MBA alum Aaron Butler asked about over-investment in China. Certainly investment rates over 40% of GDP are unusually high, but does China have too much capital? Those of us who follow China would summarize the situation somewhat differently:
- Quantity of capital. We typically measure capital intensity with the capital-output ratio: the ratio of the quantity of capital to GDP. By that measure, China isn’t much different from the US. See, for example, slides 32-33 here or slide 18 here. If that seems inconsistent with such high investment rates, remember: the denominator (GDP) is growing really fast.
- Quality of capital. If the quantity of capital seems fine, there is growing evidence that it’s poorly allocated. Some projects seem to have too much capital (think: infrastructure, empty new cities in the countryside, state-owned companies) and some too little (private firms, for the most part).
- Official banking. The institution behind this misallocation of capital is, for the most part, the official bank sector. By regulation and tradition, it pays low interest rates on deposits and offers attractive terms to officially-sanctioned borrowers.
- Shadow banking. As we saw in the US, when Regulation Q kept interest rates on bank deposits low, investors can move their money elsewhere. In China there’s been enormous growth in unofficial or “shadow banking.” Some of this is informal, some through official banks selling novel “wealth management products.” Ad hoc systems like this are both a way around unproductive regulation and an opportunity for fraud, so it will take some time for this to develop into a well-functioning financial system.
The bottom line here is that China, despite its unparalleled economic growth, faces clear challenges in building an effective financial system. The ability of the Chinese people to work their way around an incredibly cumbersome system of regulation is surely a sign that change is coming.
Update (Feb 27): More about shadow banking in the FT.