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China
Railways versus US Government Bonds: Putting China's ‘Over-Investment' in Context
July 29, 2009

By Qing Wang | Hong Kong

‘Over-Investment' or ‘Over-Savings'?

The Chinese economy is staging a strong recovery, driven by rapid fixed asset investment (see China Economics: Policy-Driven Decoupling: Upgrade 2009-10 Outlook, July 16, 2009). As the tail risk of a severe recession diminishes, an increasing number of market observers have begun to voice concerns about China's ‘over-investment', which, in their view, would only exacerbate the imbalances in China and the global economy.

A popular evidence of ‘over-investment' in China is its high investment/GDP ratio, which reached over 50% in 2008, higher than the peak levels of not only major economies such as the US, Japan and Germany, but also other major emerging market economies in the region. Although there is no theoretical benchmark for an optimal investment/GDP ratio, the fact that China has the highest level among countries is considered by many as a strong indication of over-investment in China.

With ‘over-investment' being the buzz word in the policy debate at the current juncture, much attention has been paid to the high investment/GDP ratio. However, we believe that a more important phenomenon in this regard is the high national savings ratio in China. To the extent that the high investment ratio is a function of the high national savings ratio in China, discussing over-investment without discussing the high saving ratio loses sight of the big picture, in our view. Put differently, to argue that there is over-investment, one needs to make a case that there is ‘over-savings' in the first place.

We are convinced that the high savings ratio in China can be attributed to several deep-rooted factors (e.g., demographic profile, underdevelopment of financial and capital markets, weak social safety net, high return from investment) that evolve very slowly. In this context, we think that any discussion of over-investment in China in the short-to-medium run (i.e., one to three years) should be based on the premise that the savings ratio in China will remain broadly stable at a high level.

Rapid Investment Growth = Over-Investment?

Another popular argument of over-investment in China is the high growth rate of fixed asset investment. Indeed, despite the global recession, fixed asset investment growth in China accelerated from 23%Y in 4Q08 to 36%Y in 2Q09. The concerns about over-investment are based on the argument that since the sharp contraction in external demand amid a severe global recession has already laid bare the over-capacity of production in China, additional investment will only exacerbate the problem.

While in general such concerns make sense, we believe that the devil is in the details. First, rapid fixed asset investment is the key component of the economic stimulus package implemented by the authorities to combat what is widely believed to be the most serious economic recession since the Great Depression. The case for a classical Keynesian-style policy response has never been stronger, especially when boosting private consumption in China in the short run proves to be very difficult. Any discussion of over-investment without taking this context into account is not particularly helpful, in our view.

Second, the rapid investment growth is driven primarily by infrastructure investment rather than investment in manufacturing sectors that suffer from over-capacity. Infrastructure investment actually lagged other types of investment by a large margin in the past few years. Moreover, the investment projects mainly involve railways, intra-city subways, rural infrastructure, low-income housing and post-earthquake reconstruction, which are quite different from the infrastructure projects that were carried out in the context of the Asian Financial Crisis a decade ago. Both rounds of infrastructure investment boom helped to boost domestic demand in the face of negative external shocks in the short run. However, their medium-term implications are quite different: while investment in the immediate aftermath of the Asian Financial Crisis laid the foundation for a subsequent take-off in China's manufacturing sector and hence exports, the current investment boom should facilitate urbanization and help to lay the groundwork for a potential consumption boom in the years to come, in our view.

Third, much of the concern about over-investment is based on the notion that investment is derived demand (e.g., investment to build a factory that produces widgets) instead of final demand (e.g., consumer demand for the widgets). When final demand like private consumption or exports is weak, it will eventually translate into weak investment demand. However, the line between derived demand and final demand is blurred when it comes to such urbanization-related infrastructure investment as intra-city subways, rural infrastructure and low-income housing. For a rapidly growing, low-income country like China, these investments are of final demand nature, as faster and more convenient travel is as desirable now as more food and clothing, in our view.

Bridges to Nowhere?

But isn't there over-capacity even in infrastructure in China? Is China not building ‘bridges to nowhere', as it was argued that Japan did in the 1990s? Indeed, many overseas visitors who have been to China in recent years have been amazed by the high quality of infrastructure in the country, especially in comparison to that in other developing countries at similar levels of development. Some market observers compare the current capacity utilization of infrastructure projects in China (e.g., highways) with that of industrialized countries and come to the conclusion that there is massive infrastructure over-capacity in China.

These concerns are not unwarranted, in our view. However, we see several reasons that caution against jumping to the conclusion that there is massive over-capacity in China's infrastructure:

•           First, infrastructure is public or semi-public goods, whose value to the economy cannot be assessed simply on commercial criteria. Since the contribution of infrastructure projects to the economy is reflected in improved productivity and profitability in other parts of the economy, a more appropriate measurement in this regard should be the gains in aggregate productivity of the economy, i.e., the total factor productivity (TFP). In this regard, the consensus among academic studies on this subject is that the TFP growth in China was relatively high and a key contributing factor to strong GDP growth over the last decade.

•           Second, making a static comparison of the current capacity utilization of infrastructure projects in a low-income but rapidly growing economy like China with rich and slow-growing industrialized economies like the G3 is rather misleading, in our view. In particular, many years of under-investment in infrastructure has been widely recognized as a key challenge facing some of these economies.

•           In a similar vein, comparing the current investment boom in China to Japan's experiences in the 1990s seems far-fetched, in our view. Japan's GDP per capita reached US$35,000 and its urbanization ratio was nearly 80% in the 1990s, while China's GDP per capita barely reached one-tenth of that in the 1990s and its urbanization ratio was only 45% in 2008. To wit, while some of the bridges to nowhere built in Japan in the 1990s may be unused or under-utilized today, any potential bridges to nowhere in China will most likely become bridges to somewhere in a few years, in our opinion.

•           Fourth, we argue that a more meaningful cross-country comparison in this regard should be about the capital-labor ratio in the economy. On this score, China's capital-labor ratio is, not surprisingly, way below that in industrialized economies, suggesting much upside for investment expansion. A key question in this context is: if it were to take China much less time to reach the same capital-labor ratio as in industrialized economies because of China's consistently higher investment growth, would this suggest over-investment? The answer is far from conclusive, in our view.

The Bottom Line: Railways versus US Government Bonds

A perhaps more relevant question at the current juncture is where the money would be spent were it not being used to finance the massive infrastructure investment program, or what is the opportunity cost of China's fixed asset investment program?

Given China's high national savings rate, from the perspective of the economy as a whole, there are only three forms in which China can deploy its savings: 1) onshore physical assets; 2) offshore physical assets; and 3) offshore financial assets. Since China maintains tight controls over outbound capital flows, about 70% of China's total offshore assets are in the form of official FX reserve assets as a result of investment made by a single-largest investor - the central bank. Moreover, we estimate that about 65-70% of China's official FX reserves are invested in US dollar assets, the bulk of which are US government bonds.

We therefore think that from the perspective of the economy as a whole, the opportunity cost of domestic fixed asset investment, or formation of physical assets onshore, should be the total returns on US government bonds. Put in simple terms, in the debate about over-investment at the current juncture, it actually boils down to an investment decision on building railways in China versus buying US government bonds, given China's high national savings.

In view of the negative consensus outlook for US government bonds, the opportunity cost of China's massive infrastructure investment program could be quite low and may even be negative, if the potential renminbi appreciation against the US dollar is taken into account. Considering the opportunity cost, we think that infrastructure investment is a better method of deploying China's savings, especially when the cyclical conditions also warrant a strong boost of domestic demand in a relatively short period.

The debate on railways versus US government bonds is also relevant from another perspective. Despite the attention paid to the return of China's official FX reserve assets, to be fair, the primary purpose of these assets is not for investment returns but to play the role of an insurance facility against potential domestic and external shocks to the macro economy. To date, China's outsized FX reserves serve this purpose very well. However, since the current size of China's FX reserves is arguably more than adequate for insurance purposes, we believe that more attention should be paid to the aspect of investment returns from FX reserves assets. While the short-term investment return from infrastructure projects like railways may be low, there is a large positive externality from these infrastructure projects. We liken this positive externality to the enormous benefits in terms of financial stability in general and low vulnerability to external shocks in particular, which are afforded by China's holding of sizeable official FX reserves. In this context, infrastructure projects like the railways will likely not only deliver better investment returns, but also bring about a positive externality as the outsized official FX reserves do.

When Over-Investment Warrants Real Concern...

Rapid investment growth will become a real concern if investments are not made in infrastructure or related areas that lay the foundation for a potential future consumption boom. If investment is instead made to further expand the production capacity of China's export industries, it will not help to boost China's domestic final demand and will only contribute to perpetuating China's external current account surplus, which, in turn, will result in more accumulation of China's official FX reserves. While this type of investment helps counter-cyclical downturns in the short run as infrastructure investment does, it does not result in meaningful and better allocation of national savings. Moreover, the returns from this type of investment will likely be low due to over-capacity of production that is likely to be perpetuated by prolonged weak external demand. Furthermore, the social returns from such investment will likely be very limited.

Another important concern relates to the financing of infrastructure fixed asset investment. Given its nature as a public good, the investment should be financed as much as possible by fiscal spending instead of private sources, including bank loans, in our view. This concern is more about transparency and accountability of financing rather than bank lending quality per se. Specifically, we are not particularly concerned about the quality of the loan that is used to finance these infrastructure projects, because the loans carry explicit or implicit guarantees by the central or local governments. Further, we are not concerned about the central or local governments' ability to guarantee, because the governments' balance sheets are strong - especially when the assets owned or controlled by the government (e.g., SoEs, land) are taken into account.

Market Implications

Besides the obvious benefits of boosting growth amid a serious economic downturn, quality infrastructure as a strong investment will benefit the rest of the economy. While the infrastructure projects themselves may or may not be very profitable businesses, especially in the short run, the positive externality they bring to the rest of the economy will be internalized by the private sectors in the form of improved productivity and profitability. For instance, a new subway system in a city may elevate the intrinsic value and thus the prices of real estate nearby, even if the subway system itself may not be profitable in the short run.

Looking beyond the near term and to when cyclical conditions normalize, the need to maintain strong investment to counter the cyclical downturns should diminish. However, the persistence of high national savings would suggest that more aggressive promotion of outbound investment by Chinese savers through further capital account liberalization should be the next logical step. In this regard, we take note that the Chinese authorities recently announced a number of measures to facilitate outbound foreign direct investment by Chinese enterprises. Besides direct investment, further liberalization of outbound portfolio outflows through Qualified Domestic Institutional Investor (QDII) and Qualified Domestic Retail Investor (QDRI) programs may also be considered, in our view.

Additional Thoughts: Two Pots, Three Lids

Many market observers are uncomfortable with the aggressive fashion of boosting growth in China. Some argue that China should carry out profound structural reforms to boost domestic consumption to help rebalance the economy. However, the rebalancing in China will likely be a very slow process, in our view.

China's large current account surplus is symptomatic of its high national saving ratio. If one characterizes the over-borrowing situation in the US as ‘three pots, but only two lids', an adjustment will be forced upon by the market and thus become inevitable. The over-saving situation in China can be characterized as ‘two pots and three lids', which allows room for muddling through. In this sense, while the rebalancing in the US is market-driven, that in China will more likely be policy-driven, in our view.

A policy-driven rebalancing will reflect policymakers' preference. Gradualism, which has proven to be a successful reform approach, is the hallmark of Chinese policymaking. This time is no exception. Structural reforms that help to boost domestic consumption take time, while crises entail prompt and decisive policy response. Massive investment in infrastructure that can potentially help to boost domestic consumption in the years to come is the strategy chosen by the Chinese authorities. Whether this strategy is a first-best solution from the perspective of a rigorous economics framework is debatable. However, we think that this strategy is not a bad one on the margin and therefore caution against undue concerns. First, it helps to deliver quick results in terms of boosting growth amid a serious crisis. Second, it is a better way of deploying China's large savings than the status quo (e.g., the railways versus US government bonds).

More generally, since there is much structural rigidity, or distortion, in the Chinese economy, macroeconomic management does not necessarily require the same type of surgical precision as in mature industrialized economies. China's economic success since the early 1980s suggests that as long as the Chinese economy keeps showing marginal improvement by gradually removing distortions, the resultant efficiency gains will help to sustain reasonably strong growth. The current rapid investment growth, led by infrastructure projects that could help to boost future domestic consumption, is yet another example of this. While Chinese economic policy strategy has never satisfied every pundit, investors around the globe are generally happy with what the Chinese economy has delivered. Looking ahead, we expect this trend to continue.

A key question remains: when will ‘two pots, three lids' turn into ‘three pots, two lids'? We plan to devote a report to discussing China's high national savings in the near future. Stay tuned.



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United States
Challenges to Rebalancing the US Economy
July 29, 2009

By Richard Berner | New York

Rebalancing begins.  The global financial crisis and recession have exposed the vulnerability of unbalanced US and global growth.  Excessive leverage combined with inflows of saving on attractive terms - manifest in a US current account deficit that peaked at more than 6% of GDP - helped to boost asset values and growth in US spending unsustainably over 2003-07.  Now recession is helping to rebalance the US economy and markets towards a more sustainable path.  Internally, consumers are deleveraging and boosting their saving, while externally, falling imports are shrinking the US current account deficit, and stronger growth abroad may help US exports.  The question now: Will this rebalancing process be benign for economies and markets, or will it be disruptive?

With the rebalancing imperative clearly at work both inside and outside US borders, there is some hope that the process could yield benign outcomes.  A US move towards exports as a driver for sustainable growth would help to offset the drag from consumer deleveraging and corporate restructuring.  We expect consumers to pursue a long process of deleveraging and rebuilding saving to between 7% and 10% of disposable income (see Deleveraging the American Consumer, May 27, 2009), and Corporate America needs to resize and restructure to meet a changed global pattern of demand (see Capex Bust and Capital Exit, April 20, 2009).  Abroad, my colleague Chetan Ahya details that Asian policymakers are also beginning the search for alternative, better-balanced sources of growth as Asia's export-driven growth model has faltered (see Asia Pacific Economics: Can Domestic Demand Lift the Burden of Rebalancing? July 27, 2009).  Reducing those internal and external imbalances would likewise help to reduce US financing needs. 

Would that it were so.  I'm concerned about the odds of a darker result because unlike in Asia, current US policies are not aimed at reducing imbalances; on the contrary, the risk is that US policy initiatives will expand them.  That would leave the heavy lifting of adjustment to market forces, which increases the chances for disorderly outcomes.  Unless policies change, we risk losing the confidence of global investors and officials that our policies are sustainable and that our markets will remain attractive, potentially triggering disruptive major changes in interest rates, the value of the dollar and asset prices. 

Obstacles to rebalancing.  Recessionary forces alone are unlikely to be sufficient to promote needed rebalancing; indeed, absent market or policy changes, the onset of recovery means that imbalances will grow again.  Normally, market forces could help, as a falling dollar would help to narrow these gaps.  By reducing US real incomes, it would limit domestic demand, and by making US exports cheaper, it would help to switch demand from imports back to domestic production. 

Yet there are key obstacles to such a benign rebalancing: US fiscal stimulus and policy initiatives have widened the internal saving deficit.  We estimate that combined federal, state and local deficits in the current quarter amount to 7.3% of GDP on a National Income Accounts (NIPA) basis, and will widen to 9% by early next year (measured on a unified budget basis, the red ink today would be closer to 12% of GDP).  Moreover, officials in export-driven Asian economies are blocking a significant appreciation of their currencies.  And unlike the past, concern about the sustainability of US fiscal policy is making global investors and Asian central banks more hesitant to buy US debt without a concession. 

Their concerns are intensifying as debate continues in Washington around policies that would expand deficits.  Two such new initiatives - the potential need for additional stimulus and expanding access to healthcare - are at the top of the agenda.  Meanwhile, there is virtually no discussion of how to rein in our massive entitlement programs, which are now on track to eventually lift debt in relation to GDP to unprecedented levels (see America's Fiscal Train Wreck, July 2, 2009).  Consequently, when private credit demands revive, and the Fed is fully implementing its exit strategies from an extraordinarily accommodative monetary policy, we think those blockages will redirect and vent the pressures of adjustment through higher US real interest rates and stronger currencies in other developed economies.  That's a key reason why we see 10-year Treasury yields rising to 5.5% by the end of next year (see US Economic and Interest Rate Forecast: Does the Economy Need More Stimulus? July 7, 2009). 

Cyclical obstacles to a narrower US current account gap.  Such concerns may seem bizarre in view of recent striking progress in narrowing the US external deficit: Relative to GDP, our current account gap has shrunk by half to 2.9% over the past two years.  Some of that is structural, reflecting increased US competitiveness, but unfortunately the bulk of the recent improvement simply reflects the cyclical forces of lower demand and oil prices.  As the economy turns to recovery, cyclical forces are likely to widen the gap.  First, recovery in US final demand and reduced inventory liquidation will boost import volumes, in a mirror image of the 3.7% plunge in domestic final sales and a 3.5% liquidation of non-farm inventories (measured in terms of the stock) that dragged real merchandise imports down by more than 20% over the past year.  Second, higher oil prices and non-oil import prices will boost the nominal value of imports - the ‘J curve' effect of a weaker dollar - before such price increases begin to shift production to domestic sources.  Import prices in June plunged by 17% from a year ago, but will likely soon be rising at a double-digit pace.  Third, the US surpluses on services and investment income - which soared with the onset of recession - now are shrinking from their peaks. 

Blocking the currency channel.  Moreover, two factors likely will block a significant weakening of the dollar, especially vis-à-vis Asian currencies, as a means to facilitate the rebalancing process.  First, my colleague Qing Wang notes that China cannot tolerate and will push against any significant currency appreciation, given the weak state of the global economy, the need to maintain share in global markets, and China's legitimate concerns that dollar weakness would undermine the value of its holdings of dollar-denominated assets.  After allowing the renminbi to appreciate by more than 20% versus the dollar over the three years ended in mid-2008, the authorities have maintained a stable exchange rate over the past year.  And a Chinese inflation-led depreciation of the real RMB-dollar exchange rate is not likely soon.  In that context, Chetan Ahya and my colleague Stewart Newnham point out that other Asian central banks are likely to intervene in FX markets to prevent their currencies from appreciating further versus the dollar so as not to lose competitive position (see "Currency Outlook for 2H09", FX Pulse, July 9, 2009).  As a result of those policies, currency pressures likely will vent through economies with the most flexible exchange rate regimes, like the euro and Canadian dollar, although these economies are not the primary source of US imbalances and investors are having difficulty justifying a strong euro. 

A second factor limiting dollar weakness is that, following seven years of significant depreciation, the dollar no longer appears to be overvalued.  In fact, my colleague Spyros Andreopoulos calculates that fair value for EUR/USD is now 1.18, indicating significant undervaluation (see FX Fair Values: Opportunities in the Periphery, July 16, 2009).  Of course, currencies overshoot such fair values, often persistently and by a wide margin.  Nonetheless, these factors underscore our FX strategy team's modestly bearish view on the dollar; they expect only a 7% further decline by end-2010 measured by the Fed's major currency index.

Venting through rates.  If policies oppose rebalancing and the currency channel is blocked, other asset prices will be called on to foster the adjustment to rebalancing.  The obvious candidate is higher US real interest rates; by moving higher, they will limit growth in demand and force a reduction in both internal and external imbalances.  We think that two factors will reinforce that upward bias in US rates, especially when private credit demands revive.  First, stronger Chinese growth ironically may lift US rates.  China's recent upswing is kindling hopes among global investors for a more V-shaped recovery, encouraging them to seek risky assets and sell Treasuries.  Moreover, investors increasingly expect a spillover to the US economy and elsewhere, and thus a faster exit strategy from central banks, which could push up expectations of future rates.  Second, expansionary US fiscal policy should also push up US real rates, first by adding a risk premium to our debt, and second, by increasing US dis-saving relative to investment. 

Of course, there are two countervailing forces that will keep rates in check for now.  First, central banks have committed to keeping rates low (for "an extended period" in the case of the Fed or until 2Q10 in the case of the Bank of Canada).  That commitment reflects a belief that inflation will stay low or decline for the next year or so, and that extraordinarily accommodative policy is needed to prevent it from falling below target.  We share that belief, as well as faith in central banks that they will be able to implement exit strategies successfully when the appropriate moment arrives.  Second, the weakness in private credit demands will substantially offset pressures on rates for now.  Corporate and household external financing needs are likely to remain subdued in the early stages of recovery.  But as growth continues to pick up, and market participants begin to anticipate a shift in monetary policies, interest rate volatility and term premiums will likely rise, resulting in higher long-term yields. 

No Goldilocks or global saving glut this time.  Given this backdrop, it's possible to envision a Goldilocks scenario: A better-balanced global economy, with global consumers and US producers on the upswing, and healthy growth reemerging.  That might keep the pressures on rates and asset prices more subdued.  After all, China and other currency interveners will buy Treasuries or other US debt as they seek to prevent appreciation.  And some research suggests that global imbalances alone are actually far from triggering a turn away from US assets (see Bertaut, Kamin and Thomas, "How Long Can the Unsustainable US Current Account Deficit Be Sustained?" Federal Reserve International Finance Discussion Paper 935, July 2008). 

But there are several worrying signs.  First, private capital inflows (including direct investment) peaked in 2006 and have since declined essentially to zero; private portfolio capital flows (excluding purchases of Treasuries) have turned negative.  Second, Chinese and other officials are becoming increasingly vocal about the perils of relying on the dollar as the sole reserve currency over the longer term, so support from official inflows is also waning.  With the implicit blessing of the IMF, officials in the BRIC economies (except India) are proposing a new global currency and issuance of IMF bonds denominated in SDRs to replace their holdings of dollar-denominated US debt.  Third, according to US Treasury data, Chinese and Russian officials have maintained a near-record (26%) share of their holdings of US Treasuries in short maturities.  My colleague Sophia Drossos points out that the official financing of our imbalances is thus ‘less sticky' and exposes the US to considerable rollover risk. 

More importantly, the current account gap is only one facet of our internal and external imbalances.  It's critical to analyze that gap in the context of the complete saving-investment balance.  With that in mind, we don't foresee a renewed global saving glut that can bring down rates in this cycle, because both Chinese and US policies are aimed at stimulating domestic demand.  In other words, we are asking China to buy more Treasury debt instead of US private debt at a time when China's economy is rebounding, using up domestic saving. 

In addition, neither China nor the US can morph into more balanced economies overnight, and China can't tolerate a sharp RMB appreciation to speed up the process.  So the adjustment scenario will be disappointing, involving slower US demand and Chinese export growth.  And higher US rates will be a vehicle to reinforce that outcome.  In fact, the ‘impossible trinity' may be hitting Asia in reverse.  An Asian rebound would normally induce capital inflows, rising asset values, a stronger currency and a tighter policy.  But no one wants currency strength, and it is too soon to tighten.  So, the authorities can and will intervene in FX markets and will probably tolerate too-loose liquidity and rising asset prices.  As global investors seek higher returns outside US markets, the accompanying decline in risk-aversion probably won't be good, either for the dollar or for US Treasuries.



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