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December 4, 2012

China's Addiction to Growth by Investment

By Ian Fraser via QFinance

Just in case the two men who were recently installed as China’s leader-in-waiting – premier-designate Li Keqiang and Communist Party of China chief and president-designate Xi Jinping – are short of advice about how best to steer the Chinese economy over the next few years, they have just received some from the International Monetary Fund.

In a working paper entitled Is China Over Investing and Does It Matter? authors Il Houng Lee, Murtaza Syed and Liu Xueyan said China's leaders-in-waiting must wean themselves off investment-led growth, as well as do more to promote domestic consumption. The IMF report said continued over-dependence on investment risked destabilizing the economy, and said the country needs to cut domestic investment by 10% of GDP if it is to correct its course. If the leadership fails to act, the authors warned that "vulnerabilities will continue to build."

Investment in the Chinese economy surged between 2007 and 2011 as the country sought to resist the effects of the global financial crisis, the IMF paper said. However, elevated investment rates risk distorting capital markets and other parts of the economy. In China, large state-owned enterprises have been benefiting from ready access to cheap capital, while smaller firms and households have been capital-starved.

"Depending on precise assumptions, over this period [2007-11], China may have been over-investing by between 12 and 20% of gross domestic product relative to its steady-state desirable value,” said the IMF working paper.

"Even allowing for elevated investment levels associated with most economic take-offs, the econometric evidence suggests that China is over-investing."

The IMF, which cautioned that the research paper does not necessarily reflect the organization's policies, added:

“The challenge is how to return to a more 'normal' level of investment without compromising growth and macroeconomic stability ... Going forward, the challenge is to engineer a gradual reduction in investment to a path that would maximize social welfare."

A Reuters report said China is officially targeting 7.5 per cent growth for 2012, marginally down from the unofficial rate of 8 per cent targeted by Beijing in earlier years – a level traditionally seen as essential if enough jobs are to be created for the country's 1.3 billion population and civil unrest averted.

The 468-page China 2030 report published in February – dubbed “extraordinary” by China watcher Stephen Roach – recommended limiting the power of state-owned companies. The report, authored by the the IMF's sister body the World Bank and the Development Research Center, a think-tank under the Chinese cabinet,also said that China was capable of maintaining economic growth of 6-7% a year until 2030 as long as it had the right mix of structural economic reforms.

The IMF report said that, according to the Fund’s calculations, a sustained period of over-investment meant that China was at risk of having to run to stand still, with ever higher levels of investment generating the same amount of growth. The authors forecast that investment's share of GDP would have to balloon to 60-70%, up from current levels around 50%, unless the country changed its model. The cost of funding that level of support could prove crippling for China.

The IMF paper stressed that reforms should focus on improving productivity, efficiency and the welfare of the Chinese people. Per capita income remains stubbornly low, at 21,810 yuan (about £2180) for city dwellers and 6977 yuan (about £700) in rural areas.

Writing for Project Syndicate, Roach, a former chairman of Morgan Stanley Asia, said he was confident that the country's new generation of leaders are up to the task of reconfiguring China's economy.

“Since the days of Deng, China has had an uncanny ability to rise to the occasion and meet its challenges head on. The new generation of leaders has the right skills and experience for the task. Western biases notwithstanding, we will know soon enough if they can translate strategy into action."

Courtesy Ian Fraser via QFINANCE (EconMatters author archive here

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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