Is China Over-Investing and Does it Matter?

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1 WP/12/277 Is China Over-Invesing and Does i Maer? Il Houng Lee, Muraza Syed, and Liu Xueyan

2 2012 Inernaional Moneary Fund WP/12/277 IMF Working Paper Asia and Pacific Deparmen Is China Over-Invesing and Does i Maer? Prepared by Il Houng Lee, Muraza Syed, and Liu Xueyan 1 Auhorized for disribuion by auhorized by Il Houng Lee November 2012 This Working Paper should no be repored as represening he views of he IMF. The views expressed in his Working Paper are hose of he auhor(s) and do no necessarily represen hose of he IMF or IMF policy. Working Papers describe research in progress by he auhor(s) and are published o elici commens and o furher debae. Absrac Now close o 50 percen of GDP, his paper assesses he appropriaeness of China s curren invesmen levels. I finds ha China s capial-o-oupu raio is wihin he range of oher emerging markes, bu is economic growh raes sand ou, parly due o a surge in invesmen over he las decade. Moreover, is invesmen is significanly higher han suggesed by cross-counry panel esimaion. This deviaion has been accumulaing over he las decade, and a nearly 10 percen of GDP is now larger and more persisen han experienced by oher Asian economies leading up o he Asian crisis. However, because is invesmen is predominanly financed by domesic savings, a crisis appears unlikely when assessed agains dependency on exernal funding. Bu his does no mean ha he cos is absen. Raher, i is disribued o oher secors of he economy hrough a hidden ransfer of resources, esimaed a an average of 4 percen of GDP per year. JEL Classificaion Numbers: E22, D60, D91, G21 Keywords: China, Invesmen, Social Welfare, Ineremporal Consumer Choice, Banks Auhor s Address: 1 Messrs. Lee and Syed are, respecively, he Senior and Depuy Residen Represenaive in he IMF s China office. Ms. Liu is a Senior Fellow in he Insiue of Economic Research a he Naional Developmen and Reform Commission (NDRC) of China. The views expressed in his paper do no necessarily reflec hose of he IMF or he NDRC. We would like o hank Seve Barne, Malhar Nabar, Papa N Diaye, Sun Xuegong, as well as seminar paricipans a he NDRC for heir very useful commens and suggesions.

3 2 Conens Page I. Inroducion...3 II. Invesmen in China: Lieraure Review...4 III. Neoclassical Model Approach...5 IV. A Theoreical Framework of Opimal Invesmen...7 V. Wha Can Aggregae Cross-Counry Daa Tell Us?...9 VI. Esimaing he Hidden Coss of China s Invesmen...14 VII. Conclusion...16 Daa Appendix...18 References...20

4 3 I. INTRODUCTION 1. In non-resource rich counries, mos economic ake offs are srongly associaed wih high levels of invesmen. Asia, in paricular, is a ypical example of how high invesmen has faciliaed rapid economic growh. 2 Invesmen alone, of course, does no explain he growh sory. Toal facor produciviy (TFP), labor supply, and savings from he neoclassical sense, while marke access and efficien financial inermediaion from a macro aspec, all play imporan roles. Moreover, in Asia s case, economies have also benefied from expors. Even during periods when invesmen has been below is long-erm rend, Asian economies have enjoyed rapid growh hrough access o expanding global markes, noably during mos of he 1970s when he newly indusrialized economies (NIEs) were aking off. 2. However, high invesmen has also Figure 1. Gross Capial Formaion, in percen GDP 50 proven o be cosly. Alhough Asian counries usually have a high savings rae, several counries 40 resored o foreign financing o mainain even higher invesmen raios. While such a sraegy 30 enabled hem o achieve a faser growh pah for some ime, i ypically evenually led o banking or 20 foreign exchange crisis, from which i ook hem Indonesia (1970) China (1978) Thailand (1965) Korea (1963) Malaysia (1974) several years o recover (Figure 1). This is because 10 he cos of financing such high raes of invesmen was ofen mispriced, only o be correced abruply. In emerging economies, mispricing ofen involved currency and mauriy mismaches, whose risk was obscured by implici guaranees or lack of informaion. In oher words, an arifically low cos of financing suppors excessive invesmen, including in propery and manufacuring secors, ha evenually resul in a crisis. Such a paern was also observed in oher emerging markes ouside Asia, such as in Lain America during he 1980s This paper compares China s curren invesmen level agains comparaor economies. We find ha China s capial-o-oupu raio is wihin he range of oher emerging markes, bu is pace of growh sands ou from he res, parly due o a surge in invesmen over he las decade. Moreover, when measured agains a norm esimaed from a crosscounry panel, is invesmen is oo high. While a crisis appears unlikely when assessed agains dependency on exernal funding, i raises concerns abou he underlying domesic srain associaed wih financing such a high level of invesmen, which appears o be implicily borne by households. In doing so, our paper also conribues o he lieraure by 2 During , he correlaion beween a 5 year moving average invesmen o GDP raio and economic growh was around 0.83 in developing Asia. The correlaion is somewha weaker a 0.74 for advanced economies, he G7, for example.

5 4 harnessing he insighs, sparse assumpions and increased degrees of freedom ha come from using an up-o-dae panel of comparaor economies, wih boh he counry and ime coverage carefully seleced o mach China s economic feaures and phase of developmen. 4. The res of his paper is srucured as follows. In Secion II, a shor review of curren lieraure is provided. Secion III moivaes he analysis by using he neoclassical model approach o compare China s invesmen agains a group of oher emerging marke economies. A simple welfare maximizaion model is inroduced in Secion IV o illusrae ha assessing he appropriaeness of he level of invesmen requires a more comprehensive approach han he neoclassical indicaors. Thus in Secion V, as a pracical soluion o he complexiy of he issue, we use a panel esimaion o derive an invesmen norm based on fundamenals across counries. In Secion VI, he implic cos of supporing China s high invesmen level is esimaed and secion VII concludes. II. INVESTMENT IN CHINA: LITERATURE REVIEW 5. Resuls of recen sudies a he macro level on he quesion of wheher China over-invess have been largely inconclusive. On he one hand, Bai and ohers (2006) argue ha while he reurn o capial did fall during he 1990s, i remains relaively high, suggesing ha invesmen has no been excessive. Lu and ohers (2008) draw similar conclusions from heir finding ha afer falling in he 1990s, corporae profiabiliy has been rising. Dong and ohers (2006) are more nuanced, reporing ha he marginal produc of capial has been relaively high in he las wo decades bu cauioning ha China is on a dynamically inefficien growh pah. In paricular, hey find ha he rae of invesmen has consisenly exceeded he share of capial income in GDP since he early 1990s, suggesing ha invesmen is oo high and ha social welfare could be improved by increasing consumpion a he expense of invesmen. In a similar vein, Rawski (2002) finds low invesmen reurns and widespread excess capaciy across many secors during he 1990s. Meanwhile, Barne and Brooks (2006) repor a rise in he capial-o-oupu raio and fall in he marginal produc of capial during , and Qin and Song (2009) find evidence of pervasive overinvesmen based on heir calculaion of he profi-maximizing level of capial spending using a producion-funcion approach. 6. Microeconomic sudies have ended o find greaer suppor for misallocaion of invesmen. Using daa on 10,000 firms during , Ding and ohers (2010) calculae measures of invesmen efficiency and find evidence for over-invesmen for all ypes of companies, even in he more efficien and profiable privae secor. More generally, saeowned enerprises (SOEs) end o be consisenly implicaed in he lieraure, wih Liu and Siu (2006) finding hem guily of over-invesmen because heir implied cos of capial is arificially low. Similarly, using a sample of 12,000 firms in 120 ciies during , Dollar and Wei (2007) repor ha even hough SOEs have lower marginal reurns o capial han privae or foreign firms, China s banking sysem coninues o be biased oward hem in erms of capial allocaion. If his bias were redressed, hey conend ha China s invesmen

6 5 rae could fall by as much as 8 percenage poins wihou any adverse effec on economic growh. Meanwhile, Hsieh and Klenow (2009) argue ha if capial and labor in China were reallocaed o equalize marginal producs o he exen observed in he Unied Saes, manufacuring TFP would rise by percen. Finally, Geng and N Diaye (2012) argue ha invesmen is arificially propped up in China by low ineres raes and an undervalued currency. 7. Much of he lieraure imposes a number of srong assumpions and few papers compare China s invesmen o ha in he res of he world. A variey of approaches aking o accoun for he plehora of poenial facors ha may be a play in deermining invesmen rends in China. These facors include China s low iniial capial endowmen, is level of developmen, and favorable reurns o capial. However, mos of his work is based on calculaions of invesmen efficiency ha are assumpion-based and prone o measuremen error. In addiion, many have adoped an indigenous approach focusing on China alone, wih fewer aemps o use cross-counry daa o compare is invesmen rends agains hose of oher economies. Oher common limiaions include relaively unrepresenaive samples, shor ime periods, and he relaive pauciy of sudies covering he pos-2005 furher surge in invesmen. III. NEOCLASSICAL MODEL APPROACH 8. Relaive o he Golden Rule, China is currenly over-invesing. 3 As a firs proxy o assess wheher invesmen is oo high or low, i is insrucive o compare he invesmen and capialoupu raios in an economy wih esimaes of heir long-run equilibrium (seady-sae) levels. According o he Golden Rule, such a level of invesmen is defined as i* = k*(g +d)/(1 + g), where (i*) is he seady-sae level of invesmen based on esimaes of a seady-sae capial-ooupu raio (k*), he depreciaion rae (d), and he rae of poenial oupu growh (g). On his basis, China was under invesing in he 1970s and o a lesser exen in he 1980s (Figure 2). China s invesmen has since picked up, especially afer By 2005, China s capial-ooupu raio was close o is long-run level so ha is invesmen o GDP raio should heoreically have ended o fall back owards is seady-sae value. However, during , o couner he adverse effec from he global crisis, China raised is invesmen furher. Depending on precise assumpions, over his period, China may have been over-invesing by beween 12 and 20 percen of GDP relaive o is seady-sae desirable value. 3 See Appendix for deails. Figure 2. Capial- and Invesmen-o-Oupu Raio (Emerging economies, relaive o seady-sae level in ) Oher economies China (2000-5) China (1990-5) China (1980-5) China (1970-5) Overinvesmen Underinvesmen Invesmen-o-oupu raio Capial-o-oupu raio Sources: Penn World Tables; IMF, WEO daabase; and saff calculaions.

7 6 9. There are, of course, a number of limiaions wih his approach in assessing he appropriaeness of he level of invesmen. In paricular, he esimaes do no capure srucural changes such as a shif away from capial-inensive growh or in he efficiency of invesmen over ime. Indeed, here is no a priori reason o presume ha an economy growing faser in order o cach up wih advanced economies should have a lower capial-o-oupu raio, i.e., below is long-run level, or ha is invesmen rae should be above is long-run level, as i will depend on several oher facors, noably TFP. 10. On some simple merics, China s invesmen efficiency is sill broadly in line wih oher emerging economies. As shown in Figures 3a and b, China has moved up in he capial-o-oupu raio relaive o oher emerging markes over he wo decades. However, i is sill broadly wihin he average cross-counry range. Wha sands ou is China s growh, showing ha is achievemen over his period has been unique. Figure 3a. Growh and Capial-o-Oupu Raio (Emerging economies, ) Figure 3b. Growh and Invesmen-o-Oupu Raio (Emerging economies, ) Capial-o-oupu raio Chi na Invesmen-o-oupu raio Chi na Real GDP Growh Sources: Penn World Tables; IMF, WEO daabase; and saff calculaions Real GDP Growh Sources: Penn World Tables; IMF, WEO daabase; and saff calculaions. 11. However, China s srong performance comes a a price. While in he 1990s, China was more or less wihin he bounds winessed among emerging markes worldwide in erms of he relaionship beween invesmen raes and capial-o-oupu raios (Figures 4a and b), i has since graviaed o an exreme oulier posiion ha is suggesive of poenial overinvesmen. China now requires ever higher invesmen o generae he same amoun of growh. Unless here is a surge in TFP and wih expor performance expeced o remain subdued over he medium erm (given boh sluggish demand overseas and diminishing opporuniies for dramaic gains in China s marke share), he conribuion of invesmen o growh will need o reach percen o suppor he same amoun of growh (Figures 5a and b). Under such a sraegy, vulnerabiliies will likely grow in he form of hidden deadweigh ha will have o be paid in fuure in one form or anoher. The cos of financing such an elevaed level of invesmen could undermine overall economic sabiliy, a poin ha is furher elaboraed in Secion VI.

8 7 Figure 4a. Capial- and Invesmen-o-Oupu Raio (Emerging economies, ) 3.5 Figure 4b. Capial- and Invesmen-o-Oupu Raio (Emerging economies, ) Capial-o-oupu raio Chi na Capial-o-oupu raio Chi na Invesmen-o-oupu raio Sources: Penn World Tables; IMF, WEO daabase; and saff calculaions Invesmen-o-oupu raio Sources: Penn World Tables; IMF, WEO daabase; and saff calculaions Figure 5a. Conribuion of Invesmen o GDP growh ICOR Capial formaion conribuion o growh (RHS) Figure 5b. Conribuion o Growh (in percen of oal) Final Consumpion Expendiure Gross Capial Formaion Ne Expors Moreover, consumpion has declined o abou 40 percen of GDP parly due o he falling household income as share of GDP. In fac, household income rose very rapidly excep relaive o overall GDP growh. The laer, as discussed above, was pulled up by an increasing conribuion from invesmen. To he exen ha growh is o improve he qualiy of living sandard by providing more value added o households, a falling consumpion share raises quesions abou he very purpose of he curren invesmen-led growh model. IV. A THEORETICAL FRAMEWORK OF OPTIMAL INVESTMENT 13. The benefi of a rapid growh from higher invesmen is realized economy-wide only if i maximizes social welfare. A ypical model of welfare opimizaion is abou ineremporal opimizaion of consumpion. Under his approach, invesmen is an endogenous oucome of iner-emporal consumpion preference, which in urn is influenced by he facors specified in he model such as he rae of depreciaion, marginal produc of capial, and he cos of capial. Thus, i would be difficul o assess he appropriaeness of he size of invesmen simply by comparing he marginal produc of capial. Oher variables also maer.

9 8 14. To illusrae, a welfare opimizaion model can be generalized as: 4 W 0 i u( c, l, n ) (1) where c is consumpion, l is financial asses, and n is labor (as agains leisure). Wihou losing generaliy, his can be parameerized as: E i0 1 i c i n i l i 1 (2) σ, ρ, γ, and η are all [0, 1]. Wih a ypical budge consrain of: y k (1 i ) l 1 1 ( 1 ) 1 (1 ) c k l (3) where k is capial sock, i is ineres rae, π is inflaion, and δ is depreciaion, he firs-order condiion hen is a quesion of a choice beween consumpion oday versus omorrow. Using a simple producion funcion, he choice can be expressed as (where f k is he marginal produc of capial): c ( f k 1 Ec (1 )) 1 (4) 15. A preference shif oward fuure Figure 6. Producion Funcion consumpion implies more invesmen and less consumpion oday (Figure 6). However, assuming he usual concaviy of he marginal produc of capial curve, an increase in invesmen normally leads o lower marginal produc of capial. From (4), a he equilibrium, he slope of he marginal produc of capial will be equal o cos of capial (i.e., he real ineres rae adjused by oher variables including he relaive amoun beween consumpion and financial asses and he rae of depreciaion). Thus, for he firs-order condiion o hold, a lower real ineres rae is associaed wih a lower marginal produc of capial, and, higher invesmen. 4 From L. Han and I. H. Lee (2012), which in urn was adaped from Walsh (2003).

10 9 16. Cross counry differences in capial produciviy could also be due o he availabiliy of oher facors of producion. A large number of new enries ino he labor marke, for example, would shif he producion curve upwards as shown above as B. Anoher imporan facor o invesmen decisions is he cos of financing, which in our model above is he real ineres rae r. Ceeris paribus, higher savings would reduce he real ineres rae (as in he Solow growh model), which in urn would imply higher invesmen and a lower marginal produc of capial. Moreover, a firm wih cos advanage will be able o enjoy emporary profi unil new enries push ou indusry supply. However, if demand also coninues o increase due o new marke discoveries, hen he firms will coninue o make profi, aracing increasingly more enries. The expanding size of he marke will mos likely also ensure ha firms produce a he lowes poin in heir long erm average cos. During he marke expansion period, invesmen will also be high reflecing new enries. Thus, srong expor will likely be accompanied by growing invesmen, and faser overall economic growh. V. WHAT CAN AGGREGATE CROSS-COUNTRY DATA TELL US? 17. Under a welfare maximizing sae, iner emporal consumpion preference will deermine he level of consumpion. However, he relaive ime preference is no direcly observable. An indirec way of measuring such iner-emporal preference would be o assume ha he average level of consumpion, or invesmen, of a relaively large sample of counries approximaes such a preference. Then, an opimal invesmen level, or a norm, could be defined as he level ha would maximize social or household welfare. Based on Secion IV, such a level of invesmen will be deermined by economic fundamenals including he real ineres rae, and he depreciaion rae and can be esimaed from regressions linking crosscounry invesmen raes over ime o a se of fundamenals. 18. We ran dynamic panel daa models for 36 economies over he period The panel was unbalanced, wih one innovaion being ha he saring period for each economy was calibraed o capure is economic ake-off (and associaed elevaed levels of invesmen). This ensures ha our invesmen norm is no biased downwards and in fac represens a higher bar han usual for deecing any poenial over-invesmen. The sample consiss of emerging marke economies, as well as Japan and Taiwan Province of China. Around one-hird of he sample is made up of Asian economies. Our empirical sraegy allows for changes in preferences over ime, bu imposes a normal preference for ineremporal consumpion across emerging markes relaive o fundamenals. By carefully calibraing his around ake-off periods and including China s Asian peers ha have also ended o rely heavily on invesmen, his average is likely o be adequaely represenaive. 19. The models relae invesmen-o-gdp in counry x a ime o a hos of explanaory variables moivaed by our heoreical model. These include he lagged dependen variable; savings-o-gdp and credi-o-gdp measures o capure he availabiliy of financing; real lending raes o capure he cos of capial; expors-o-gdp o capure he

11 10 poenial exernal conribuions o invesmen; real growh raes as a proxy for he reurn o capial; he level of real GDP o capure he level of economic developmen; age dependency raios o capure he poenial impac of demographics; and macroeconomic uncerainy capured by he sandard deviaion of hree-year rolling windows of real GDP growh and reserves-o-gdp o measure he need for counries o save in order o couner volaile capial flows. These variables are all grounded in our underlying model (as well as ohers developed in he lieraure), such ha he esimaion is beer hough of being srucural in naure, and no reduced-form. 20. The models are esimaed in firs-differences (o conrol for fixed effecs) using GMM o accoun for he presence of he lagged dependen variable (which renders OLS fixed-effecs inconsisen), measuremen error and poenial endogeneiy of he regressors (by using heir lagged values as insrumens). 5 The esimaion also includes ime dummies, covering boh he Asian crisis and he laes global financial crisis. Provided here is no higher-order serial correlaion in he residuals and he insrumens are valid, his approach should yield unbiased and consisen parameer esimaes. Boh hese condiions are esed using sandard ess. 21. The esimaed invesmen equaions fi he acual daa well for mos economies and sugges he following (wih column 5 of Table 1 being he preferred specificaion): 5 See Appendix for deails.

12 11 Table 1. Invesmen Equaions 1/ 2/ (1) (2) (3) (4) (5) (6) Lagged dependen variable 0.652** 0.628** 0.630** 0.615** 0.652** 0.664** (0.07) (0.06) (0.07) (0.06) (0.08) (0.07) Real per capia GDP growh 0.372** 0.339** 0.350** 0.329** 0.364** 0.390** (0.05) (0.04) (0.04) (0.05) (0.05) (0.53) Growh in credi (annual percen of GDP) 0.033** 0.030** 0.023* 0.032* 0.031* (0.01) (0.01) (0.01) (0.02) (0.02) Real per capia GDP (US$) * * * * (0.00) (0.00) (0.00) (0.00) Age dependency raio 3/ * * * ** (0.35) (0.39) (0.36) (0.36) Uncerainy 4/ ** ** ** (0.09) (0.07) (0.06) Real ineres rae ** ** (0.02) (0.02) Expors-o-GDP (0.04) p-value of specificaion ess m2 es (no second-order serial correlaion in residuals) Hansen es (insrumen validiy) Number of economies Number of observaions Time period Source: WEO, WDI, and Fund saff calculaions. 1/ Dependen variable is invesmen-o-gdp raio. Firs-differenced GMM specificaions, wih year dummies. Insrumens are lagged values of regressors. 2/ Robus -saisics in parenheses, wih * indicaing significance a 10 percen and ** a 5 percen level. 3/ Populaion over 65 o populaion aged / Sandard deviaion of hree-year rolling window of real GDP growh. Invesmen ends o be persisen. The lagged dependen variable is large and highly significan, indicaing a significan degree of ineria in aggregae levels of invesmen. Sronger oupu growh leads o higher invesmen. Including expors o his specificaion does no lead o a significan coefficien (column 6), suggesing ha he primary roue hrough which globalizaion affecs invesmen is by leading o sronger overall economic growh and hence raising reurns o capial. An increase in he cos of capial lowers invesmen. Higher real ineres raes reduce invesmen, as expeced. Increased availabiliy of credi is associaed wih higher invesmen. We ried using boh change in credi and savings-o-gdp as he relevan measure, and found he former o render he laer insignifican.

13 12 As economies develop, hey ypically need higher invesmen. To capure poenial non-lineariies and hresholds beyond which his posiive relaionship no longer holds, we also included a squared per capia GDP erm. However, his was no significan, suggesing ha he economies in our sample are on average sill aking-off. This is no surprising since he majoriy remain in he middle-income caegory. Macroeconomic uncerainy leads o lower invesmen. Condiioning for he sandard deviaion of hree-year rolling windows of GDP growh, our alernaive proxy variable of changes in reserves was no significan. This suggess ha higher uncerainy does lead o lower invesmen bu ha his effec is beer capured by he volailiy of growh raher han he accumulaion of reserves (which, afer all, may be driven by oher consideraions besides precauionary moives). Aging of he populaion reduces invesmen, possibly as his leads o slower growh and hus reduces he reurns o invesmen. Invesmen will consequenly fall in he absence of echnological progress and oher srucural changes ha raise labor produciviy. Our resuls sugges ha his effec dominaes any shor-run increase in invesmen as firms inves more o subsiue capial for labor as a means of coping wih a growing shorage of workers Using hese parameer esimaes, invesmen in China may currenly be around 10 percen of GDP higher han suggesed by fundamenals (Figure 7). Even allowing for elevaed invesmen levels associaed wih mos economic ake-offs, he economeric evidence suggess ha China is over-invesing. China s prediced invesmen norm over he las hiry years has ranged beween percen of GDP. In realiy, i has flucuaed in a much broader band of percen of GDP. The model consisenly predics a lower norm for China, bu unil 2000, he deviaions were usually no ha significan and ypically closed over a 5-year ime horizon Figure 7. China: Invesmen-o-GDP (Acual and prediced) Acual Prediced norm The relaive magniude of impac is, of course, smaller han he size of he esimaed coefficiens because of he differen scales of he explanaory variables. Wih esimaion in firs-differences, he annual change in he demographic variable is very small. As a resul, he acual impac of he oher variables on invesmen is significanly larger. For example, excluding he demographic variable from he specificaion only increases he prediced level of invesmen in China by 1 percen of GDP in 2009.

14 13 Table 2. Probi: Probabiliy of crisis (1) (2) Real ineres rae ** ** (0.003) (0.003) Real per capia GDP growh ** ** (0.011) (0.011) Growh in credi (annual percen of GDP) (0.003) (0.003) Curren accoun (percen of GDP) ** ** (0.008) (0.008) Over-invesmen (percen of GDP) 0.031** (0.013) Number of economies Number of observaions Time period Source: WEO, WDI, and Fund saff calculaions. 23. Using a probi model, we find ha our error erm is posiively associaed wih he probabiliy of a crisis (Table 2). We use he error erms of he above regression as a measure of over-invesmen, as well as a number of oher variables previously considered o have explanaory power for predicing economic crises. Crises are daed in our sample according o he year when hey occurred, based on he daing of banking crises by Reinhar and Rogoff (2008). On average, oher hings being equal, over-invesmen by 1 percen of GDP as measured in our crosscounry regression leads o a 0.03 percenage poin increase in he probabiliy of an economy encounering a crisis. 24. The curren deviaion is he larges ever and has been accumulaing over he las decade. While he furher widening of he deviaion since 2009 could be regarded as emporary due o he 2009 simulus package, he divergence sared before hen, and is also larger and persisen han he implied over-invesmen in oher Asian economies leading up o he Asian crisis or in Japan in 1980 before he onse of is los decade (Table 3). Boh hese episodes were followed by proraced growh and invesmen declines. Credi growh (paricularly pos-crisis) and he cos of capial in China in recen years also appear o be in dangerous erriory compared o hese oher counry experiences. Mechanically applying he coefficien esimaes from our probi model o China s esimaed over-invesmen, he probabiliy of a crisis would rise from 8 percen in 2005 o around 20 percen oday. These numbers are only indicaive however. No only is here he usual uncerainy around our parameer esimaes bu, as discussed below, he naure of China s invesmen model is very differen from ha of oher emerging markes and ends o reduce he probabiliy of a crisis relaive o he average counry in our sample. Table 3. Evoluion of variables in he lead-up o crisis (5-years) i-i* i-i* (average) (cumulaive) Number of years i>i* Credi/GDP (annual percen change Real cos of capial (annual average) Real GDP per capia (annual percen change) Indonesia Japan Malaysia Philippines Thailand China (2005-9)

15 However, he rigger of a crisis, if ever, in China will likely be differen from oher counries. Wha disinguishes China from he res is is self-reliance on he resources of invesmen. In large par, his is due o is high savings (Figure 8). However, various sudies indicae ha savings are arbirarily high because of remaining conrols in he financial secor ha de faco enail a subsidy ransfer from households and SMEs o large corporaes. Whereas in oher counries he high cos from excess invesmen has been exposed in he form of bank sress or foreign exchange marke crisis, in China, i will likely be capured in, or riggered by, any one of he weak links of his implici subsidy sysem. VI. ESTIMATING THE HIDDEN COSTS OF CHINA S INVESTMENT 26. The cos of over-invesmen is implicily borne by households hrough he financial secor. Resource allocaion can be described, in a highly simplified way, as a wo sage process wih credi iniially allocaed o large corporaions (LCs) a around he benchmark rae (Figure 9). The remaining credi is hen allocaed o small- and medium-sized enerprises (SMEs) largely hrough he nonbank financial secor. As such, he demand curve of SMEs faced by he financial secor is kinked. Large corporaions, herefore, enjoy a large profi margin relaive o a compeiive environmen, benefiing from a de faco resource ransfer from he res of he economy (i.e., households) and represened by he shaded area A. SMEs, on he oher hand, pay higher ineres as hey have o procure capial from he nonbank secor where risk is higher. Figure 9. Profi Margin and Credi allocaion beween LCs and SMEs Swr: Supply of funds wihou risk (implici guaranee from he governmen) Sr: Risk adjused supply of funds DLC: Demand from large corporae DSME: Demand by SMEs iup: Reservaion price (ineres rae which corporaions are willing o pay for qlc) id: Deposi rae ieq: Marke clearing ineres rae inb: ineres rae charged by nonbanks (assume zero spread) qlc: Lending quoa qlc: quaniy of credi exended o large corporae qsme: quaniy of credi exended o SMEs Shaded area: A: Profi margin (depending on mark up above he benchmark lending rae, profi is divided beween banks and non-financial corporae)

16 The oal resource ransfer and higher cos from he regulaed wo ier financial secor can poenially be large (Figure 10). In addiion o he resource ransfer from households o corporaions (area A), resource ransfer also akes place from household o banks. The precise amoun will depend on he size of he spread se by he regulaors relaive o he nonconsrained spread, i.e., area C. Meanwhile, he higher cos paid by SMEs is represened by area E; and he deadweigh loss, in addiion o he usual loss from inefficien financial inermediaion, can be represened as area F. 28. While he exac amoun of hese ransfers, higher coss, and deadweigh loss are very difficul o esimae, rough approximaions sugges hey could be very large in China s case. As a rough proxy for i eq (marke clearing rae) and P (ineres rae spread) ha would have prevailed under unconsrained equilibrium condiions, we use he average value of hose of he ASEAN-4, Hong Kong SAR, and Korea. To accoun for counry differences when esimaing he ransfer of resources from household o corporaions (area A), we adjus hese average raes by real GDP growh differences (upper bound) o capure differences in he rae of reurn on capial, as well as simply by inflaion differences (lower bound). The amoun varies year o year, wih lower bounds someimes in negaive erriory. The average of he mid-poins of hese ranges over he las 10 years was abou 4 percen of GDP (Figure 11). Figure 10. Resource ransfers and dead weigh loss P : Spread under compeiive seing P : Spread se by regulaors Shaded area: C: Profi ransfer from households o banks C+D: Profi for banks (afer deducing inermediaion cos) Shaded areas A: Transfer of resources from deposiors o corporae C: Transfer of resources from deposiors o banks E: Addiional cos o SMEs due o risks (credi ouside banks where implici deposi guaranees are no provided) F: Deadweigh loss 29. The addiional cos borne by SMEs over he large corporaions, on he oher hand, is smaller, reflecing he smaller share of bank credi used by SMEs. The addiional cos arises from heir need o raise capial ouside he banking sysem, i.e., from nonbanks. The funding coss are higher as no implici guaranees are provided o he funding sources of nonbanks (unlike banks). For our calculaion, he funding cos is assumed o be he inerbank marke. The rue cos will be even higher as many SMEs have o raise capial also from he informal secor where he risk premium is much higher. Thus, based on his conservaive assumpion, he addiional cos averaged abou 0.2 percen of GDP, bu wen up Figure 11. Esimaed Amoun of Resource Tranfer from Households o Large Corporae (In percen of GDP) Upper bound (relaive GDP) and lower bound (Inflaion) Addiional Cos o SMEs (RHS)

17 16 o 0.8 percen of GDP in 2011, reflecing ighened liquidiy condiions. 30. The amoun of resource ransfer from households o banks, however, was on average negaive. Specifically, he difference in bank spreads beween China and he average of he Asian economies was -0.5 percen in nominal erms, and -0.3 percen in real erms (adjused for inflaion differenials). This is in large par due o he benchmark used o esimae he marke clearing ineres raes for China, given ha Asian banks on average have larger spreads han non-asian banks. Finally, we failed o calculae an esimae of he dead weigh loss due o he usual idenificaion problem. VII. CONCLUSION 31. There is lile doub ha China s exraordinary economic performance over he pas hree decades is in large par aribuable o invesmen. Despie he prolonged period of heavy invesmen, China s capial-o-oupu raio is sill in he range of hose of oher emerging marke economies while is growh rae has far oupaced ohers over he las wo decades. Neverheless, he marginal conribuion of an exra uni of invesmen o growh has been falling, necessiaing ever larger increases in invesmen o generae an equal amoun of growh. Now wih invesmen o GDP already close o 50 percen, he curren growh model may have run is course. 32. Measured agains a norm esimaed from a panel daa on a large number of counries, China is over-invesing. Moreover, he deviaion ha has been accumulaing over he las decade is larger and more persisen han he esimaed over-invesmen in oher Asian economies leading up o he Asian crisis. The laes divergence was undersandably he resul of he 2009 measures used o conain he spillover from he global financial crisis. In his regard, he governmen is well aware of his challenge and is hus acceleraing is effor o reorien he economy, moderaing invesmen growh while promoing consumpion. 33. While a crisis appears unlikely when assessed agains dependency on exernal funding, poenial srains from financing high invesmen sill exiss and could be quie large. Assuming he condiions ha prevailed in oher emerging marke economies during heir pre- and pos-crisis periods also apply o China, he probabiliy of a crisis in China would mechanically be abou one in five. However, because of he differences in he modaliy of financing of invesmen, an exernal crisis of he kind experienced by many oher emerging marke economies appears very unlikely o occur in China. Bu his does no mean ha he cos is also absen. Raher, i is disribued o oher secors of he economy in he form of a hidden and implici ransfer of resources. In China, a large burden of he financing of over-invesmen is borne by households, esimaed a close o 4 percen of GDP per year, while SMEs are paying a higher price of capial because of he funding prioriy given o larger corporaions. 34. Going forward, he challenge is o engineer a gradual reducion in invesmen o a pah ha would maximize social welfare. Since ha pah is no idenifiable, he norm

18 17 esimaed using a large sample of emerging markes could provide some guidance. Based on cross-counry regressions, lowering China s invesmen by 10 percenage poins of GDP over ime would bring i o levels consisen wih fundamenals. Oherwise, vulnerabiliies will coninue o build. To he exen ha elevaed levels of invesmen during he pos-crisis period in China were somehow abnormal and necessiaed by he sharp exernal slowdown, he challenge now is how o reurn o a more normal level of invesmen wihou compromising growh and macroeconomic sabiliy. Obviously, reaching he level iself should no be he only goal, bu i should be accompanied by reforms ha would raise produciviy and efficiency, while ensuring ha he fruis of China s remarkable growh are shared more equiably across differen economic agens, in paricular ordinary Chinese households. Inernaional experience shows ha hese are prerequisies for susainable growh in any counry.

19 18 Implemening he Neo-Classical Approach DATA APPENDIX Neo-classical model: Seady-sae level of invesmen (i*) is given by: i* = k*(g +d)/(1 + g), based on esimaes of a seady-sae capial-oupu raio (k*), he depreciaion rae (d),and he rae of poenial oupu growh (g). Capial sock: Derived from he sandard perpeual invenory mehod. Daa on gross fixed real invesmen during is obained from Penn World Tables, and from 1980 onwards from he IMF World Economic Oulook (WEO) daabase. The iniial esimae of capial sock was obained assuming ha he counry is a seady-sae capial-oupu raio in To obain his raio, he averages of k, g, and d over were used (Easerly and Levine, 2001 adop a similar mehodology). Alernaive assumpions were used (e.g., seing i equal o 10 imes he iniial level of invesmen), and he resuls show ha he guess a he iniial capial sock becomes relaively unimporan decades laer. k*: For a given depreciaion rae, k* is found as he maximum value of he capialoupu raio on average over long (15- and 20-year periods) beween 1950 and This helps ensure robusness, paricularly vis-à-vis boom and bus periods. The average capial-oupu raio for he counries in our sample was around 2½ during and for indusrial counries i was similar during d: A number of depreciaion raes were used 5, 7, and 10 percen. Resuls shown in he ex are for a 7 percen depreciaion rae, bu resuls were robus o alernaives. g: Two ses of assumpions were used for poenial growh: using he maximum growh rae over long periods beween 1950 and 2011 for each counry (capped a 5); or using medium-erm projecions for growh from he laes WEO daabase (which, a around 8 percen, are higher for China). Resuls shown in he ex rely are based on he laer, bu were generally robus. Since hese growh raes are higher in he case of China, hey presen a sricer es of over-invesmen since i* is larger. Cross-counry invesmen regressions Aggregae-level panel daa was used o esimae he following invesmen model: I c bzi, GDP i i (1) where I/GDP is he invesmen-o-gdp raio (from he WEO daabase) and Z is a vecor of addiional variables, including he lagged dependen variable, real per capia GDP growh, uncerainy (measured as he sandard deviaion of hree-year rolling windows of real GDP), (all from he WEO); growh in credi as a percen of GDP, real GDP per capia in US dollar erms, he age dependency raio (defined as he populaion aged over 65 o he working-age

20 19 populaion) and he real ineres rae (all from he World Bank World Developmen Indicaors daabase). The sample was unbalanced, covering he period , and he following emerging marke economies (saring year in parenheses): Albania (1993); Algeria (1994); Argenina (1970); Armenia (1995); Belarus (1995); Bolivia (1979); Brazil (1970); Bulgaria (1991); Chile (1970); China (1982); Colombia (1970); Croaia (1994); Czech Republic (1997); Egyp (1970); Hungary (1989); India (1970); Indonesia (1971); Iran (2004); Israel (1980); Japan (1955); Korea (1963); Malaysia (1970); Mexico (1971); Morocco (1978); Pakisan (2004); Peru (1986); Philippines (1970); Poland (1991); Romania (1994); Souh Africa (1964); Sri Lanka (1978); Taiwan Province of China (1965); Thailand (1970); Turkey (1973); Venezuela (1984); and Vienam (1993).

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