China’s overinvestment: the problem of having too much

This is part 2 of 7 in the series China Economy: Hard Landing and Beyond

One of the key arguments made by the pessimists (including ourselves) is that China has been investing too much. In China’s national account, Investment accounted of roughly half of total output, something almost unprecedented. The high rate of investment was not sustainable. However, as investment was large chunk of GDP, slowing investment inevitably means slowing economic growth as other parts of the economy, such as consumption and exports, are clearly not able to offset slowing investment completely.

There was, there is, and there will be argument on whether China has an over-investment problem. One of the most compelling one, we think, is the fact that China’s total capital stock does not appear to be too high. In fact, China’s total capital stock appears to be too low if measured on a per capita basis, while other believe that despite huge amount of investment being done, return on investment has not gone down very significantly.

The chart below shows the comparison of investment/GDP ratio of a number of economies. Where China now stands is almost unprecedented, with the exception of Singapore, which did reach those levels of high investment in the early 1980s before coming down significantly.

Source: IMF

The alternative view that China is not over-investing is best summarised by the following chart from Goldman Sachs, showing capital stock per worker of various countries. China is clearly far behind other countries.

Source: Goldman Sachs

Some take that as a “proof” that not only has China not over-invested, but China should invest more. But we believe this comparison is totally inappropriate, as China remains to be a pretty poor country compared with those in the top of the league in above table.

The next chart shows China’ capital stock as a percentage of GDP, also from Goldman Sachs. This chart has totally changed the ranking. It is clear here that although China’s capital stock as a percentage of output is not in the lead, it is certainly among the developed economies. In fact, it is even greater than the United Kingdom, a country which is much richer than China on a per capita basis, and almost the same as the United States and Canada, which are, again, countries which are much richer than China.

Source: Goldman Sachs

This comparison, we think, might be more appropriate. While the capital shock per capita comparison shows that there is huge room for even more investment, Capital stock as a percentage of GDP shows that China already has quite enough of capital relative to its economic output.

However, a more fundamental problem to judge whether China has had enough of capital stock is not the volume of capital stock, nor the volume of it per worker/capita, not even the volume of capital relative to economic output. The more fundamental problem is the return on such investment.

There is, unfortunately, no easy way to accurately gauge that. Not-so-up-to-date measure such as incremental capital output ratio (ICOR) has shown deterioration in the recent years, but optimists argue that it is still way below the level where Thailand was during right before the Asian Financial Crisis.

Source: Goldman Sachs

Clues we gather from various news reports, financial reports, and anecdotes, however, paints a somewhat gloomier picture.

For example, many airports in China are losing money, yet China is building more anyway. According to the FT:

China will build another 45 airports over the next five years, the industry regulator said on Thursday, raising fresh questions about the potential for overcapacity in the transport sector.

Li Jiaxing, the head of the Civil Aviation Administration of China, said that the new investments would take the total number of airports in the country to 220, even though most of the existing airports were losing money.

Similarly, railways investments are just doing as bad. According to the first half account of the Ministry of Railways, the Ministry lost RMB8.81 billion in the first half of 2011, while total liabilities climbed to RMB2.526 trillion.

Meanwhile, corporate profits (excluding banks) are falling. On top of that, manufacturing PMI detailed figures have shown an increase in inventory as manufacturing companies have clearly been producing too much and sales have been going too slowly. Meanwhile, a piece of somewhat outrageous anecdotal evidence said that inventory for the entire apparel industry is enough 3 years or sales.

Steel companies’ profit for each tonne of steel has gone down to almost non-existent.

Also, New York Times reported that unsold cars in China are rising, yet new auto factories are being built anyway:

Inventories of unsold cars are soaring at dealerships across the nation, and the Chinese industry’s problems show every sign of growing worse, not better. So many auto factories have opened in China in the last two years that the industry is operating at only about 65 percent of capacity — far below the 80 percent usually needed for profitability.

Yet so many new factories are being built that, according to the Chinese government’s National Development and Reform Commission, the country’s auto manufacturing capacity is on track to increase again in the next three years by an amount equal to all the auto factories in Japan, or nearly all the auto factories in the United States.

And surely, who can forget the over-building of real estate?

Surely, you may say, that the economy is slowing, which contributes to slower sales, thus lower profitability of companies and rising inventory.

However, please remember: China was still growing at 7.6% yoy as of the second quarter.

How is it that an economy grows at 7.6% yoy is squeezing corporate profitability so hard? How is it that an economy growing at 7.6% yoy feel like there is not enough demand for all the goods and services being produced? Even if we are all cynics and think that China’s GDP growth has been overstated by 2 percentage point, 5.6% yoy remains pretty decent (not for China of course), and yet corporate profits are collapsing.

And how is it that the US economy grows at 1.7% in Q2 (annualised) yet US corporate profits are at record high levels?

The answer, to our mind, is quite simply that China has been investing in too much productive capacity, which in turn produces too much. These are simply the manifestation that China has been investing so much that the return is getting so low that even 7.6% yoy of economic growth is too low for many of these companies (both public and private) to survive profitably. The return on investments might be good before the financial crisis, yet the collapse of external demand after the financial crisis and more recently in the persistent Euro Crisis have cut external demand significantly. Meanwhile, domestic demand is not growing quite enough to pick up the slack created by collapse of external demand. Worse still, it is rather clear that domestic demand has been sustained by none other than investment itself. Thus, it should come as very little surprise that IMF’s estimate put China’s capacity utilisation at just about 60%.

We reckon that there will be arguments being made that China has not been investing too much, and the arguments will not stop until years after growth has slowed structurally and people start wondering what’s happening to China. Of course, we are not saying that China should just stop building or investing in anything. Although we cannot think of any, we are certain that there must be something that China needs to invest in. But there is little doubt to our mind that even though there are things that China should invest in, on the whole, China has had quite enough for the moment. To be clear, we are quite sure that if China continued to grow after facing the current challenge (albeit at a slower pace) into a rich country like the United States, capital stock would be much higher than where it is now. But then, it is a question about what will happen in 50 or 100 years time, a time-frame that is relevant to almost nobody in terms of investment decision.

Series: China Economy: Hard Landing and Beyond

• China Economy: Hard Landing and Beyond
• China’s overinvestment: the problem of having too much
• China’s “little” debt problem
• Chinese central bank’s ability to ease monetary policy is constrained by outflow
• Effectiveness of PBOC’s monetary easing will be limited by deleveraging
• China’s difficult choice between stimulating the economy and not
• China’s hard landing is not the end of the world

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About Zarathustra

Zarathustra: Founder and Managing Editor of Also sprach Analyst. Once an analyst, now an investor and entrepreneur. Based in Hong Kong, but Londoner at heart.