IMF economists see perils in China’s investment binge

by Kevin Rafferty

Special To The Japan Times

China’s investment binge has been the envy of many other countries, not least India where inadequate roads mean that 40 percent of crops are spoiled on the way to market, and Japan, where 30-year-old tunnels are passing their sell-by dates and maintenance is not keeping up with demand.

In city after city in China, skyscrapers glitter and shopping malls groan with luxury goods. Massive highways and high-speed rail lines make travel easier, at least until you reach the city traffic jams.

In an area of Anhui province officially designated an “impoverished county,” the government office block looks exactly like the White House, only newer and whiter. In some places there has been overindulgence: Ordos in Inner Mongolia has state-of-the-art skyscrapers for a million people, but has only 30,000 inhabitants, so it has been called the world’s biggest ghost city.

There has been a price to pay for the sheer scale of investment.

Economists from the International Monetary Fund have now joined other critics in warning that China may be facing a painful hangover for its investment binge with potentially dangerous consequences, both economically and socially.

The authors estimate that overinvestment of the past few years could amount for as much as 20 percent of gross domestic product, though they settle on a safer figure of 10 percent. The bill falls heavily on households, with a significant tab also paid by small and medium enterprises (SMEs).

They claim that, “Now with investment to GDP already close to 50 percent, the current growth model may have run its course. In China, a large burden of the financing of overinvestment is borne by households, estimated at close to 4 percent of GDP per year, while SMEs are paying a higher price of capital because of the funding priority given to larger corporations.”

The three authors are ultra-careful and sensitive in handling the topic. Their working paper, titled “Is China over-investing and does it matter?,” contains the caveat that the views in the paper “do not necessarily reflect those of the IMF.”

Two of the authors, Il Houng Lee and Murtaza Syed, are, respectively, the senior and the deputy resident representative of the IMF’s China office, so it is hard to get a more authoritative source for IMF thinking. The third author, Liu Xueyan, is a senior fellow in the institute of economic research of the National Development and Reform Commission of China, whose contribution carries the caveat that the paper does not reflect NDRC’s views either.

There is a controversy about the appropriate level of investment, complicated by whether you look at the historic stock of investment, where China may still lag, or the flow of new investment, where China is breaking records.

The IMF working paper looks at China in the context of other countries that have also seen their economic takeoff boosted by high investment.

Other Asian countries blazed a trail of high growth backed by investment, good savings rates and exports. But, as the paper points out, “high investment has also proven to be costly” both in other Asian experience and previously in Latin America during the 1980s.

High investment ratios, fed by foreign financing, allowed countries to achieve faster growth, but then led to disaster of banking or foreign exchange crises.

“In emerging economies, mispricing often involved currency and maturity mismatches, whose risk was obscured by implicit guarantees or lack of information,” the authors write. “An artificially low cost of pricing supports excessive investment, including in property and manufacturing sectors that eventually result in a crisis.”

They estimate that, based on a cross-country regression, China’s overinvestment gives it a one-in-five chance of an economic crisis, but they say that may be overstating the risk because of China’s low reliance on foreign capital.

China, as in other areas, is different. Its investment binge has not relied on external financing, so it is largely protected from a foreign exchange crisis. But the IMF working paper points out that “While a crisis appears unlikely when assessed against dependency on external financing, it raises concerns about the underlying domestic strain associated such a high level of investment, which appears to be implicitly borne by households.”

The risk is that the economic costs increase and impose additional strains. The IMF authors point out that “China requires ever higher investment to generate the same amount of growth.”

With prospects of export growth subdued because of the sluggish global economy, unless there is a unexpected surge in China’s productivity, “the contribution of investment to growth will need to reach 60-70 percent to support the same amount of growth,” the IMF authors warn.

At such levels, they add, “the cost of financing such an elevated level of investment could undermine overall economic stability.”

In their conclusions, they say “The challenge is to engineer a gradual reduction in investment to a path that would maximize social welfare.”

That path is not clear, they say, but China could lower its investment by 10 percentage points of GDP “over time” without compromising growth and macroeconomic stability. But they also plead — carefully, as if not wishing to offend anyone either officially or unofficially — for “reforms that would raise productivity and efficiency, while ensuring that the fruits of China’s remarkable growth are shared more equitably across different economic agents, in particular ordinary Chinese households.”

That’s easier said than done. Lynette H. Ong, an associate professor at the University of Toronto, is more direct and less circumspect in pointing out how construction has driven and taken a grip of China’s economy, with attendant risks.

Potential social problems are exacerbated by the raw deals that ordinary Chinese suffer at the hands of government officials. Under Chinese law, which states that collectively owned farmland must be converted to state ownership before being released to private developers, local governments can make huge profits in expropriating land from villagers.

Elderly duck farmer Luo Baogen drew international attention to the purchasing policies of Wenling city in Zhejiang province when he refused to accept compensation of 220,000 yuan for his house that he had recently built for 600,000. For a while Luo’s home stood out as a “nail house” incongruously in the middle of a new road to the railway station before he accepted slightly increased compensation and the house was demolished.

Landesa, a nonprofit organization based in Seattle, claims that, on average, local governments in China earn $740,000 per acre (0.4 hectares) of land, or more than 40 times the average paid to displaced farmers. No wonder that China has 120,000 land-related protests every year.

In a lively “Snapshot” article for Foreign Affairs, Ong points to some of the economic and social risks. Local government debt in building the infrastructure soared to 14.4 trillion yuan, or 36 percent of China’s GDP, by the end of 2010, according to official figures, but to between 50 and 100 percent of GDP according to skeptical private analysts after adding in contingent liabilities.

In addition, about 300,000 peasants are removed from their villages every year, adding to an army of 60 million Chinese who have been moved since 1980.

The IMF report again draws China’s attention urgently to rebalance its economy, but that means cutting through the powerful connections linking promoters of investment, the state-owned enterprises and politicians and bureaucrats at all levels.

Kevin Rafferty was executive editor of the Indian Express newspaper group.