Much of the concern about global imbalances have centered on the unprecedented high United States current account deficit and the rising surpluses elsewhere in the world. Should this imbalance be viewed as a savings glut, or is the true problem is the world is investing too little? Raghuram Rajan, the IMF’s chief economist, says it’s the latter, and argues that more investment is needed in the surplus countries. But he cautions that “China is an exception in needing less, not more, investment.”
Mr. Rajan views are probably based on one of the most popular and widely held views against investment in China. The argument often goes as follows: fixed-asset investment growth is excessive, while the investment-to-GDP ratio in China is already more than 45%－above the levels reached by Asian economies before the 1997 crisis; this investment boom is financed by misallocated bank credits and generates little returns; and therefore, there is an overinvestment time bomb in the Chinese economy, which will soon result in a sharp correction in investment and GDP growth, rising NPLS at the banks, and deflation.
Given the prevalent suspicions of macro data from China, it is indeed surprising to see that many people have based their entire assessment of China’s economy on one data point－the reported investment-to-GDP ratio. Suspicions arise when one tries to derive the implied growth rate or the national savings rate using the reported investment-to-GDP ratio. For example, if investment has grown at 20%, and if the ratio of investment to GDP is around 45%, real GDP growth from investment alone would be 9 percentage points, even without any growth in consumption and net exports. Alternatively, the reported current account surplus is about 8% of GDP. Adding a 45% investment-to-GDP ratio, this would imply China’s national saving rate is above 50%! However, most studies find the national saving rate for China is at most in the low 40s. Arguably, international trade data are the most reliable macro data points for China. Therefore, this casts serious doubts on the assertion that China’s domestic investment-to-GDP ratio is above 40%.
The headline investment growth is likely being overstated, and more importantly, the GDP level and growth being understated because of significant underestimation of consumption. The latest upward revision of the GDP level in 2004 by almost 17% exemplifies the point starkly. Most of the revision came from upward adjustments of the service sector, resulting in an upward revision to the share of consumption in GDP.
The emergence of housing demand since the end of the 1990s is likely a main contributing factor to the misperception of overheated investment vs. inadequate consumption. Is buying a house an investment or a consumption outlay? Private housing purchases are classified as investment spending in China, following conventional international practice. However, housing spending started from a nil base in 1998-1999 but has since been growing much faster than GDP. As a result of such a rapid structural change in household outlays, the debate seems to be barking up the wrong tree. How can consumer demand be weak in China when housing and auto sales have skyrocketed in the last few years?
Another often-forgotten dimension in China’s over-investment debate is that the level of investment-to-GDP ratio is intricately linked to an economy’s development stage. It tends to rise for countries during their period of fast growth, often associated with the fast industrialization process, as their total capital stock to output and labor ratios trend up from relatively low levels. In addition, the real investment-to-GDP ratio may need to be around 40% in order to support China’s 9% plus annual growth. The intuition is simple: with fast growth, more investment is needed not only to produce more output but also to replace depreciated capital stock.
As China grows and catches up with the richer nations, further capital deepening will be a crucial part of the process of becoming rich. Despite 27 years of fast growth and a formidable economy in aggregate size, the fact remains that China is still a low-income developing country on a per capita basis, and its capital-to-labor ratio is still a fraction of that in the U.S. and Japan. Goldman Sach’s BRICS research projects that, by 2035, the size of the Chinese economy may surpass the U.S. to become the largest economy in the world and be 11 times what it was in 2004 in nominal dollar terms. Assuming the capital-stock-to-output ratio stays constant until then, China would need to expand its total capital stock by 11 times in dollar terms. Moreover, if the capital-stock-to-GDP ratio needs to rise further in the medium term, the investment-to-GDP ratio would need to be even higher.
Nevertheless, there could still be serious bumps on the road if investment returns fall below the cost of capital. Data issues aside, neither the speed of investment nor its ratio to GDP can tell investors much about the sustainability of China’s investment strength. It is the efficiency of investment that ultimately holds the key to the sustainability question, although little efforts have been made to check how corporate profits have actually performed. If one examines financial data reported by Chinese companies listed overseas (about 500 plus companies), and those by the National Bureau of Statistics (about 200,000 listed and unlisted companies), the actual “stylized” facts on corporate profitability in China in recent years paint a very different picture than the popular perception that China has invested too much inefficiently:
First, corporate profit growth has consistently surprised on the upside in the last five years. Despite persistent warnings or predictions of a collapse in corporate earnings by many analysts, after-tax profit growth each year has stayed in the 20%-40% range since 2002, exceeding market consensus by a significant margin.
Second, return on capital has been solid, on an uptrend, and substantially exceeded the official lending rates. A divergent path between the actual rate of return on capital and the growth rate of capital stock tends to be a good indicator that there may be some overexuberance by investors. But using the NBS data, one finds the after tax rate of return on invested capital has risen steadily since the late 1990s, exceeding historical high levels, and showing no signs of any divergence from the speed of real capital accumulation.
Interestingly, based on the same methodology and database, a significant divergence did show up during the 1993-95 investment boom-bust episode, when the rate of return was deteriorating in tandem with accelerating capital accumulation. If one has doubts about the quality of the NBS data, let us take a look at the performance of the overseas-listed Chinese companies, whose financial reports are audited according to international accounting standards. Here again, the popular perception that Chinese companies generally deliver mediocre shareholders’ returns finds little support. Chinese corporates’ return on equity (ROE) has actually been solid and rising steadily in the last few years, and now stands at around 15%, comparable to other developed markets.
Thirdly, corporate China is modestly levered and investment is funded mostly through retained earnings. Bank financing only provides about 20%-25% of the funding source for China’s investment, and its share has been declining, while the bulk of the investment spending has actually been funded through retained earnings. As a result, Chinese companies are able to gradually de-leverage and reduce their dependency on debt to finance their capital needs despite their fast expansion. The high credit-to-GDP ratio (114% as of June 2006) in China does not reflect high corporate leverage, but rather the limited development of the bond market. For example, even though the credit-to-GDP ratio in the U.S. is only 44%, the size of its corporate-bond market is more than 100% of GDP, compared with about 4% in China.
Fourth, if profit growth persistently outpaces the overall GDP growth, the share of national income that accrues to capital must be rising. China’s flows of funds data indeed confirm that the share of capital income has been rising steadily since the late 1990s, while the share of labor income has been falling. This is contrast to the early 1990s, when corporates had dismal earnings growth despite the macro boom. This finding has two other significant implications. First, wage costs have been managed much better during this cycle compared with the early 1990s, likely reflecting rising labor-market flexibility. Second, the implied income distribution, however, may also explain why mass consumption has been more muted than high-end consumer demand, for property and auto.
Fifth, corporate China would have earned higher returns if commodity prices were lower. Unlike Russia or Australia, China is a net (and growing) importer of oil and most commodities. Therefore, high and rising commodity prices present a negative terms-of-trade shock to China, and should be damaging to its aggregate corporate profitability.
Lastly, profit margin is held up steady at improved levels, and the PPI-CPI inflation gap does not signal profit squeeze. If we use the total-net-profit-to-sales ratio as a proxy for average profit margin, the corporate profit margin of “China Inc.” began to perk up in 2003, and has remained at cyclical high levels in the last few years despite the significant cost increase in raw materials. Moreover, the empirical correlation between corporate profitability vs. the PPI-CPI inflation gap is strongly positive, and exactly the opposite of what has often been suggested. Furthermore, this positive relationship also applies to downstream industries. If there is any empirical causality (that is, which data series tends to lead the other), the data seems to suggest it is the rise in PPI inflation that tends to indicate better profit growth.
But, if China’s real economy is so impressive, either in terms of its overall real growth or the rate of return on investment, why has the performance of its financial sector been so disappointing? The answer to this disconnect goes to the fact that the state-owned financial sector has mostly served the inefficient SOES, but provided little service, if at all, to the most vibrant part of the economy－private enterprises.
Therefore, the performance of the financial sector does not reflect the performance of the overall real economy, but rather those of the inefficient and declining part of the economy. Policy prescriptions for China can differ fundamentally depending on the diagnosis for the economy. If the real problem of the underlying economy is indeed over-investment with a falling rate of returns, then policy adjustments should aim at restraining investment growth while promoting consumption and export growth. However, if the real imbalance in the economy is insufficient domestic demand amid rising trade surpluses and robust corporate returns, the right policy choice should involve a real appreciation of the currency to smooth the demand rotation away from exports, and implementing other domestic-demand-friendly policies, including those supporting domestic investment.
What can China invest in? China still has a big deficit in urbanization-related investment, as its ratio of urban residents to total population remains exceptionally low by international standard. Industrialization without urbanization is a unique Chinese phenomenon, owing to decades of government policies that segregated urban and rural labor markets. The release of the “pent-up” demand for urbanization in China will not only sustain investment demand from China for longer, but will also be one of the most important events affecting the global economy in the next few decades, not least through its impact on industrial and soft commodities. This process will likely involve substantial investment in infrastructure and housing-related (electricity, water, and waste treatment systems, as well as residential property) projects. Such investment is being undertaken less to increase the supply capacity of China as a manufacturing powerhouse, but more to facilitate urbanization and further increases in consumption by the Chinese as they grow richer and more affluent.
Therefore, a successful rebalancing of the Chinese economy, and to a large extent the global economy, needs to involve a smooth transition of more investment domestically by the Chinese and less into the US (or any other OECD countries’) Treasuries. On this note, Mr. Rajan at the IMF is wrong－China, too, needs more, not less, investment, perhaps in order to eventually consume more. The key challenges facing China in are twofold: First, will China allow more yuan appreciation to curtail domestic inflationary pressures in the process of investing more domestically and help international demand adjust smoothly? And second, can China fix its financial system quickly and sufficiently so that more investment is allocated to the right sectors and companies?
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