Investment is key to maintaining production, growing production, increasing the productivity of employees, in allowing goods to be transported quickly and efficiently, in providing better health care and education and all types of infrastructure key to allowing an economy’s resources to be used efficiently. Growing investment typically leads to growing output and incomes, but capital investment also requires return, and a good part of that return is private consumption expenditure.
So why should we be concerned over the most recent quarter’s large capital investment component of current Chinese GDP? Much too large an investment component, a much smaller private consumption component and a decline in net exports.
Two recent posts from FT’s Alphaville highlight these and other issues over China’s Q2 data.
China’s GDP and the investment factor – the first stresses the credibility of the large jump in capital investment that offset much weaker domestic consumption and net exports.
Some observations and oddities in China’s Q2 GDP – the second raises questions over the GDP deflator used to discount nominal GDP Growth.
Whereas a very large jump in the investment component of GDP would be welcomed in practically every country in the world, there is valid concern over Chinese dependence on, and the risks associated with, gross fixed capital investment (GFCI).
Where expenditure is heavily focussed on gross fixed capital investment, then so will non GFCI expenditure be likewise dependent on GFCI activity – a bit like a town overly dependent on one major employer. A slowdown in GFCI expenditure will impact other components to a much greater extent.
Economic growth should be like a climber moving towards the summit, where all four limbs are moving in balance. The loss of contact of one is a given at any point in time, but you need at least two strong points of contact to avert a fall. The bigger the GFCI component of GDP, the greater the dependence on one point of contact and the bigger the shock to other growth components when GFCI declines.
The levels of GFCI seen in China are heavily debt dependent.
If there is sufficient excess investment, then productive and non productive capital risks being underutilised, meaning the return on capital is likely to fall below the level needed to finance the debt and justify future GFCI. A lower return should a) result in a fall in the value of debt impacting the solvency and liquidity of the financial system and the viability of the shadow banking system (as with US subprime), and b) impact the ability to finance debt, forcing a rise in defaults on that debt, and gain impacting the solvency and liquidity of the banking and shadow banking system.
In a developing economy GFCI is likely to be much larger than it is in a developed economy and rates of return lower in the event of excess.
What are the outcomes of excessive capital investment?
Misallocation of resources – a financial system can only lend so much and under performing debt prevents the reallocation of money supply to growing areas of the economy. So large debt levels could well impact rebalancing.
Structural imbalances in the economy – not just consumption/investment imbalances, but the balance of support services and industries that run alongside infrastructure projects.
Risk to the financial system and private savings vehicles (in the case of the shadow banking system) in the event of debt defaults, declining growth and falling asset values.
Perhaps in order to manage the shift to balanced growth, the Chinese government will need to absorb a significant element of current debt, and to accommodate the transition from excess investment to appropriate investment.
But state involvement in capital allocation decisions needs to be scaled back if the economy is going to be able to allocate capital in ways which will aid the development of a more structurally balanced economy.
The larger the debt overhang and the larger the misallocation of capital investment, the bigger the economic risks of readjustment.
Other useful references: