Monday, 28 May 2012

When Is Overinvestment Not Malinvestment?

This week’s edition of The Economist has a special report on the Chinese economy. It makes some interesting points, many of which I agree with. Its particular focus is de-emphasising the role of exports and China’s trade surplus, which is now below 3% of GDP and falling. Instead, the report identifies the main engine of Chinese growth as investment, which runs at over 45% of GDP – far larger than other East Asian economies like South Korea and Japan during their boom years. Unsurprisingly, this enormous rate of investment has led many to conclude that Chinese growth is unsustainable, fuelled by an inflating investment bubble which is inevitably doomed to burst.

The Economist’s report seeks to characterise the nature of this bubble by marking a distinction between overinvestment – investment which exceeds savings to an unstable extent – and malinvestment – inefficient and unproductive investments, of which the ‘ghost city’ of Kangbashi is one example. It is easy to argue that Chinese investment, largely provided by state-owned enterprises and financed by banks at artificially low rates, is inefficient. However, whether the Chinese are investing too much is another issue altogether.

The Economist concludes that, with the savings rate even higher than investment at 51% of GDP, charges of overinvestment cannot be levelled at China. But the distinction between overinvestment and malinvestment seems to imply there can be overinvestment without malinvestment - efficient, productive investment being a bad thing.

This is a little bit strange. Surely ‘too much’ investment would be too much purely because it was inefficient? An excess of investment over saving is not always a bad thing. Obviously, excess of investment over savings would ordinarily cause a rise in the interest rate, so that the excess disappears. However, the interest rate may be sticky, either for generic reasons or because the Chinese government caps the return payable on bank deposits. It would then not adjust to correct the imbalance. What then happens is that the increased investment causes GDP and incomes to rise; as people see their incomes rise, their propensity to save increases, and balance is achieved through an increase in saving.

An interesting counterpoint to this theory is that, as the Chinese get richer, it is expected that consumption will become a greater proportion of GDP. In this case, what is occurring is that, though savings rates fall, the balance is achieved by a greater fall in investment as the economy adjusts to a model more dependent on domestic consumption.

The effect of an increase in GDP restoring the investment-saving equilibruium would obviously not occur if the investment did not serve to increase GDP – i.e. the investment was wasteful and inefficient. The Economist article refers to the East Asian financial crisis of the 1990s as an example of overinvestment. However, here, foreign finance clearly served solely to inflate asset price bubbles rather than for any real economic gain. This implies that some of the investment was unproductive, and that the real problem was malinvestment. A similar story is visible in the Spanish economy of the 2000s.

It is clear that market liberalisation would lead to reduced malinvestment in China. It is also evident that, as the economy inevitably shifts towards a model more dependent on domestic consumption, rates of both savings and investment will fall. However, this will probably represent a fall in the productive rate of investment combined with less malinvestment; it won’t be because there are productive investments to be made, but making them would be unsustainable.

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