Is China Investing Too Much?

Just about every outside observer seems to agree that China is investing too much.

And the numbers sure look that way:

- China's gross investments make up close to 50 % of GDP.

(Edit: Checked the official national accounts data, and the exact number was "only" 42-43 % in 2004-07)

For comparison:

- Germany records around 20 %

- The US barely manages 15 %.

Already back in the 90s, Krugman famously argued that Asia's "tiger economies" were using more and more capital to achieve their high growth, whereas total factor productivity remained pretty constant. Based on this finding, he argued that the Asian "growth miracle" wasn't particularly miraculous after all.

However, high amounts of capital investment don't necessarily imply inefficient production or overinvestment. This is only the case if the return on the capital employed is not good. Countries can have a different economic structure: For instance, the US has comparatively little capital-intensive manufacturing, whereas Germany has lots of it. This probably explains why Germany has a higher investment rate than the US, even though the US economy has been growing faster than Germany's.

However, the difference between 15 % in the US and 20 % in Germany is dwarfed by China's 50 %. Can such a gargantuan investment rate possibly be adequate and sustainable?

Well, there might be a reason to argue that indeed it can be:

- Germany's economy is basically stagnating (average real growth over the last ten years has been barely more than 1 % p.a.)

- China's economy has been growing at roughly 10 % p.a.

When an economy grows fast, the capital stock also needs to grow fast. This means that new investment as a percentage of GDP must be higher in high-growth countries, otherwise the capital stock will shrink as a percentage of GDP.

Let's illustrate this with numbers:

- Assume that on average, investments have a useful life of 15 years

- In a stable economy such as Germany, a 20 % investment rate implies a total "equilibrium capital stock" of 300 % of GDP (20 % * 15 years).

- Assume China's economy is structurally the same as Germany's, i.e. also has an equilibrium capital stock of 300 % of GDP.

- If China grows at 10 % every year, it needs to grow its equilibrium capital stock at 10 % as well. As the capital stock is assumed to be 300 % of GDP, 10 % growth implies that 30 % of GDP need to be newly invested every year on top of replacement investments.

- China's replacement investments will be lower than Germany's 20 %, as the economy has grown fast, so what used to be 20 % of GDP is far less by the time the investments have reached the end of their useful life. So China's replacement investments are probably more like 10 % of current GDP.

=> Based on the assumptions above, China would have equilibrium investments of 40 % of GDP as compared to Germany's 20 %. The difference is needed to keep the capital stock constant in % of GDP while the economy is growing at 10 %.

(If the average useful life of investments is longer than 15 years, equilibrium investments will be even higher than 40 %. If the useful life is shorter, they will be below 40 %.)

So China's high investment rate doesn't necessarily mean that there is a huge degree of overinvestment and lots of capital is wasted: A high investment rate is perfectly in line with a capital-intensive economy (similar to Germany's) which needs to expand its capital stock to keep up with high overall growth rates.

(Note: I do not intend to make the claim that China's investment binge is fully appropriate. I agree with most other observers that China seems to be overdoing things investment-wise. But based on the thoughts outlined above, I do believe that the extent of the overinvestment is probably less than commonly suspected.)