Bulls' latest salvo won't ruffle the China bears

Goldman Sachs report takes aim at those who think the Chinese economy is a bubble about to burst – but they won't convince sceptics

PUBLISHED : Wednesday, 05 September, 2012, 12:00am
UPDATED : Monday, 30 May, 2016, 5:00pm

In the eternal battle between the China bulls and the China bears, US investment bank Goldman Sachs has just fired a broadside at those who believe the Chinese economy is an enormous bubble just about to burst.

In a research report published on Monday, Goldman's chief Asia economist Michael Buchanan and his colleague Zhang Yin examine widespread worries that China is guilty of massive over-investment.

According to the bears, Chinese state companies and local governments have frittered away trillions of yuan in recent years on wasteful investment projects financed largely by debt.

When the investments fail to pay off, warn the bears, those debts will turn bad, plunging China's financial system into crisis and markedly slowing the economy's rate of growth.

Considering that Goldman as an institution has long been bullish on China, it is no surprise that Buchanan and Zhang find little merit in the bears' argument.

They concede that investment in China is high relative to the size of the economy. At 46 per cent of gross domestic product last year, fixed capital formation is higher in China today than in any other major economy at any point in history. Even at the height of its investment boom in the early 1970s, Japan never exceeded 36 per cent. South Korea only reached 39 per cent.

But to sound the alarm just because investment levels are high, argue Goldman's analysts, would be to confuse flow with stock. They point out that despite China's high investment rate, its stock of capital remains low compared with other economies.

With capital stock worth less than US$50,000 per urban worker, compared with levels of US$150,000 in South Korea and more than US$250,000 in the United States (see the first chart), they believe China can profitably build many more roads, railways and industrial plants.

For example, they point out that despite heavy investment in its rail system, China's rail network remains small relative to its vast land area and population size. As a result, Buchanan and Zhang argue that even with its high investment level, China is allocating capital relatively efficiently.

This year, they estimate it will take around 5 yuan of capital investment to generate an additional yuan of output in 2013. This equates to an incremental capital output ratio, or Icor, of 5, which means investment in China is far more efficient than in the world's developed economies.

"There is still no evidence of nationwide overinvestment," they declare.

None of these arguments is likely to impress the bears.

Sceptics point out that while China's capital stock might be low for the magnitude of its population, at 300 per cent of GDP it is high relative to the size of its economy - higher for example than in Britain.

As a result, given the rapid pace of investment, they question whether China's capital is being allocated to the best projects or whether it is really as productive as the top-down figures imply.

For example, China's rail network may be small for its size, but that doesn't mean its brand new high speed passenger lines are capable of generating a big enough economic return to cover their astronomical cost of construction.

Reports that the Ministry of Railways made an 8.8 billion yuan loss in the first half of the year, the bears fret, could be sign of worse to come across the economy as a whole.

The health of China's Icor ratio compared to those in developed countries is little consolation. The bears point out that not only does China's investment to GDP level exceed those in South East Asia immediately before the regional crisis of 1997, but that its Icor is worse than the pre-crisis ratios seen in both Malaysia and Indonesia (see the second chart). In other words, China is a bubble waiting to burst.

Expect the battle to rumble interminably on.