Given that China’s rising level of debts is directly caused by excessive fixed asset investment (FAI), common sense dictates that, to restrain the growth of debts, China needs to slow the growth in FAI. However, this goes against the logic that, at the current stage of economic development, China needs more FAI to escape the middle-income trap.

 

A point of academic contention is thus these seemingly conflicting roles (i.e. contributing to rising debts and growth at the same time) played by FAI in both the debt trap and the middle-income trap.

 

Importance of FAI in Driving Growth

 

To begin with, not all observers believe that China should curtail investments to make room for rising consumption, or that it should avoid using debts to fund the investments. In fact, some see high level of investments as essential for China’s current and future growth because of the country’s high saving, a die-hard Chinese habit that is unlikely to change in the short term due to long-standing cultural attitudes.[1]

 

To understand why, let’s look at the very basic model of circular flow of income and expenditure which assumes that all incomes are spent on consumption. As long as everyone spends everything that he or she earns, the total income and output are equal and constant. The circular flows of factors, goods, and money can theoretically go on indefinitely.  However, when people start savings, which is a form of withdrawal from the circular flow, overall income level will decline over time. This is because as more is saved and consumption falls, the lower demand will induce firms to produce less inevitably leading to lower employment and lower personal and national income which in turn result in even lower consumption.

 

Conceptually, saving more and consuming less thus result in a downward spiral of income and consumption. To stop or even reverse the downward spiral, savings must be injected back into the circular flow of income as investments to create more employment opportunities and rising personal and national income which in turn leads to more consumption. Investments thus do the reverse of savings. Without investments, high saving will in time lead to declining income. A simple analogy is to imagine a barrel (circular flow economic system) that is leaking (money stashed away as savings). Water leakage (savings) can only result in falling water level (national income). The immediate solution is to collect the leakage and inject it (investment) back into the barrel to maintain the water level (national income).

 

In reality, with international trade coming into the picture in an open economy, GDP can be broken down into four components: consumption (C), government expenditure (G), investment (I), and net exports (NX). Saving is defined as what is not spent on C and G and is equal to the sum of I and NX. In the case of China, consumption, government expenditure, investment, and net exports, as a share of GDP, come to 38%, 15%, 44%, and 3% respectively. The comparable figures for the US are 68%, 18%, 17% and minus 3%.[2]

 

Saving is thus exceptionally high in China at 47% of GDP compared to 14% in the US. Investment in the US is relative low because the high consumption allows economic growth to be maintained. But for China, without the injection of high savings as investments back into the economic system, growth will decline very quickly. Moreover, significant changes in savings, consumption and net export are not likely to happen quickly. In contrast, investments can be relatively easier to control through adjusting government’s discretionary spending on infrastructure building or by introducing favourable policies to induce contraction or expansion of corporate sector activities.

 

Hence, until consumption rises significantly, Chinese policymakers will still have to depend on investments by local governments and by firms to drive economic activities so that growth can be maintained at a pre-determined level to generate enough new employment for young Chinese joining the workforce.

 

Besides, China is still far from being over-built. As an agrarian society, Old China’s infrastructures were underdeveloped to begin with. During the 20th century, even those rudimentary infrastructures were wrecked by decades of civil war, with the Nationalists first fighting the regional warlords followed by then the Communists, and a war against foreign aggressor Japan. Even after the fighting had ended, infrastructure developments in the inefficient centrally planned command economy were hampered by a serious lack of resources. Reconstruction really only took off after the turn of the century. With China’s accession to the WTO, economic growth spiked and provided the Chinese government with the wherewithal to upgrade the country’s underdeveloped and dilapidated infrastructures.

 

Excess capacity, Declining Profit Margin and a Property Market Bubble

 

Initially, China’s intensive infrastructure developments were underpinned by real needs to raise standard of living and to support economic developments. However, in recent years, particularly after the 2008 Global Financial Crisis (GFC), infrastructure spending has not only become a convenient countercyclical tool for the central government to spur growth in the slowing economy. Cadres at the local levels are also using it as a performance evaluation tool to compete for promotion.  

 

Meanwhile, for the private sector, a lot of resources went into property development. At the beginning, property prices were pushed up by supply shortages as demand rose with income. After the GFC, however, with the market flushed with liquidity from the stimulus, speculative demand spiked and property prices raced ahead in leaps and bounds. The problem is not just the systemic risk associated with the speculative housing bubble. The high property prices deprive young Chinese the dream of owning a home while diverting resources from otherwise meaningful consumption that could help to drive the economy. 

 

As for the manufacturing sector, the focus of investments was more in expanding capacity than on moving up the value-add ladder. Theoretically, capacity building is good because it is “self-liquidating”. As capacity increases, income also increases to fund the paying off of the initial debt. This is contradistinction to consumer borrowing which are considered to be “non-self-liquidating” because they are used to fund consumption and inflate property market which are essentially non-productive activities. In the case of China, however, the capacity expansion, fuelled by debts, is overdone. As a result, firms in both the public (i.e. SOEs) and private sectors are faced with excess capacity and declining margin while still remaining heavily dependent on foreign technologies.

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Not surprisingly, FAI by both the local governments and the corporate sectors have reached the point where marginal return is diminishing. Today, more and more FAI is needed in order for the overall economy to achieve the targeted growth rate. In its 2017 annual review, IMF noted that China’s “credit efficiency” had deteriorated sharply over the past decade, with ever larger amounts of money needed to generate the same amount of growth. In 2008, for example, new credit of about 6.5 trillion yuan was needed to raise nominal GDP by 5 trillion (i.e. ratio of 1.3 to 1). By 2016, it took 20 trillion yuan in new credit (i.e. ratio of 4 to 1).[3]

 

This can also be seen from the divergence growth trend between growth of GDP and debt since the GFC. Between 2007 and 2015, and expressed at constant 2015 values, debt increased by 228%, from 51 trillion yuan to 169 trillion yuan. This far outpaced expansion in GDP which grew by 154%, to 68 trillion yuan in 2015 from 35 trillion yuan in 2007. Over the ten years between 2005 and 2015, GDP grew at rates of between 9% and 14% annually but debt grew by between 17% and 35% of GDP each year, with the exception of 2009, when debt increased by 47% of GDP.[4]

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Finally, another worrying sign is that the state sector may be gradually crowding out the private sector in investment. FAI for 2018 till November by private businesses in China, for example, came to 37.8 trillion yuan ($5.5 trillion), an increase of 18% from three years earlier. Those by state and SOEs, on the other hand, climbed at twice the rate at 36% to 21.6 trillion yuan. That’s the wrong part of the economy to be favouring, given the private sector's strength in export-led growth. ​

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Overall, as pointed earlier, China is far from being over-built. There is still room for bad FAI to go down but at the same time, a lot of public investment is still needed to improve basic amenities such as housing, utilities and healthcare, particularly in third- and fourth-tier cities and the rural areas, to help raise standard of living and to revitalize environments ravaged by the past “growth at all costs” economic model. Similarly, to escape the middle-income trap under the MIC2025 initiative, China needs major investments in R&D, to reduce its dependence on foreign technology, and in education and training, to upgrade its workforce.

 

In short, despite the aggressive buildup already done over the past two decades, there still more room for FAI for a long time to come. What is more pertinent henceforth for China is not the quantity but the quality of investments.

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REFERENCES

[1] See Frank Newman & Dan Newman. (2016). “High levels of investment – and debt – are good for China’s economy.” 22 February, 2016.

[2] See Frank Newman & Dan Newman. (2016). “High levels of investment – and debt – are good for China’s economy.” 22 February, 2016.

[3] See Tom Mitchell. (2017). “IMF warns China over ‘dangerous’ levels of debt.” FT. 15 August, 2017.

[4] See Tim Morgans. (2017). “What is Really Happening with the Chinese Economy?” Surplus Energy Economics. 11 March, 2017.

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