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China's Infrastructure Projects Suffer Diminishing Returns

Since 2008 returns on infrastructure projects in China have faltered due to oversupply and stalled reforms

Daniel Rohr, CFA 3 October, 2017 | 8:01AM

China's highways

Investment in roads, factories, or machines should in theory deliver greater productivity benefits in poor countries than in rich countries. For example, a new paved road in a country with only dirt roads will generate a higher return than a new paved road in a country with an extensive highway network.  

The potential for higher returns in poor countries is a big reason why, in theory, poor countries ought to grow faster than rich countries. Yet poor countries do not always realise that potential in practice, for the following reasons:

  • Constrained investment
  • Poorly educated workers might prompt multinationals to site a new factory elsewhere
  • Political instability could render large investments too risky
  • An underdeveloped financial market may prevent funds from flowing to attractive projects
  • Rampant corruption and rent-seeking might also deter otherwise attractive investments 

Aggressive reforms in the post-Mao era helped China overcome these constraints. So too did the structure of China's political economy, which has proven remarkably adept at driving rapid, if not always efficient, capital accumulation, or building up a country's physical assets.

Artificially low benchmark deposit rates set by the People's Bank of China - and dutifully followed by state-owned banks - forced households to save more than they otherwise might. Tight capital controls ensured household savings stayed within the country.

State ownership of the biggest banks and borrowers ensured aggressive lending and eager borrowing whenever it suited Beijing's interests - and often when it did not. Finally, limited property rights and alignment of central and local elite incentives made ambitious projects more achievable than they otherwise might have been.

Impressively, despite enormous additions to the capital stock, returns on investment across the economy remained high for most of the reform era. This was partly due to decades of economic mismanagement under Mao, which left China with an especially paltry capital stock and a correspondingly ample array of promising investment opportunities. More important, however, were continued reforms that boosted prospective returns and improved capital allocation.

China's First-World Road Network

Since 2008, however, returns have faltered due to repeated stimulus and stalled reforms. China's total capital-output ratio, which measures how efficiently the country's total capital stock is being put to use, has deteriorated amid overinvestment across vast swathes of the economy. 

China's incremental capital-output ratio, or ICOR, which measures how efficiently new capital is being put to use, looks even worse. China currently generates 50% less GDP for each new unit of capital than it did in 2007. 

Quite literally, whereas China was once not too dissimilar from our hypothetical country with only dirt roads, it now has much more in common with our hypothetical rich country crisscrossed by highways. In 1988, China had a mere 100 kilometers of expressways. By 2016, China's National Trunk Highway System, or NTHS, spanned 130,973 km, making it more than two thirds longer than the Interstate Highway System in the United States at 77,334 km, a country of comparable landmass. While China has one third fewer motor vehicles than the US of 186 million versus 265 million, it now has more than double the expressway kilometers per vehicle.

China's Debt - chart

Heavy Spending Has Swollen China's Debt 

It should come as no surprise that the decade-long rise in China's capital-output ratio is mirrored by an increase in the country's debt burden. After all, the two are products of the same underlying cause: heavy spending despite falling returns. China's debt-to-GDP ratio has nearly doubled in just a decade to 257%. That's twice the indebtedness of the typical middle-income country and slightly greater than the United States.  

Today's China can no longer rely on brute capital accumulation as a major source of productivity gains. If anything, maintaining the current level of spending would likely reduce productivity growth. As we'll detail later in our series on China's next 10 years, overinvestment and overborrowing are direct consequences of China's political economy, which prioritises and incentivises growth at all costs and does not subject government-linked borrowers to market discipline. 

These problems are structural and, as such, cannot be solved with political discipline. Beijing's frequent admonitions of reckless borrowing and spending by provincial and local governments have had little impact over the years. Nor are administrative measures - for example, President Xi's various "supply-side reforms," which include capacity reduction quotas, debt-to-equity swaps, and hybrid ownership structures - likely to have lasting consequences.

That's because until Beijing abandons overly ambitious GDP growth targets, repeated stimulus efforts are likely. And until local governments and state-owned enterprises face hard budget constraints, they will be able to borrow and invest to meet those growth targets. Barring true structural change, returns on capital will deteriorate further, bad debt will continue to accumulate, and productivity growth will come under added pressure.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Daniel Rohr, CFA  is a senior equity analyst at Morningstar.