Friday, December 08, 2006

The Issue of Over- And Malinvestment in China

China have for the last quarter century or so been the world's most successfull economy, with average annual growth of about 10% per year. As a result its economic might have increased.

The main driving force behind the high growth rate is the high investment rate, which in turn is driven by its high savings rate which in turn is a result of China's lack of a welfare state.

Frequently though, the issue is raised if not the Chinese investment boom is a false boom, an "Austrian"-style credit-driven over/malinvestments boom that is going to end in a bust.

The answer is that while there are indeed quite a lot of malinvestments in China, that does not mean that there will an economy-wide bust.

While the Chinese save quite a lot, their financial markets are still relatively underdeveloped, which is why large Chinese firms usually are listed in Hong Kong rather than Shanghai or Shenzen. That also means that all of this savings go through the banking system. And with China of course having fractional reserve banking, this will fuel significant monetary inflation. Moreover, much of the loans are often issued to people connected to local government officials with investment projects of questionable value.

This means that a significant portion of investments in China is really malinvestments. Moreover, a lot of savings is also squandered through in the build-up of massive foreign exchange reserves to keep the yuan from rising faster. As significant yuan appreciation is really inevitable, much of this will be lost in exchange rate losses.

But this will only mean that growth in China while being high on a absolute level will be lower than it could have been had its financial institutions been sounder. Or in other words that aggregate statistics hide a combination of increased production due to sound investments and malinvestments that will be dead ends.

But for an aggregate bust to occurr, we must have monetary growth well in excess of what is sustainable. Which is what would be required for People's Bank of China to significantly rein in credit growth.

Yet while money- and credit growth seem high on an absolute level, they are not really that high relative to China's super-high structural growth rate. As The Economist recently pointed out, credit growth in China is not that much higher than nominal income growth. And asset prices have in fact increased slower than income growth.

That means that that there is only a limited potential of the kind of acceleration in consumer price inflation that would force the central bank to the kind of dramatic tightening of monetary policy that could trigger a recession. And in sharp contrast to the South East Asian economies before the Asia crisis in 1997-98, China have a large current account surplus and is therefore not dependent on foreign credit whose nominal value could swell if the domestic currency collapses.

Thus, I am not worried about China suffering the fate of Thailand, Indonesia, Malaysia and South Korea in 1997. While the Chinese banking system generates quite a lot of malinvestments, there are enough sound investments to sustain continued high growth.


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