How much investment is optimal?

2013-06-13 18:38:17

In the May 10 issue of my blog I referred to a very interesting IMF paper written by Il Houng Lee, Murtaza Syed, and Liu Xueyan. The study, “China’s Path to Consumer-Based Growth: Reorienting Investment and Enhancing Efficiency”, attempts among other things to evaluate the efficiency of investment in various provinces within China. I argued in the newsletter that the paper supported my contention that China has overinvested beyond its capacity to absorb capital.

This argument is in opposition to claims made by many analysts that China has not overinvested systematically, and that in fact, with much less capital stock per worker than advanced countries like the US or Japan, China has a long ways to go before it begins to bump up against the productive limits of investment. For example in a September 3, 2012, issue of Asia Economics Analyst, Goldman Sachs makes the following point:

China is often criticized for investing too much and too inefficiently, and for consuming too little…However, focus on the investment/GDP ratio risks confusing flows and stocks and we believe is not the right metric for assessing whether a country has invested too much. For that, we also care about the capital stock rather than the investment flow—on this metric, on a top-down approach, China still has a long way to go—its capital stock/worker is only 6% of Japan’s level and 16% of Korea’s.

The Economist has also made a similar argument. This, for example, was published about a year ago:

The IMF says so. Academics and Western governments agree. China invests too much. It is an article of faith that China needs to rebalance its economy by investing less and consuming more. Otherwise, it is argued, diminishing returns on capital will cramp future growth; or, worse still, massive overcapacity will cause a slump in investment, bringing the economy crashing down. So where exactly is all this excessive investment?

…The level of fixed-capital formation does look unusually high, at an estimated 48% of GDP in 2011 (see left-hand chart). By comparison, the ratio peaked at just under 40% in Japan and South Korea. In most developed countries it is now around 20% or less. But an annual investment-to-GDP ratio does not actually reveal whether there has been too much investment.

To determine that you need to look at the size of the total capital stock—the value of all past investment, adjusted for depreciation. Qu Hongbin, chief China economist at HSBC, estimates that China’s capital stock per person is less than 8% of America’s and 17% of South Korea’s (see right-hand chart). Another study, by Andrew Batson and Janet Zhang at GKDragonomics, a Beijing-based research firm, finds that China still has less than one-quarter as much capital per person as America had achieved in 1930, when it was at roughly the same level of development as China today.

Leaving aside the rather strange claim that China today is at roughly the same level of development as the US in 1930, because China’s capital stock per capita is so much lower than that of much richer countries, claim Goldman Sachs, the Economist, and many others, Chinese investment levels overall are still much lower than they optimally ought to be. While it is of course always possible for China to misallocate individual investments, which everyone agrees is a bad for growth, these analysts strongly disagree with the claim that China has overinvested systematically.

Since the newsletter came out I have had a number of conversations with clients who wanted to pursue a little further the issue of how to think about an optimal level of capital stock per capita. In my central bank seminar at Peking University we recently spent a couple of sessions hashing this out in a way that we found very useful, and I thought it might be helpful to summarize those discussions in order to explain a little more schematically how I think about this issue.

The two models of investment

To begin this discussion it is worth remembering what the IMF paper suggested about investment in China. The abstract of the paper is:

This paper proposes a possible framework for identifying excessive investment. Based on this method, it finds evidence that some types of investment are becoming excessive in China, particularly in inland provinces. In these regions, private consumption has on average become more dependent on investment (rather than vice versa) and the impact is relatively short-lived, necessitating ever higher levels of investment to maintain economic activity. By contrast, private consumption has become more self-sustaining in coastal provinces, in large part because investment here tends to benefit household incomes more than corporates.

If existing trends continue, valuable resources could be wasted at a time when China’s ability to finance investment is facing increasing constraints due to dwindling land, labor, and government resources and becoming more reliant on liquidity expansion, with attendant risks of financial instability and asset bubbles. Thus, investment should not be indiscriminately directed toward urbanization or industrialization of Western regions but shifted toward sectors with greater and more lasting spillovers to household income and consumption. In this context, investment in agriculture and services is found to be superior to that in manufacturing and real estate. Financial reform would facilitate such a reorientation, helping China to enhance capital efficiency and keep growth buoyant even as aggregate investment is lowered to sustainable levels.

In contrast to claims cited above suggesting that Chinese investment levels are too low, among other things the paper argues that although investment levels as measured by capital stock per capita are obviously lower in the poor inland provinces in China than they are in the richer coastal regions, in fact investment in the former areas may be less productive than investment in the latter areas. This implies that the regions with less capital are also less able to absorb additional capital efficiently.

Should this be a surprise? For those who argue that China is poor because capital stock per worker in China is much lower than in the advanced countries, and that China should aggressively increase investment to close the gap, the findings in this paper ought to be surprising. If the further an economy is from US levels of capital stock the more appropriate it is to increase investment, then investment in the poor inland regions should have a higher return than investment in the richer coastal regions.

But whether or not the findings of this and other similar studies should surprise us depends on how we decide what the optimal level of capital is for any economy. I would argue that there are basically two different models for thinking about how much investment is optimal:

1. The capital frontier constraint. One model suggests that the most advanced and capital-rich countries have developed, perhaps through trial and error, the appropriate level of capital investment given the state of technology, trade, and managerial organization, and they effectively represent the frontier for investment.

According to this model it is pretty easy to figure out what an appropriate investment strategy is for a developing country – more investment is almost always good. Because in this model what separates poor countries from rich countries is primarily the amount of capital stock per worker, poor countries should always increase their capital stock until they begin to approach the frontier. Until they do, an increase in capital stock automatically causes an increase in workers’ productivity that exceeds the cost of creating the capital stock, and so the country is economically better off because the benefit of investment exceeds the cost of investment. This model implicitly underlies claims made by many analysts that because China’s capital stock is much lower than that of the US, Japan or other rich countries, it is meaningless to say that China is overinvesting in the aggregate.

2. The social capital constraint. The other model suggests that for any economy there is an appropriate level of investment or capital stock per worker that depends on the ability of workers and businesses in that economy to absorb additional capital stock. I am going to call this ability to absorb capital stock “social capital”.

The implication is, then, that the higher a country’s social capital, the higher the optimal amount of capital stock per worker. The fundamental difference between rich countries and poor countries, in this case, is not the amount of capital stock per worker but rather the institutional framework that gives workers and businesses the ability to absorb additional capital productively. Advanced economies are understood simply to be those economies that are able to absorb high levels of investment productively. Backward economies are constrained in their abilities to do so.

What determines the level of social capital? Lots of things do. The right institutions matter tremendously, but because there is no easy way to quantify what the “right” institutions are, we tend to ignore their importance in favor of more easily measurable factors, such as broad measures of capital stock. I would argue, however, that economies are much better at absorbing and exploiting capital if they operate under an institutional framework that

creates incentives and rewards for managerial or technological innovation (which probably must include clear and enforceable legal and property rights),

encourages the creation of new businesses and penalizes less efficient businesses, perhaps at least in part by institutionalizing methods by which capital can quickly be transferred from less efficient to more efficient businesses, and

maximizes participation in economic activity by the whole population while minimizing distortions in that participation.

Measuring social capital

Perhaps in the early stages of what Alexander Gershenkron called “economic backwardness” these institutions matter less if the there are clear and obvious steps that need to be taken to increase productivity rapidly – if manufacturing capacity and infrastructure levels are non-existent, for example. As economies become large and complex, however, economies with greater flexibility, higher levels of participation, and correctly aligned incentive structures seem to be much better at squeezing value out of investment.

I should point out that the term “social capital” already has a meaning. The World Bank defines it this way:

Social capital refers to the institutions, relationships, and norms that shape the quality and quantity of a society’s social interactions. Increasing evidence shows that social cohesion is critical for societies to prosper economically and for development to be sustainable. Social capital is not just the sum of the institutions which underpin a society – it is the glue that holds them together.

The term was apparently first used in 1916, by the American Progressive Era educational reformer, LJ Hanifan, and he described it in terms of social relationships:

The tangible substances [that] count for most in the daily lives of people: namely good will, fellowship, sympathy, and social intercourse among the individuals and families who make up a social unit. . .. The individual is helpless socially, if left to himself. If he comes into contact with his neighbor, and they with other neighbors, there will be an accumulation of social capital, which may immediately satisfy his social needs and which may bear a social potentiality sufficient to the substantial improvement of living conditions in the whole community. The community as a whole will benefit by the cooperation of all its parts, while the individual will find in his associations the advantages of the help, the sympathy, and the fellowship of his neighbors.

I am using the term much more broadly than either Hanifan or the World Bank, to mean the constellation not just of social relationships that affect the economy but also the full range of legal, institutional, and economic relationships that can make an economy more or less productive. It is this complex mix of institutions, I would argue, and which I call social capital, that drives advanced economic growth, and not simply additional labor or capital.

This is not to say that labor and capital inputs are not part of growth. Of course they are. I am simply arguing that an economy requires both the inputs and the ability efficiently to absorb and exploit those inputs for it to grow. If its level of inputs is too low, as Chinese infrastructure almost certainly was twenty years ago, then the easiest way to achieve growth is to increase the necessary inputs – airports, bridges, roads, factories, office space, and so on in the case of China twenty years ago.

But if social capital is too low or, to put it another way, if capital stock exceeds the ability of an economy to absorb it efficiently, then the best way to achieve growth may be to focus not on increasing inputs, which may end up being wasted and so may actually reduce wealth, but in improving the ability of the economy to absorb the existing inputs. The point is not whether we can easily define these institutions but rather whether there is evidence that they matter to economic growth.

In a sense what I mean by social capital is what William Easterly and Ross Levine might call “something else”. “The central problem in understanding economic development and growth,” they say, “is not to understand the process by which an economy raises its savings rate and increases the rate of physical capital accumulation.”

Although many development practitioners and researchers continue to target capital accumulation as the driving force in economic growth, this paper presents evidence regarding the sources of economic growth, the patterns of economic growth, the patterns of factor flows, and the impact of national policies on economic growth that suggest that “something else” besides capital accumulation is critical for understanding differences in economic growth and income across countries.

The paper does not argue that factor accumulation is unimportant in general, nor do we deny that factor accumulation is critically important for some countries at specific junctures. The paper’s more limited point is that when comparing growth experiences across many countries, “something else” – besides factor accumulation – plays a prominent role in explaining differences in economic performance.

They go on to argue in their paper that

While specific countries at specific points in their development processes fit different models of growth, the big picture emerging from cross-country growth comparisons is the simple observation that creating the incentives for productive factor accumulation is more important for growth than factor accumulation per se.

It is these various institutional and social “incentives” for productive factor accumulation that I am calling “social capital”. Daron Acemoglu and James Robinson, the authors of Why Nations Fail, believe that there is very strong evidence in favor of the importance of social (i.e. economic and political) institutions and on their blog they write:

Our theory isn’t that political institutions directly determine economic prosperity. Rather, we claim that economic institutions determine economic prosperity, and explain why the link is between inclusive economic institutions and sustained economic growth — not necessarily short-run economic growth. We then argue that inclusive economic institutions can only survive in the long run if they are supported by inclusive political institutions. On the way, we provide explanations and examples for why for extended periods of time economic institutions with fairly important inclusive elements can coexist with extractive political institutions.

This is all brought together under our discussion of extractive growth under the auspices of extractive political institutions. This is either because, as in the Soviet Union or the Caribbean plantation economies, extractive political and economic institutions can reallocate resources in a way that brings economic growth — typically when the elite expects to be the main beneficiary from such growth. Or because as in South Korea or Taiwan, extractive political institutions permit a certain degree of inclusivity to develop. In both cases the logic is clear: the elite, all else equal, would prefer more output, more revenue and more growth. It is the fear of creative destruction that often prevents it from adopting economic arrangements favoring growth or even blocking new technologies. When it feels secure or deems that it doesn’t have any other option, the elite will encourage economic growth.

Clear rules

To me one of the most obvious pieces of evidence that it takes a lot more than increases in capital stock to achieve sustainable wealth is the experience of previously advanced economies that have been laid low by war. It is noteworthy that – excluding trading entrepôts like Hong Kong and Singapore or small, commodity-rich entities like Kuwait or 18th Century Haiti – very few poor and undeveloped economies have made the transition from poor to rich. The exceptions may be South Korea and Taiwan, both under very favorable circumstances during the Cold War. “Poor” but advanced countries, however, like Belgium and Germany after WW1, or Germany and Japan after WW2, saw their GDP per capital soar after devastating wars as they made the transition from newly poor to rich with relative ease.

The reason, it seems to me, is that although war may have destroyed physical capital in these countries, because it did not destroy social capital these countries were able sustainably to increase investment at a rapid pace after the war and see their per capita incomes soar permanently. Why is this so easy for advanced economies made poor by physical destruction of their capital base but so hard for developing economies?

The most plausible reason I can think of is that the advanced economies already had in place the institutions that allowed them to exploit investment fully, and so once they were able to increase capital stock, they quickly became rich again. This argument is reinforced, I think, by the well-known fact that most cross-border capital flows (over 90%, I think) are to rich countries, not to poor ones. This wouldn’t make sense at all if rich countries didn’t have a greater ability to absorb new capital efficiently and profitably than poor countries. If what mattered on the other hand was distance from the capital frontier, the further a country was from that frontier, the more profitable it would be to invest there, and so more capital would flow to poor countries rather than to rich countries. The opposite is true.

So what kinds of institutions might matter? Economies with clear and enforceable legal systems, to take one factor, tend to have higher levels of social capital because it is much easier for entrepreneurs to take advantage of conditions and infrastructure to build profitable businesses. Without a clear legal framework, business opportunities tend to be monopolized by entities that have the political clout to take advantage of the legal system, and not only is it not obvious that more powerful entities are more economically efficient, but in fact the opposite may be true – these are what Acemoglu and Robinson call “extractive” elites.

Very powerful entities tend to support the status quo, to undermine disruptive new technologies and business organizations, and otherwise often to favor the less efficient (themselves) over the more efficient. As part of social capital, clear ownership rules for land and other assets matter. Here are Acemoglu and Robinson on the subject:

Key to our argument in Why Nations Fail is the idea that elites, when sufficiently political powerful, will often support economic institutions and policies inimical to sustained economic growth. Sometimes they will block new technologies; sometimes they will create a non-level playing field preventing the rest of society from realizing their economic potential; sometimes they will simply violate others’ rights destroying investment and innovation incentives.

I would also argue that the institutional framework around the writing down of overvalued assets, and the liquidation process itself, is an important part of how efficiently an economy is able to absorb the benefits of capital stock. A formalized bankruptcy process that takes assets away from inefficient users, writes them down to a fair market value, and reintroduces them into the economy, creates a much more efficient economic system than one in which bad loans are not recognized, effectively bankrupt companies are allowed to continue in value-destroying activity, and the use of assets is not systematically transferred from the less efficient to the more efficient user.

In fact an efficient and relatively rapid bankruptcy process is, I would argue, of fundamental importance to the ability of an economy to exploit capital stock efficiently. Even very advanced countries without a formal process to transfer resources quickly can have a hard time exploiting its capital and labor factors, especially after a period in which a great deal of labor and capital were directed into unproductive uses. I think Japan’s twenty years of nearly zero growth may be explained in part by the very slow process in Japan by which resources were transferred from “losers” to “winners” after the investment orgy of the 1980s.

In fact more generally the sophistication and flexibility of financial systems are an important component of social capital because these determine the capital allocation process. Financial system capable of taking risk and supporting new and disruptive technologies or organization structures tend to result in a greater ability by a society to absorb capital. In that light, and as an aside, I would suggest that the country that sees the most change in the list of its largest companies from decade to decade – because this list creates a simple way of determining how quickly companies can be created and destroyed as their level of efficiency changes – is probably better at absorbing capital than a country whose largest companies are the same decade after decade.

Crony capitalism

These are probably the most important components of social capital, but I would include a lot more in my definition than just the relative strength of extractive elites and well-functioning legal, ownership, financial and bankruptcy frameworks. The extent of corruption, nepotism, or the importance of what the Chinese call “guangxi”, erodes social capital because in a society in which corruption or guangxi is more important, the winners in business competition are, in the aggregate, not the most efficient but rather the most connected, and in fact they are often the least efficient for the reasons already noted (they profit not from improving efficiency but rather from improving their access to transfers of resources).

The extent of monopoly power or the extent of significant subsidies to favored sectors and companies also limits social capital for the same reasons. Monopolists and the subsidized tend to be more interested in protecting and extending their power to expropriate national resources than in accelerating efficiency – the rewards for the former far exceed the rewards for the latter which, in many cases, may even be negative.

There are many social and political reasons to be concerned about the various characteristics of what is often called crony capitalism – corruption, guanxi, nepotism, limiting access to credit to powerful insiders, protecting national champions from more efficient competitors, etc. – but the important point in our context is that because they limit the ability of economic agents to take advantage of the benefits of capital stock by heavily tilting rewards towards agents that can play the political game better rather than towards those that can play the economic game better, they undermine the economy’s ability to absorb high levels of investment. The purpose of investment, in countries with high levels of crony capitalism, is often not to maximize productivity but rather to reward political access, and so agents that can exploit capital stock more efficiently are undermined in their ability to do so.

This is not to say that crony capitalism cannot deliver growth. Clearly it can. But I would argue that it can deliver growth only when the interests of the elite are correctly lined up with growth. So, for example, I would argue that in the early stages of reform, especially in countries that have suffered many years of terrible economies and weak investment, crony capitalism can be consistent with high levels of growth because the kinds of programs that lead to growth – mostly massive investment programs in countries in which capital stock is excessively low – benefit the elites directly. Once there is a divergence in interests, however, crony capitalism can become inconsistent with rapid growth.

Beyond these measures, which are basically measures of the ability of elites to distort participation in the economy, I would argue that educational levels also matter. More educated societies and, perhaps even more so, societies in which there is limited ability by the elite to block participation by the non-elite, tend to be better at exploiting economic opportunities because they benefit from economies of scale in accessing talent and ideas.

Social trust matters too, as this can sharply reduce frictional costs. It is not an accident, I would argue, that many of the wealthy industrialists in Britain during the first industrial revolution were Quakers. Because their religion forced them to be honest at all times, even in business dealings, they were generally associated with trust and were eager targets for business relationships, which lowered their frictional costs substantially.

The relative lack of bureaucracy matters too, partly because more bureaucratic systems are more open to corruption and to interference by powerful players, and partly because more bureaucratic systems, by imposing higher costs on starting new businesses, tend to favor the richer and more powerful, who have the ability to pay these frictional costs, at the expense of the poorer and less powerful. Even cultural attitudes to business can matter. Recently I read the following about the how doing business in the US is different from elsewhere:

Having essentially run the same company from both countries, Mr Kelleher has found the most important difference to be the attitude. “From the moment I arrived, I knew it to be different. People are more open to hearing about your business idea; they won’t make themselves hard to reach, or dismiss proposals or ideas because they haven’t come through the right channels” he says.

I can go on but I think my point is relatively clear. The social capital model suggests that there is some amount of investment that is wealth enhancing for any economy, depending on its ability to absorb and exploit the benefits of that investment. Beyond this amount, however, it can be difficult for an economy that scores lower in social capital to take full advantage of investment, in which case the additional productivity generated by higher levels of investment are low, and are more likely to be exceeded by the cost of the investment.

Raising the amount of investment, in this case, is wealth enhancing up to some point, beyond which it can become wealth destroying. At that point it is far more efficient to improve the institutional ability to absorb investment than to increase investment itself (although, because this is intimately caught up in social and political power structures, it can be brutally difficult to do so).

The “Doing Business” report

One attempt at measuring social capital as I define it is the World Bank’s “Doing Business Report”, which tries to score countries according to the ease with which businesses can operate. In the latest report China ranks in the middle – number 91 out of the 185 countries ranked, just below Barbados, Uruguay and Jamaica and just above the Solomon Islands, Guatemala and Zambia. In the report, as the table below shows, China ranks differently according to various sub-rankings, some of which I think are more important (starting a business, protecting investors, resolving insolvency) and some less (paying taxes, trading across borders).

Social capital is a tough measure to score, and I do not want to suggest that the World Bank rankings are a good or even adequate measure. They are merely a rough proxy, and some analysts, for example those associated with labor unions, argue that because labor regulations have a negative impact on the World Bank ranking, these rankings are at least in some cases driven more by ideology than by objective requirements. China itself is opposed to these rankings and is apparently trying to get the World Bank to discontinue them. According to a recent Financial Times article:

China is leading an effort to water down the World Bank’s most popular research report in a test of the development institution’s new president, Jim Yong Kim. According to people close to the matter, China wants to eliminate the ranking of countries in the Doing Business report, which compares business regulations – such as the difficulty of starting a company – in 185 different nations.

…Pushed by China and other critics – including trade unions, international aid charities and some other developing countries – last year Mr Kim set up an independent review of the report chaired by Trevor Manuel, South Africa’s planning minister. But a number of people involved in the process complain that Mr Manuel has appointed two longstanding critics of the report as advisers to the panel, raising doubts about its impartiality.

I do not want to get into the debate about the usefulness of this particular set of rankings because it is not relevant to whether or not there is such a thing as a level of social capital that constrains the ability of a country to take advantage of investment. What is more, in large countries like China or the US, there may be significant variations in social capital even within a country. The key point is that this model presents a very different argument about what an appropriate level of investment is for any country.

We can visually represent the two models and their implications for increasing investment according to the accompanying graph:

The red line (“Optimal A”) in this graph represents the frontier of investment set by the most advanced economies, and it suggests that every country, no matter what its level of social capital, has broadly speaking the same “appropriate” level of capital stock that is optimal for the economy. The blue line (“Optimal B”) represents the optimal level of investment for every country as a function of its social capital, and it proposes that more advanced economies are economies in which higher levels of investment can be exploited efficiently.

If we assume very plausibly that investment in China currently lies somewhere between the red line and the blue line, the two different models will have very different things to say about continued investment. The red line model (the capital frontier constraint) would suggest that investment in China is still too low, and that a diversified increase in investment will result in an increase in productivity that exceeds the cost of the investment, in which case increasing investment will make China richer. This is basically what the Goldman Sachs research piece and the Economist article I cited above argue.

The blue line model (the social capital constraint) would suggest that there is an optimum investment level for each country depending on its level of social capital, and that it is low in China, which may have already invested more than it can efficiently absorb, in which case the cost of additional investment is likely to exceed the value created by any increase in productivity. Further inappropriate investment would make China poorer, not richer, in this case – although in the short term further investment will make China feel richer because it causes an increase in economic activity equal to the increase in investment (times the investment multiplier).

To take it a little further, the red line describes recent Chinese economic history as simply forcing up investment towards the capital frontier, and argues that China has been correctly following this process for the past thirty years and should continue for the next thirty. The blue line describes recent history very differently.

It suggests that thirty years ago China lay below the blue line, and as investment rates were forced up China became wealthier until, at some unspecified time (I would argue over a decade ago), it passed the blue line, after which time as it has forced up investment it has not been getting richer, in real terms, at nearly the rate implied by its GDP growth rate – although of course it has continued to see high levels of economic activity.

I am not going to insist that one model is obviously better than the other at describing reality. This is clearly a subject of reasonable debate and there is nothing approaching unanimity on the subject. My main point here is just to suggest that there are implicitly two very different ways of looking at the world, and they have very different implications for continued investment in China. I of course believe the social capital model is the appropriate one, and I will try to explain why, but I don’t want to suggest that mine is the only reasonable and consistent point of view.

Inland investment

Where this disagreement about what is an optimal level of capital stock comes out most clearly is in the debate about China’s decision aggressively to pursue investment growth in the poorer inland provinces. The inland provinces in China are generally much poorer than the coastal provinces and much more backward economically (and in fact this has been true for centuries). If you believe in the capital frontier constraint, then the policy implications are obvious beyond much dispute: Beijing must encourage as much investment as possible in the poor inland provinces, even to the extent of diverting investment from the richer coastal areas.

If you believe in the social capital constraint, the implications are more complex. It makes sense, in this case, to encourage some investment into the inland regions, but only up to a point. Because these poorer inland regions are almost certainly much less able efficiently to absorb the benefits of investment and capital stock, we are also likely to reach the productive limits of investment much earlier. This means we are also likely to waste capital at much lower levels of capital stock per worker.

So which model does a better job of describing reality in China today? One way of thinking about it is to adapt the graph above to reflect conditions within China. Here it is:

The red line in this graph represents the capital frontier within China, with wealthy places like Shanghai representing the upper limit of capital stock per worker. It implies that because all ofmainland China operates more or less under a single legal and political system, every part of China is as likely to benefit from any given level of capital stock per worker as any other part. Very poor Guizhou, in other words, is just as able to exploit Shanghai levels of investment efficiently as comparatively rich and advanced Shanghai.

The blue line represents the optimal amount of investment as a function of social capital. It suggests that Guizhou should optimally have much less capital stock per worker than Shanghai because it is less able to take advantage for a variety of reasons having to do with local institutions, political and social conditions, and so on.

The green line represents a strategy – the current one in China – to mobilize capital investment in the poor inland regions in order to drive away the disparity in wealth. It implies that investment in the poorer parts of China would have been lower absent a government strategy to raise investment levels in the poor regions. The closer we can bring capital stock per worker in Guizhou to Shanghai levels, according to this way of thinking (which implicitly assumes the capital frontier constraint, at least within China) the better off China is and the less income inequality there is likely to be.

So which way should investment go in China? If you believe in the capital frontier constraint, then clearly we are better off diverting resources from Shanghai to Guizhou. Not only will this reduce inequality within China, but it will increase China’s overall wealth because the total returns to China, including hard-to-record externalities, will be much higher for investment inGuizhou than for investments in Shanghai.

Of course if you believe in the social capital constraint, then you would not want to divert resources from Shanghai to Guizhou. You would in fact want to do the opposite. Diverting resources from Guizhou to Shanghai might increase income inequality but it will make China richer overall. To address the inequality, this model would suggest, either we should keep investing in Shanghai and simply transfer income from Shanghai to Guizhou, or we should work especially hard to reform the social, political, financial and economic institutions in Guizhou so that it can grow not so much by increasing investment but rather by increasing its ability to transform existing investment into more productive uses.

The IMF paper with which I started this newsletter, and other similar analyses, comes out implicitly quite strongly in favor of the social capital constraint. Here is what it says:

This paper reviews trends in investment at the provincial level in China and finds evidence that some types of investment is becoming excessive, especially in inland regions. In these regions, investment Granger-causes consumption on average. By contrast, in coastal provinces, private consumption has on average become more self-sustaining and less dependent on investment. Moreover, in relative terms, investment is more closely associated with higher household income in coastal provinces while in inland provinces it seems to influence corporate income more. This suggests that the share of investment contributing to the productive capital stock in coastal areas is larger than in inland provinces. If this trend is continued, valuable resources are likely to be wasted.

If investment in the inland regions is indeed less productive than investment in the coastal regions, it is hard to justify the capital frontier constraint model. Since Guizhou is much further from the frontier than is Shanghai, investment in Guizhou, according to the model, should in the aggregate be more productive than investment in Shanghai. The IMF says it isn’t. Of course the social capital constraint model would have no problem with the IMF’s findings.

I leave it to my readers to decide which model they think is a better description of reality. One way of thinking about this is to consider why historically some countries that have “gone west” and invested in poorer regions were successful (the US in the 19th Century, for example) and some were not (Brazil in the 1950-80 period and the USSR in the 1930-1960 period, for example). One possible explanation may be that in the successful cases, higher investment followed increases in social capital, and in the unsuccessful ones they preceded them.

But whichever model one finds more congenial, I would insist that whenever anyone discusses the appropriate level of investment in China, he is implicitly using one model or the other to value investment. He should however do so explicitly, since the implications are so radically different.

The capital frontier constraint model says we should continue to increase investment in China as quickly as we can and we should especially direct this increase to the poorest and most backward parts of China. The social capital constraint model says we should slow overall investment growth as much as possible, especially in the poorer inland regions, because they result in a huge cost to China’s economic wealth – although the resulting losses are as of yet unrecognized because capital stock is not being written down to its “correct” value and losses are simply buried in the debt which is continuously rolled forward.

The social capital model also suggests that the most powerful way of increasing Chinese wealth in the next few years is to implement the political, economic, financial and social reforms needed to allow China to increase its ability to absorb and exploit its already too-high level of capital stock. These are the kinds of reforms Beijing may in fact be discussing.

Can convergence be imposed?

Before discussing Beijing’s attitude, I want to digress a little. One of my favorite sell-side analysts, albeit someone a lot more bullish than I am about medium term growth prospects for China, recently made a proposal that plays up the very big differences between the two models. According to an article in People’s Daily, there is indeed scope for rapid catch up among the poorest provinces:

China’s regional disparity could bring vast potential for economic growth, a top economist from Standard Chartered Bank said Wednesday. “In the next five years, China’s economy will maintain a growth rate of 7 to 8 percent thanks to the growth opportunities offered by the regional disparity,” said Stephen Green, Standard Chartered’s chief economist for China. China’s economic growth ticked down to 7.7 percent in the first quarter, falling short of market expectations and suggesting a tepid rebound for the economy.

Green said those worried about China’s economic slowdown are overreacting, as the differences in economic development between China’s regions could provide a strong engine for economic growth. Green used data acquired through the bank’s research to categorize Chinese cities into three tiers according to their GDP per capita. Beijing, Shanghai and Tianjin are first-tier cities, with an annual GDP per capita of nearly 80,000 yuan (about 12,903 U.S. dollars), he said.

He described second- and third-tier cities as those with an annual GDP per capita of 50,000 yuan and less than 30,000 yuan, respectively. Green said the research indicates that if second-tier cities reach first-tier GDP levels, the economy will maintain an annual growth rate of at least 7 percent for the next five years.

Green’s points are that there is a large difference between the richer and poorer provinces, and that the same set of policies that drove up income levels in the richer provinces can, presumably, be applied to the poorer provinces in the same way and for the same effect as their income levels converge with those of the richer provinces. This convergence alone will guarantee that China will grow by 7-8% for many more years.

Green may be right, but I think it is worth pointing out under what conditions he would be right and under what conditions he would be wrong. If the difference in wealth between the richer and poorer provinces is indeed caused mainly by the difference in capital stock per worker, and if otherwise there are no significant institutional differences between the two that prevent the poorer regions from catching up, then it is probably true that the policies that worked in the coastal regions can be successfully applied to the inland regions with much the same economic impact. Beijing can turn all of China into Guangdong and Zhejiang.

But if the poorer regions are poorer not because they lack investment but rather because they are institutionally more “backward” and so lack the ability to absorb investment efficiently, then it is not so clear that their income levels can converge with those of the richer regions within China except under conditions of significant social and political change. As an aside I am struck by the fact that the disparity between richer and poorer regions in China has existed in very much the same way for many centuries, and wonder if this isn’t due at least in part to dramatic differences in what I am calling social capital.

If social capital is indeed much lower in the poor regions than in the rich, then it isn’t at clear to me that we can expect much further convergence except at a huge cost to China’s economy overall. Resources, in other words, can simply be transferred wholesale from the rich to the poor regions, so that convergence is achieved not by speeding up growth in the poor areas but rather by reducing it in the rich. At any rate, depending on which model is correct, we will see over the next five years if there is indeed significant convergence and at what cost.

What does Beijing believe?

It is pretty obvious if you consider China’s track record and the statement of government officials that for many years Beijing has implicitly believed in the capital frontier model (although the kinds of reforms pushed in the 1980s by Deng Xiaoping, who seemed to understand intuitively the importance of institutional constraints, were more in the form of institutional reforms than increases in investment). Since the early 1990s the solution to every social or economic problem or crisis has been to increase investment, and in recent years there has been an especially strong push to increase investment in the poorer regions. In my November 7, 2012, piece for Foreign Policy I put it this way:

China’s spectacular growth over the past 30 years, like that of the USSR and Brazil before it, was made possible mainly by the ability of policymakers to control credit and unleash waves of investment when needed. This allowed Beijing to keep growth rates high regardless of the circumstances and no matter how the leadership managed domestic problems.

It was able to avoid a surge in unemployment when it restructured the hugely inefficient state-owned industries in the 1990s by sharply increasing infrastructure investment. Investment spending helped it smooth over the social dislocations caused by its rigid and antiquated political structure. It eased political conflicts and factional fighting by directing billions of dollars into pet projects, much of which the politically connected have since siphoned off. China grew vigorously through the Asian crisis of 1997, the Chinese banking crisis a few years later, and, the collapse of the global economy in 2007-08. In each case, unrestricted access to savings allowed China to power growth by pouring cash into the projects of its choice.

The only way to justify this astonishing increase in investment in the medium term is to argue that even though Chinese investment levels are extraordinarily high (comparing them not to the US or Japan but rather to other developing countries like Brazil, whose per capita income and worker productivity levels are low but still higher than those of China), they are so far from the optimal level determined by the capital frontier that China is always made richer in the aggregate because of the increase in investment.

But attitudes in Beijing may be changing. Consider Premier Li’s statements last week, which some people are claiming (a little prematurely, perhaps) represents a major shift in policy. According to an article in last week’s Xinhua:

China will allow the market to play a bigger role in economic innovation, Premier Li Keqiang said on Monday at a State Council meeting on the reform of government. As more power is delegated to lower levels, the government should shift its focus to three areas — improving the policy environment for development, providing high-quality public service, and upholding social fairness and justice, he said.

There should be a better balance between the government and the market, and between the government and society, the premier said during a videophone conference to launch a new round in transforming the functions of the cabinet and its branch agencies. The reform of government functions is a major effort to help the nation maintain growth, control inflation, reduce risks, and enjoy healthy and sustainable economic development.

According to the premier, the reform will minimize government approval needed to authorize general investment projects and general qualification certificates. It will contribute to fair competition in the market, and to corporate-level efforts to upgrade management and technology. It will ultimately expand employment opportunities, through speeding up the registration of industrial and commercial enterprises, and give more latitude to small and medium-sized enterprises and to service industries. It will also inject greater vitality to development initiatives at local level.

Li stressed that more effective administration should be in place on matters of deep public concern, including food safety alarms, the environment and work safety. Justice should be meted out in a timely manner when the law has been broken in such cases. More should be done to cut redundant capacity in industries that suffer such problems, he said.

The South China Morning Post has him adding “If there in an over-reliance on government-led and policy driven measures to stimulate growth, not only is this unsustainable, it would even create new problems and risks.” Li, in other words, is not suggesting that China should increase investment. On the contrary he wants to slow investment growth. He is instead implicitly suggesting that China should take steps to change the way in which it absorbs investment.

And it is not just Premier Li. The South China Morning Post has an article claiming that President Xi is also very much on board with the need to change the underlying growth model:

Chinese President Xi Jinping has taken charge of drawing up ambitious reform plans to revitalise the economy, sources close to the government said, shunning policy stimulus for fear it could worsen local government debt and inflate property prices. A consensus had been reached among top leaders that reforms would be the only way to put the world’s second-largest economy on a more sustainable footing, said the sources, who are familiar with the plans and Xi’s involvement.

China’s economic growth is at its weakest in 13 years, although still the envy of any major economy. Xi will present the reforms at a key meeting of the ruling Communist Party later this year that will set the agenda for the next decade, signalling his seriousness to see breakthroughs, the sources told Reuters. Some of the sources cautioned that the reforms could face resistance from vested interests, especially state firms.

Broadly, the measures would liberalise interest rates and overhaul the fiscal system for local governments to ensure they had a steady stream of tax revenues rather than relying on volatile land sales to raise funds. The reforms would also free up China’s rigid residence registration, or hukou, system that precludes people from access to basic welfare services outside their official residence area, the sources said.

Notice the direction of these polices. Rather than resolve the problem of slowing growth simply by increasing investment – which is what was always done in the past, and which would “work” again if the capital frontier model is the valid one from which to consider the impact of higher investment – Beijing seems to be going out of its way to preclude this way of dealing with slowing growth. Instead it will try to change other factors, factors that I would argue affect social capital by determining China’s ability to absorb existing investment levels.

The market seems to agree with this new approach. According to an article in Friday’s Xinhua:

Chinese shares jumped on Friday after the State Council announced fewer economic and investment activities would be subject to central authorities’ approval, extending the rally to three consecutive trading days.

A major change

I believe that in the past two to three years there has been a significant and welcome shift in Beijing’s attitude towards maintaining growth, and that this shift implicitly represents a shift from the capital frontier model of optimal investment levels to the social capital model. Keynes famously reminded us that “even the most practical man of affairs is usually in the thrall of the ideas of some long-dead economist,” and I would argue that in this sense models do matter. The economic model that we implicitly use to justify policy can result in hugely different policies with hugely different outcomes.

The surge in debt of the past few years has created tremendous concern, but I would argue that this concern would not be justified if investment levels in China were still too low. In that case any credit-fueled increase in investment would likely have resulted in a net improvement in China’s debt servicing capacity, in which case, with government debt at well below 25% of GDP, rising debt would not be a concern.

But if investment is being misallocated, if investment levels are higher than China’s ability to absorb and exploit capital stock, then it should not be surprising at all that debt capacity is becoming a problem. In fact, as I have argued for many years, this is simply an automatic consequence of additional investment in the investment-driven growth model. Debt, in this case, must be rising faster than debt servicing capacity, in which case Beijing’s true debt level is not the nominal debt level but rather the nominal debt level plus estimates of contingent liabilities likely to rise as a consequence of wasted investment.

Let me not overstate my case. The fact that China’s debt is rising much more quickly than China’s debt servicing capacity is consistent with my implicit model – which claims that the optimal amount of capital stock in China is a function of China’s relatively low level of social capital, and that Chinese investment has far exceeded its optimal level – but it doesn’t prove it. The fact that debt may be rising faster than debt servicing capacity is not necessarily inconsistent with the capital frontier model. After all, as the US amply proved in the 19th Century, even countries in which additional investment is economically justified can still run into debt problems and even crises.

Neither model has been proved. China may have too much capital stock, or it might not have enough, in which the current debt worries may simply reflect bubble conditions in the credit market. The policy implications of the two models, however, could not be more different.

If you believe that China can and should continue to increase investment until capital stock per capita approaches US or Japanese levels, then clearly China should continue to invest, and it should invest more in the poorer regions than in the richer ones. Everyone, even among the remaining China bulls, agrees now that Beijing must change some of its credit allocation conditions, but the old growth model will continue to be the right one according to the capital frontier model. There is no need to change the capital allocation process significantly and there is no need to liberalize interest rates.

What is more, according to this model, China’s very low consumption share of GDP mainly reflects the extraordinary growth in GDP. As high investment levels are maintained, it will simply be a question of time, and probably a short time at that, before the household income share of GDP, and with it the household consumption share, begins to surge. GDP growth can remain at 7-10% for at least another decade.

If you believe, however, that China’s very low level of social capital has long ago made its investment strategy obsolete, the consequences and implications are radically different. It suggests that China has overinvested beyond its capacity to utilize these investments economically, and so there are hidden losses on bank balance sheets created by the failure to write down physical capital to its true value. In this case Chinese growth cannot help but drop significantly as these losses are finally recognized and as investment levels are sharply curtailed.

What Beijing must do, in this case, is to ignore GDP growth rates and focus on household income growth rates, which anyway are what should really matter. Rather than continue to increase investment in manufacturing capacity, infrastructure, and real estate, Beijing should find ways to curtail investment growth sharply and to allocate what capital is invested to small and medium enterprises, to service industries, and to the agricultural sector, all of which are sectors whose growth at the expense of the current beneficiaries of high investment growth (SOEs, local and municipal governments, national champions, etc.) are likely to imply improvement in China’s social capital. Doing this will also require significant changes in the legal, social, financial and political institutions that constrain China’s ability to absorb capital efficiently.

What to do?

The real challenges for China, if you believe in the social capital constraint, are not about maintaining high rates of growth in the short term but rather of raising the levels of social capital in China. This is much more difficult and much more likely to be virulently opposed by the elites whose ability to constrain economic efficiency is precisely at the heart of their wealth – which consists of appropriating resources rather than creating resources – and of their power. It is, however, the only real way to sustain growth over the medium and long terms.

In fact, the social capital model suggests that the famous “middle income trap” might just be a social capital trap. Countries can force up economic growth rates (actual the growth rate of economic activity) simply by mobilizing savings and forcing up investment rates, but ultimately their inability to absorb continuously the higher levels of capital mean that they cannot push real wealth per capita beyond some fairly hard constraint represented by their institutional inability to absorb investment.

This hard constraint, in other words, is the “middle income trap”. Reforming social, political, financial and economic institutions in ways that raise social capital quickly would be, in this view, the only sure way to avoid the dreaded middle-income trap. The two sets of policy implications, as I see them, are the following:

The implications of the capital frontier constraint:

· Beijing should not abandon the investment-driven growth strategy, but it should adjust the credit allocation process to slow the growth in “bad” debt, which is a separate issue and not fundamental to the economy. The seemingly unsustainable rise in debt, in other words, is not a systemic problem reflecting a combination of the need to keep investment high with a systemic inability to invest productively. It is simply an accidental result of distorted incentive structures within the financial system and so can be administratively resolved.

· China’s economic growth rate might slow a little, but this is simply the consequence of China’s having gotten much closer to the capital frontier, in which case a lower return on investment should be accepted. Chinese growth will stay in the 7-10% region for many years.

The implications of the social capital constraint:

· China has invested far more than its ability to absorb the investment, which means that for many years GDP growth has been overstated and that this overstatement is hidden in the form of unrecognized bad debt. Rising bad debt is, in other words, a systemic problem and cannot be resolved within the current system. Beijing must constrain investment growth sharply, redirect a much lower level of investment into areas that improve social capital (SMEs, agriculture, services), and engage in significant social, political, economic and financial reforms to force up China’s ability to absorb additional investment.

· Not only will China’s real GDP growth drop as China shifts towards a different growth engine, but it will drop even more as China is forced to recognize the hidden losses buried in its debt levels.

Before closing, I want to mention a seminal 2002 paper by Daron Acemoglu and James Robinson (“Economic Backwardness in Political Perspective”). The paper is important not just because of its explanation of development but also because of its attempt to understand the political implications of technological and institutional changes that promote development. The authors conclude:

In this paper, we constructed a simple model where political elites may block technological and institutional development, because of a “political replacement eect”. Innovations often erode political elites’ incumbency advantage, increasing the likelihood that they will be replaced. Fearing replacement, political elites are unwilling to initiate economic and institutional change. We show that elites are unlikely to block developments when there is a high degree of political competition, or when they are highly entrenched. It is only when political competition is limited and also the elites’ power is threatened that they will block development. We also show that such blocking is more likely to arise when political stakes are higher, and in the absence of external threats.

This is an abbreviated version of the newsletter that went out three weeks ago. Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at, stating your affiliation, please. Investors who want to buy a subscription should write to me, also at that address.

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迈克尔•佩蒂斯是卡内基国际和平基金会的高级研究员、北大光华管理学院的金融教授,专注中国金融市场。迈克尔•佩蒂斯教授还分别于2002年至2004年在清华大学经济管理学院、1992年至2001年在哥伦比亚大学商务研究所授课。迈克尔•佩蒂斯自1987年起开始在华尔街工作,他当时受雇于汉华银行(现合并为摩根大通银行)的政府债务项目,工作领域涉及贸易、资本市场以及公司财务。从1996年至2001年,迈克尔•佩蒂斯在贝尔斯登公司任拉丁美洲资本市场及债务管理组的主管。他还是一家经营商业银行业务的事务所的合伙人,该事务所主要经营将拉丁美洲的资产证券化的业务。另外,他还受雇于瑞士信贷第一波士顿公司(CSFB),负责领导新兴市场贸易团队。Michael Pettis is a Senior Associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management, where he specializes in Chinese financial markets. He runs a blog Michale Pettis’ China Financial Markets (
How much investment is optimal?
财经网网友:  ive segment of the population has risen to 70%.Government must insure that all levels of society can provde for their own welfare through individual effort and responsibility, and not by taxing and transferingwelfare benefits. The latter approach begins the process of social decay.
How much investment is optimal?
财经网网友:  Very interesting article. The social capital problem emerging in the USA is the rising level of social benefits--primarily transfer payments--eroding the personal responsibility of an increasing portion of the public, and diverting an increasing portion of the economy to non-productive use. The USA Federal expenditures have risen to 24% from 18% of GNP in a decade, and the portion of that budget represented by transfer payments, funded by taxes on the product
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