Return to Capital is not low in China
There are two famous myths about China.
The first one is that the savings rate is high because ordinary Chinese worry about the lack of safety net. This myth has been busted because evidence has shown that Chinese household savings rate is actually lower than the Indian one. The overall saving rate is high because businesses heavily save their self-generated profit for re-investment. For private business, the reason is the lack of access to other forms of external finance. For state-owned enterprises, managers always prefer re-investing the profits to paying dividends to the government. Therefore, the right solution is: (a) to reform the financial sector and improve the access to finance for private sector businesses; (b) force state-owned enterprises to pay dividends! Building a safety certainly will help, but only at the margin.
The second famous myth is that return to capital is very low in China, and that the current high investment rate is a sign of money being wasted. A NBER working paper "The return to capital in China", written by three prominent Chinese economists, however shows that the return to capital in China has been remained flat at roughly 20% since 1998, which is not low compared to the rest of the world. Olivier Blanchard also provides a nice discussion (PDF file) of of the results.
As a matter of fact, the myth about the high investment rate per se has also been overturned. Goldman Sachs economist Hong Liang show that the investment rate is between 36%-40%, and the incremental capital-output ratio (ICOR) is about 3.1 in recent years. These are two very reasonable numbers for a rapidly growing economy. In at least the export-oriented sectors in China, improvement in productivity still remains that greatest driver of growth.
I have long been the subscriber of the view that China is still a very poor country; the gap to the productivity frontier is still so wide that the main decision to make is still how much to invest rather than where to invest. Chinese are starting to worry about investment efficiency, but at this moment it is still of second order importance. The nation’s production is still so inefficient that there are numerous easy opportunities waiting for entrepreneurs to capitalize on. In order for this to happen, the government should remove the planning-economy-era regulations that create the inefficiency, and protect the property rights of entrepreneurs. These reforms will create prosperity much more than will any scientific breakthrough.
Newspapers like to repeat the same punch line “the money is wasted in building roads that lead to nowhere” when describing the government investment in infrastructure in China. But people familiar with the geography of China would find it difficult to find any such “roads that lead to nowhere.” Even if an idiot randomly draw a line on the map in the eastern seaboard and build a toll road; in five years the road capacity will be full. That’s exactly why there are so many corruptions in such infrastructure projects: high returns are guaranteed so long as you can get the license to build the toll roads that almost always lead to somewhere. The new Chinese saying: money follows the roads.
The Return to Capital in China (download pdf file)
Chong-En Bai, Chang-Tai Hsieh, and Yingyi Qian
NBER Working Paper No. 12755
December 2006
ABSTRACT: China's investment rate is one of the highest in the world, which naturally leads one to suspect that the return to capital in China must be quite low. Using the data from China's national accounts, we estimate the rate of return to capital in China. We find that the aggregate rate of return to capital averaged 25% during 1978-1993, fell during 1993-1998, and has become flat at roughly 20% since 1998. This evidence suggests that the aggregate return to capital in China does not appear to be significantly lower than the return to capital in the rest of the world. We also find that the standard deviation of the rate of return to capital across Chinese provinces has fallen since 1978.
