growth and macroeconomic stability.
Finally, this observation from the paper’s literature review says a lot about why this imbalance issue has taken a while to bubble up into the mainstream:
Much of the literature imposes a number of strong assumptions and few papers compare China’s investment to that in the rest of the world. A variety of approaches taking to account for the plethora of potential factors that may be at play in determining investment trends in China. These factors include China’s low initial capital endowment, its level of development, and favorable returns to capital. However, most of this work is based on calculations of investment efficiency that are assumption-based and prone to measurement error. In addition, many have adopted an indigenous approach focusing on China alone, with fewer attempts to use cross-country data to compare its investment trends against those of other economies. Other common limitations include relatively unrepresentative samples, short time periods, and the relative paucity of studies covering the post-2005 further surge in investment.
As we’ve been saying for a long time around here, assumptions about China are rampant, from the urbanisation myth to the belief that it will continue to grow above 8 per cent, that it should, and that the rest of the world even needs it.