Can China wean itself off its addiction to investment?

China's economy slowed unexpectedly in the second quarter of this year. Just as unexpectedly, most data released since July suggests that China's growth has stabilised. Markets, not surprisingly, have breathed a collective sigh of relief. But should investors still be nervous?

Currently, the most severe problem confronting Chinese authorities is over-capacity. For example, China's annual production capacity for crude steel is close to one billion tonnes, but its total output in 2012 was 717 million tonnes - a capacity utilisation rate of about 72 per cent.

More strikingly, the steel industry's profitability was just 0.04 per cent in 2012. Indeed, the profit on two tonnes of steel was just about enough to buy a lollipop. The average profitability of China's top 500 companies was 4.34 per cent in 2012, down 33 basis points from a year earlier.

Some say that today's overcapacity is a result of China's past overinvestment. Others attribute it to a lack of effective demand. The government seems to come down in the middle.

On the one hand, the government has ordered thousands of companies to reduce capacity. On the other hand, it has introduced some "mini-stimulus" measures, ranging from exemptions from business and sales taxes to pressure on banks to increase loans to exporters.

The official line is that China's growth model requires less investment and more consumption. But not all Chinese economists agree. They argue that capital stock is the key factor for growth and that China's per capita capital stock is still low relative to developed countries.

To be sure, capital accumulation is a driving force of economic growth, and catching up with developed-country income levels implies that China must increase its capital stock in the long run. But what is at issue is not the size of the capital stock or even the level of investment; the problem is the growth rate of investment, which has been significantly higher than that of GDP for decades.

According to official statistics, China's investment is approaching 50 per cent of gross domestic product. Given absorption constraints, capital efficiency has been falling steadily amid increasing deadweight. If environmental damage caused by breakneck investment growth were taken into account, China's capital efficiency would be even lower.

Human capital and technological progress are as important to economic growth as physical capital and labour, if not more so. If resource allocation is skewed towards physical capital at the expense of accumulating human capital - for which adequate consumption is indispensable - economic growth would be more likely to slow than rise. So China should reduce the growth rate of investment and increase that of consumption, allowing the investment rate to settle at a more sustainable level.

Of course, it is not entirely untrue that China's overcapacity reflects a shortfall of effective demand. But where can effective demand come from?

Again, China's steel industry provides a telling example. Despite China's lack of a comparative advantage for steel production, it has built some 1,000 mills, with output accounting for roughly half of the global total. As early as 2004, Beijing tried to clamp down on overinvestment and, yet, output increased dramatically, from 300 million tonnes that year to a billion tonnes in 2012, owing to strong demand generated by investment in infrastructure and real estate development.

China's investment consists mainly of three broad categories: manufacturing industry, infrastructure and real estate. In late 2008 and 2009, at the height of the global financial crisis, stimulus-fuelled infrastructure investment sustained output growth. In 2010, investment in real estate development replaced infrastructure investment as the main driver of growth. Today, both infrastructure and real estate are important drivers of China's growth.

China does need more infrastructure investment, particularly in power and water utilities, transport and communications. But the pace of investment must take financial constraints into consideration. More importantly, China should invest more in social infrastructure such as schools, hospitals and retirement homes.

However, real estate investment is another story. It is difficult to judge how serious China's property bubble is and when it might burst. But one thing is certain: it has invested too much in real estate development.

With per capita income at less than US$6,000, home ownership in China is roughly 90 per cent, compared to less than 70 per cent in the United States. Average floor space per capita is 32.9 square metres, while median floor space per family in Hong Kong is just 48 square metres. China has 696 five-star hotels, with another 500 on the way. Five of the 10 tallest skyscrapers under construction worldwide are in China. In my view, this is madness.

China's economy is being held hostage by real estate investment. On the one hand, China should not try to eliminate overcapacity by maintaining the high growth rate of real estate investment. While investment in social housing should be welcomed, real estate investment, currently running at 10 to 13 per cent of GDP, is already far too high.

On the other hand, if real estate investment growth falls, overcapacity will be difficult to eliminate. This dilemma highlights the structural-adjustment challenge that China faces - and should give investors reason to hold their breath.

That said, there are two caveats. First, unlike other categories of investment, real estate investment does not increase productive capital stock. There is no fundamental difference between a house and an expensive durable consumer good.

Second, in China's statistics, the growth rate of gross fixed-asset investment is much higher than that of gross capital formation. This indicates that data on the growth rate of fixed-asset investment may have exaggerated the pace of capital-stock accumulation.

Hence, while the Chinese government should be firm on reducing the dependence of growth on investment, it must exercise the utmost care when doing so.

Yu Yongding is former president of the China Society of World Economics and director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences, and has also served on the Monetary Policy Committee of the People's Bank of China. Copyright: Project Syndicate