Can China consume without investing?

In a recent publication Citibank has an interesting graph on the relationship between total social financing (a broader measure of debt than simply RMB loans in the banking system) and GDP. According to their graph, which I cannot reproduce, China’s GDP rose from RMB 12 trillion in 2001 to RMB 24 trillion in 2009 in constant 2001 RMB. TSF during that time rose from RMB 15 trillion to RMB 30 trillion, which means it more or less kept pace.

Over the next four years GDP rose from RMB 24 trillion to RMB 40 trillion, TSF, however, rose from RMB 30 trillion to an astonishing RMB 76 trillion. While GDP rose by around 70%, in other words, the credit behind it rose by more than twice that, or around 150% (by the way Citibank shows a similar graph for the US).

  

Clearly it is taking more and more credit to generate measurable economic activity. If Beijing wants to show higher growth levels, it can only do so by allowing even more rapid credit expansion. If it wants to keep credit expansion constant, then almost certainly growth rates will drop sharply over time. What happened in the first quarter, with a slowing of GDP growth and a quickening of credit growth, in other words, is exactly what should be happening if we are right about the amount of investment that has been misallocated.

…The key question, as China switches away from investment, is whether it is possible to increase consumption growth, or at least to hold it steady. A recent paper by the IMF on the topic is very interesting and not encouraging.

  

…Among the interesting findings of the paper, one is not (to me) at all unexpected. The authors find that investment is much less efficient in the poorer inland provinces than in the richer coastal provinces. This shouldn’t be a surprise. The inland provinces have much lower levels of worker productivity and lower social capital. This means that they should be much less capable of absorbing high levels of capital than the coastal regions.

But this argument – so logical, at least to me – flies in the face of the single most widely-used argument that China bulls have made in favor of additional investment. They argue that because capital stock per capita is much lower in China than in the US, the automatic conclusion is that China has a near-infinite ability usefully to expand investment – at least until it begins to approach the frontier of US levels. If this argument is true, investment should be much more productive in the inland provinces than in the coastal provinces because the inland provinces have much lower capital stock per capita than the coastal provinces and so are further from the “frontier”.

But it isn’t, according to the IMF paper. It is even more wasteful. Richer, more productive economies with higher levels of social capital (which include property rights, a clear legal framework, education, minimal regulatory distortions, minimal government intervention, limited corruption, etc.), in other words, are better able to absorb investment than poorer less productive economies. The appropriate level of investment for a country that is much poorer than the US is much lower than the appropriate level in the US. China does not have infinite ability to expand investment productively, and in fact, I would argue, has long ago passed the point where investment in the aggregate is wealth creating.

…The other very interesting finding of the IMF paper is that – surprise! surprise! – consumption growth is itself dependent on investment growth, and this is more true in the inland provinces than in the coastal provinces. The more money you pour into investments, no matter how unnecessary, the more local households consume. This shouldn’t have been unexpected because local household income is so dependent on consumption, especially in regions in which government-led infrastructure spending is the only real source of economic activity – such as the poor inland provinces.

The conclusion, I think, is that it is going to be very hard for China to maintain the current level of consumption growth if investment stops growing, and if consumption can only create 4.2 percentage points of GDP growth at current levels, why would we assume China’s long-term growth rate is much above that unless we assume that China can keep investment levels growing for a long time?