Some surprising new recruits join the ranks of China bears
The bulls say China can still profitably build more infrastructure but others conclude that it has poured in too much too soon
The debate rumbles on.
On one hand we have the bulls who believe China needs more investment to power its future development.
On the other are the bears, who argue that by investing so heavily, China is wasting money on a colossal scale.
The bullish view is championed by banks like HSBC and Goldman Sachs, which have invested heavily in China themselves and hope to generate big future earnings from their businesses there.
"There is still no evidence of nationwide over-investment," declared Goldman's economists in September, arguing that China's stock of capital per worker is low compared with other economies and that it can profitably build many more roads, railways and factories.
"China is far from over-invested and still needs to build more infrastructure," agreed Qu Hongbin, HSBC's chief China economist, in a report published the following month.
In contrast the bears, who believe China is misallocating capital at an unprecedented rate come mostly from independent research houses, or from hedge funds with short exposure to Chinese markets.
Recently, however, the bearish faction has enlisted some unlikely new recruits. In a working paper published last month, Il Houng Lee, senior resident representative at the International Monetary Fund's Beijing office, his deputy Murtaza Syed, and Liu Xueyan, who works for China's National Development and Reform Commission, concluded that China is indeed overinvesting.
They calculated that China underinvested in the 1970s and '80s. But by 2005 China's capital to output ratio had made up the lost ground, implying that from then on investment should have fallen back as a proportion of gross domestic product.
Instead China piled on the investment ahead of the Beijing Olympics and in response to the financial crisis. As a result, the researchers reckoned that over the last five years China has been overinvesting by between 12 and 20 per cent of GDP, relative to its sustainable long run rate.
Unfortunately, the economy is now running up against the law of diminishing returns. "China now requires ever higher investment to generate the same amount of growth," the paper's authors wrote, noting that to maintain recent growth rates over the coming years, investment levels would have to climb to between 60 and 70 per cent of GDP.
"The cost of financing such an elevated level of investment could undermine overall economic stability," they warned.
China's current investment rate also looks high compared with the trajectories followed by rapidly developing economies in the past. If China had taken a similar path to other Asian economies including Japan and Taiwan during their phases of high investment and rapid growth, then its expected investment level would currently be around 40 per cent of GDP. Instead it is approaching 50 per cent (see the first chart).
That means overinvestment in China today is even more pronounced than in Japan during the years of its bubble economy or in Southeast Asia immediately before the 1997 Asian crisis.
"Credit growth (particularly post-crisis) and the cost of capital in China in recent years also appear to be in dangerous territory compared to these other country experiences," the researchers warn.
That doesn't mean China is heading for a Thai or Indonesian-style financial crisis. Its investment level may be high, but unlike Southeast Asia in the mid-1990s, China can fund its investment from domestic savings (see the second chart).
Instead the burden is being borne by households and small private companies, at an annual cost the researchers estimate at close to 5 per cent of GDP.
The challenge now for China, the paper's authors conclude, will be to cut investment by 10 percentage points of GDP.
"Otherwise, vulnerabilities will continue to build."