## _wp1383

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### Introduction and policy context
- China’s growth model has been “heavily reliant on exports and investment” and “may have run its course.”
- Key policy challenge: how to lower investment toward a sustainable steady-state without precipitating a large fall in consumption — i.e., raise capital efficiency so growth remains relatively robust as aggregate investment declines.
- High-level conclusions:
  - Some types of investment are becoming excessive, especially in inland regions.
  - Investment in coastal provinces is more likely to contribute to productive capital and to household income; in inland provinces investment is more closely associated with corporate income and transient GDP effects.
  - Shifting investment toward agriculture and services is likely superior to manufacturing and real estate for sustaining household income and consumption.
  - Reorientation would require financial sector reform to enhance capital efficiency.
- Policy signal: Chinese government for the first time called for a reduction in “redundant” public investment at its most recent Economic Work Conference.

### Literature review (select findings and positioning)
- Prior cross-country work (Lee et. al (2012)) found China’s “excess investment” grew to around 10 percent of GDP and was financed via a hidden transfer from households and SMEs toward large corporates amounting to around 4 percent of GDP every year.
- Empirical studies cited document lower returns to capital in state-owned firms and inland/western provinces relative to the Eastern coast.
  - Wu (2008) finds an investment efficiency score of around 66 percent for China as a whole, but significantly smaller in inland and Western regions.
- Novel features of this paper:
  - Includes post-global-crisis period when investment was further ratcheted up.
  - Uses consumption and income linkages to identify investment excessiveness (complements or alternatives to returns-to-capital and ICOR measures).
  - Assesses provincial and sectoral variation to inform policy reallocation.

### Conceptual framework: defining and identifying excessive investment
- Definition:
  - Excessive/unproductive investment is the component of investment that does not add to the productive capital stock (i.e., does not create future flows of goods and services), instead contributing only to contemporaneous GDP and later being wasted via depreciation.
- Formal intuition:
  - Distinguish used capital (k_u) and unused/excess capital (k_w); unused investment contributes to output only contemporaneously and then is wasted.
- Empirical second-best strategy:
  - Use GDP excluding investment (GDP_adj,t = GDP_t - I_t) as a proxy for the productivity of investment up to t-1 and any spillovers from I_t on GDP_t.
  - If the share of wasted investment I_w is persistently high, investment-to-GDP will rise while GDP_adj growth falls.
- Observed patterns:
  - Over the last two decades investment growth trending up and GDP_adj growth trending down suggests declining investment efficiency.
  - In some inland provinces GDP_adj/GDP ratio fell to as low as 10 percent.
  - Two-thirds of the rise in China’s investment-to-GDP ratio and all of the decline in China’s private consumption-to-GDP ratio over the last ten years is attributable to inland provinces.

### Empirical tests — data and strategy
- Dataset and scope:
  - Provincial-level data over 1978-2011 covering 22 provinces, 3 municipalities (all except Chongqing), and 4 autonomous regions (all except Tibet).
  - Provinces classified as coastal: Beijing, Hebei, Fujian, Guangdong, Hainan, Jiangsu, Shandong, Shanghai, Tianjin and Zhejiang (10 jurisdictions). The rest were inland, with the exception of Liaoning and Heilongjiang (North eastern provinces treated separately).
  - Variables deflated with provincial GDP deflators, CPI, and FAI investment price indices. Base year 2000.
  - Variables found I(1) by panel ADF tests; models estimated in growth rates (log first-differences).
- Two testable implications:
  1. If investment is excessive, investment should Granger-cause consumption; consumption should have little lasting power on its own (transmission via household income).
  2. If investment is excessive, it should raise corporate profitability more than household income.

### Empirical tests — main findings and magnitudes
- Granger causality:
  - Panel Granger tests generally find investment Granger-causes private consumption for the overall sample and most subsamples; exception: coastal provinces in the post-2000 period where causality was not found.
- Consumption dependence on investment:
  - Overall sample: a 10 percent increase in investment increases private consumption by around 2 percent in the first year and up to 3 percent over time.
  - Since 2000: the overall impact strengthened; a 10 percent increase in investment leads to an increase of up to 6 percent in private consumption over three years.
  - Coastal regions (post-2000): private consumption has become more self-sustaining and less dependent on investment; effect of investment on private consumption is now insignificant in coastal provinces in recent period.
  - Inland regions:
    - Private consumption became more dependent on direct support from investment.
    - A 10 percent increase in investment leads to a 2.5-3 percent increase in private consumption over time (overall inland estimate).
    - The effect rose from around 1.5 percent pre-2000 to almost 6 percent in the last decade for inland provinces.
    - Private consumption in inland regions shows little self-sustaining momentum and a weaker relationship with GDP_adj.
- Robustness and transmission:
  - Structural consumption function analysis shows household income transmits much of the investment impact to private consumption. Adding investment to a specification that already includes household income renders investment insignificant; excluding household income makes investment highly significant.
- Income channels and corporate vs household impacts:
  - Investment is positively associated with household income; relationship is stronger in coastal provinces than in inland provinces.
  - Investment is more strongly associated with corporate profitability in inland provinces than in coastal ones (suggesting inland investment benefits corporates relatively more than households).
- Sectoral composition and household income:
  - Investment in agriculture and services yields a greater boost to household income than investment in manufacturing and real estate.
  - Agriculture and services combined account for around 60 percent of China’s GDP but were responsible for only one quarter of the rise in fixed asset investment observed since 2004 — implying scope to reallocate investment toward sectors with larger household income spillovers.

### What about financing excessive investment? (constraints and sustainability)
- Three historical financing sources enabling high investment:
  1. Land resources (local government land sales).
  2. Abundant labor and subdued labor share of income.
  3. Bank financing and ample liquidity expansion.
- Land resources (figures and constraints):
  - Local governments raised substantial revenue from land sales: RMB2.9 trillion in 2011; fell to RMB2.35 trillion in the first 11 months of 2012 due to slow real estate market.
  - Cost of land acquisition rose to RMB1.69 trillion, amounting to 72 percent of land sales revenue.
  - Draft amendment of the Land Management Law requires local governments to raise the purchasing value by ten–fold for purchased arable land, signaling future land procurements will be costlier.
  - Arable land has hit the minimum limit set by the State Council for food security; recent years show no net conversion of arable land into construction and more distant reclaimed land being used to preserve arable land near cities.
- Abundant labor and demographics:
  - Unit labor cost has moved into positive territory since the late 2000s, indicating faster wage increases (or falling capital efficiency) and a tightening labor market.
  - Demography-induced savings likely peaked and will decline.
- Bank financing and liquidity:
  - Rapid expansion of bank financing provided liquidity to fund investment; by the late 2000s liquidity surged above productive capacity, fueling asset-price spikes: a stock market bubble in 2007 and a rapid increase in property prices in 2009-10 after stimulus.
  - Conclusion: China no longer has the spare room to stimulate via monetary expansion without creating asset bubbles; future stimulus must rely more on efficiency gains in resource allocation.
- Government resources and local government urgency:
  - With increasingly inefficient investment at provincial levels, especially in non-Eastern provinces, and tighter financing conditions, local governments need to curtail investment and prioritize projects that generate greater and more lasting private-sector responses within reasonable timeframes.
  - Local governments face tightening budgets due to weaker land-sale revenue and higher land procurement costs.

### Policy implications and recommendations
- Reorient investment:
  - Shift away from projects that mainly boost corporate income transiently (particularly in inland provinces) and toward sectors with greater labor intensity and stronger household-income spillovers: agriculture and services.
  - Prioritize projects that demonstrably add to productive capital stock rather than generate only contemporaneous GDP.
- Financial sector reform:
  - Mobilize financial reforms to enhance capital allocation efficiency and to redirect credit away from low-return projects toward investment that supports household incomes and sustainable consumption.
  - Liberalization of the financial sector is presented as urgent to allow greater reliance on market signals.
- Provincial differentiation:
  - Avoid indiscriminate replication of the coastal investment model in inland provinces; exploit provincial comparative advantage rather than attempting to convert all provinces into manufacturing bases.
- Fiscal and land policy:
  - Recognize limits of land-based financing; prepare for reduced local government revenue from land sales and higher acquisition costs.
- Monetary policy:
  - Manage monetary and liquidity policy carefully to avoid asset-price bubbles; rely increasingly on structural reforms and efficiency improvements rather than blunt liquidity expansion.
- Trade-off and objective:
  - Cutting investment, even if excessive, will inevitably slow growth; the only way to maintain relatively robust growth is to raise capital efficiency to avoid large deadweight losses from wasted investment.

### 2011 — Investment financing, fiscal space, and transition
- Central government role and fiscal space:
  - The central government resources are described as "their last line of defense," and "it appears increasingly evitable that the central government will need to step in to support investment financing during the transition period until a more durable growth model sets in."
  - "The current stock indicates that the government has fiscal space to support local government investment during the transition period."
  - Policy challenge: "to use this remaining fiscal space wisely to ensure that China can be placed on a new footing that will ensure another decade of successful economic growth."
- Composition of savings and reserves:
  - "A larger share of the pickup in investment in 2011 was financed from corporate savings."
  - Consequence: "As such, net corporate savings fell sharply."
  - "Household savings have been relatively stable throughout the last decade."
  - "On the other hand, government net savings have been rising steadily." Caveat: this rising government net savings "ignores growing contingent liabilities (including from an aging population)."
  - Despite the non-convertibility of the RMB, "China has significant financial resources saved up as official reserves."
  - Distinction in reserves: the non-sterilized component of NFA accumulation has a counterpart in local liquidity; the sterilized component represents pure savings usable both locally and abroad.
- Shift to consumption-led growth:
  - Central policy objective: "ensuring strong and stable consumption will be the key to sustained growth in the coming years."
  - Investment will play a diminished role but remain important "by boosting productivity and raising household incomes."
  - Structural change required: "overall investment will have to be lowered and also reoriented by allowing consumption to guide what investments are made."
  - Examples: "expanding agriculture and servicesincluding investing in healthcare, education and financial servicesare likely to be more important instead of building more factories to supply steel, cement and appliances for foreign consumers."
  - Risk of continuing current trends: "valuable resources are likely to be wasted and nonperforming assets will accumulate," with financing constrained by "dwindling land, labor, and government resources as well as risks associated with excess liquidity."
- Regional and urbanization considerations:
  - Empirical result: "some degree of excessive investment in inland provinces."
  - Policy guidance by region:
    - "Coastal areas on average appear to have reached a stage where consumption is self-sustaining and not dependent on contemporary investment."
    - "Inland regions on average would be better off cutting their overall investment, and reorienting a reduced amount of investment that would more effectively contribute to the capital stock and lead to more enduring beneficial impacts on consumption and economic activity."
  - Urbanization sequence: "infrastructure investment, and construction of housing, putting in place the social services system, and then finally the creation of a market where further value-added will be generated and economic activity sustained."
  - Warning: "the creation of a market will require a different set of skills that should be underpinned by transparent and simple rules for businesses. Otherwise, urbanization could lead to growth of the urban poor."
- Final assessment:
  - "Increasing the efficiency of investment under the current top-down allocation model will be difficult given the increasing complexity of China’s economy and the uncertain nature of future growth engines amid a changing global landscape."
  - Hence, "a greater reliance on market signals would seem inevitable. This will be possible only through financial sector reform."
  - The trade-off: higher capital efficiency is necessary to maintain relatively robust growth when cutting excessive investment; otherwise "large deadweight losses from wasted investment will arise that could become increasingly difficult to resolve."

*Source: _wp1383 - References (excerpts from the referenced IMF working paper PDF).*

### References .............................................................................................................

### _wp1383 - References

### Introduction and policy context
- China’s growth model has been “heavily reliant on exports and investment” and “may have run its course.”
- Debate on future role of investment:
  - One view: “huge infrastructure needs” and ongoing urbanization require continued ample investment.
  - Opposing view: limited absorptive capacity, increasingly inefficient investment, and tightening financing conditions constrain continued high investment.
- Policy signal: Chinese government for the first time called for a reduction in “redundant” public investment at its most recent Economic Work Conference.
- Key policy challenge: how to lower investment toward a sustainable steady-state without precipitating a large fall in consumption — i.e., raise capital efficiency so growth remains relatively robust as aggregate investment declines.
- Paper’s high-level conclusion:
  - Some types of investment are becoming excessive, especially in inland regions.
  - Investment in coastal provinces is more likely to contribute to productive capital and to household income; in inland provinces investment is more closely associated with corporate income and transient GDP effects.
  - Shifting investment toward agriculture and services is likely superior to manufacturing and real estate for sustaining household income and consumption.
  - Reorientation would require financial sector reform to enhance capital efficiency.

### Literature review (select findings and positioning)
- Prior cross-country work (Lee et. al (2012)) found China’s “excess investment” grew to around 10 percent of GDP and was financed via a hidden transfer from households and SMEs toward large corporates amounting to around 4 percent of GDP every year.
- Empirical studies cited document lower returns to capital in state-owned firms and inland/western provinces relative to the Eastern coast.
  - Wu (2008) finds an investment efficiency score of around 66 percent for China as a whole, but significantly smaller in inland and Western regions.
- Novel features of this paper:
  - Includes post-global-crisis period when investment was further ratcheted up.
  - Uses consumption and income linkages to identify investment excessiveness (complements or alternatives to returns-to-capital and ICOR measures).
  - Assesses provincial and sectoral variation to inform policy reallocation.

### Conceptual framework: defining and identifying excessive investment
- Definition:
  - Excessive/unproductive investment is the component of investment that does not add to the productive capital stock (i.e., does not create future flows of goods and services), instead contributing only to contemporaneous GDP and later being wasted via depreciation.
- Formal growth-accounting intuition:
  - Distinguish used capital (k_u) and unused/excess capital (k_w); unused investment contributes to output only contemporaneously and then is wasted.
- Empirical second-best strategy:
  - Use GDP excluding investment (GDP_adj,t = GDP_t - I_t) as a proxy for the productivity of investment up to t-1 and any spillovers from I_t on GDP_t.
  - If the share of wasted investment I_w is persistently high, investment-to-GDP will rise while GDP_adj growth falls.
- Observed patterns:
  - Over the last two decades investment growth trending up and GDP_adj growth trending down suggests declining investment efficiency (Figure 2 description).
  - In some inland provinces GDP_adj/GDP ratio fell to as low as 10 percent.
  - Two-thirds of the rise in China’s investment-to-GDP ratio and all of the decline in China’s private consumption-to-GDP ratio over the last ten years is attributable to inland provinces.

### Empirical tests — data and strategy
- Dataset and scope:
  - Provincial-level data over 1978-2011 covering 22 provinces, 3 municipalities (all except Chongqing), and 4 autonomous regions (all except Tibet).
  - Provinces classified as coastal: Beijing, Hebei, Fujian, Guangdong, Hainan, Jiangsu, Shandong, Shanghai, Tianjin and Zhejiang (10 jurisdictions). The rest were inland, with the exception of Liaoning and Heilongjiang (North eastern provinces treated separately).
  - Variables deflated with provincial GDP deflators, CPI, and FAI investment price indices. Base year 2000.
  - Variables found I(1) by panel ADF tests; models estimated in growth rates (log first-differences).
- Two testable implications:
  1. If investment is excessive, investment should Granger-cause consumption; consumption should have little lasting power on its own (transmission via household income).
  2. If investment is excessive, it should raise corporate profitability more than household income.

### Empirical tests — main findings and magnitudes
- Granger causality:
  - Panel Granger tests generally find investment Granger-causes private consumption for the overall sample and most subsamples; exception: coastal provinces in the post-2000 period where causality was not found.
- Consumption dependence on investment (Table 2 and discussion):
  - Overall sample: a 10 percent increase in investment increases private consumption by around 2 percent in the first year and up to 3 percent over time.
  - Since 2000: the overall impact strengthened; a 10 percent increase in investment leads to an increase of up to 6 percent in private consumption over three years.
  - Coastal regions (post-2000): private consumption has become more self-sustaining and less dependent on investment; effect of investment on private consumption is now insignificant in coastal provinces in recent period.
  - Inland regions:
    - Private consumption became more dependent on direct support from investment.
    - A 10 percent increase in investment leads to a 2.5-3 percent increase in private consumption over time (overall inland estimate).
    - The effect rose from around 1.5 percent pre-2000 to almost 6 percent in the last decade for inland provinces.
    - Private consumption in inland regions shows little self-sustaining momentum and a weaker relationship with GDP_adj.
- Robustness:
  - Structural consumption function analysis (Table 3) shows household income transmits much of the investment impact to private consumption. Adding investment to a specification that already includes household income renders investment insignificant; excluding household income makes investment highly significant — consistent with investment operating through household income.
- Income channels and corporate vs household impacts (Table 4 and Figure 7):
  - Investment is positively associated with household income; relationship is stronger in coastal provinces than in inland provinces.
  - Investment is more strongly associated with corporate profitability in inland provinces than in coastal ones (suggesting inland investment benefits corporates relatively more than households).
- Sectoral composition and household income (Table 5 and Figure 8):
  - Investment in agriculture and services yields a greater boost to household income than investment in manufacturing and real estate.
  - Agriculture and services combined account for around 60 percent of China’s GDP but were responsible for only one quarter of the rise in fixed asset investment observed since 2004 — implying scope to reallocate investment toward sectors with larger household income spillovers.

### What about financing excessive investment? (constraints and sustainability)
- Three historical financing sources enabling high investment:
  1. Land resources (local government land sales).
  2. Abundant labor and subdued labor share of income.
  3. Bank financing and ample liquidity expansion.
- Land resources:
  - Local governments raised substantial revenue from land sales (RMB2.9 trillion in 2011; fell to RMB2.35 trillion in the first 11 months of 2012 due to slow real estate market).
  - Cost of land acquisition rose to RMB1.69 trillion, amounting to 72 percent of land sales revenue.
  - Policy change: draft amendment of the Land Management Law requires local governments to raise the purchasing value by ten–fold for purchased arable land, signaling future land procurements will be costlier and financing via cheap land purchases less viable.
  - Constraint: arable land has hit the minimum limit set by the State Council for food security; recent years show no net conversion of arable land into construction and more distant reclaimed land being used to preserve arable land near cities.
- Abundant labor:
  - Labor costs were historically running below productivity increases, aided by a low share of labor income, enabling rapid capital accumulation.
  - Unit labor cost has moved into positive territory since the late 2000s, indicating faster wage increases (or falling capital efficiency) and a tightening labor market.
  - Demography-induced savings likely peaked and will decline (reference to Lee et al. (2013)).
- Bank financing and liquidity:
  - Rapid expansion of bank financing provided liquidity to fund investment. At first liquidity was below monetized value of capacity and room existed for expansion.
  - By the late 2000s liquidity surged above productive capacity, fueling asset-price spikes: stock market bubble in 2007 and a rapid increase in property prices in 2009-10 after stimulus.
  - Conclusion: China no longer has the spare room to stimulate via monetary expansion without creating asset bubbles; future stimulus must rely more on efficiency gains in resource allocation.
- Government resources and urgency for local governments:
  - With evidence of increasingly inefficient investment at provincial levels, especially in non-Eastern provinces, and tighter financing conditions, local governments need to curtail investment and prioritize projects that generate greater and more lasting private-sector responses within reasonable timeframes.
  - Local governments face tightening budgets and constraints from weaker land-sale revenue and higher land procurement costs.

### Policy implications and recommendations (implicit in analysis)
- Reorient investment away from projects that mainly boost corporate income transiently (particularly in inland provinces) and toward:
  - Sectors with greater labor intensity and stronger household-income spillovers: agriculture and services.
  - Projects that demonstrably add to productive capital stock rather than generate only contemporaneous GDP.
- Financial sector reform:
  - Mobilize financial reforms to enhance capital allocation efficiency and to redirect credit away from low-return projects toward investment that supports household incomes and sustainable consumption.
- Provincial differentiation:
  - Avoid indiscriminate replication of the coastal investment model in inland provinces; exploit provincial comparative advantage (e.g., agricultural advantages) rather than trying to convert all provinces into manufacturing bases.
- Fiscal and land policy:
  - Recognize limits of land-based financing; prepare for reduced local government revenue from land sales and higher acquisition costs.
- Manage monetary and liquidity policy carefully to avoid asset-price bubbles; rely increasingly on structural reforms and efficiency improvements rather than blunt liquidity expansion.

*Source: _wp1383 - References (excerpts from the referenced IMF working paper PDF)._

### 2011. Their last line of

### _wp1383 - 2011. Their last line of

### Investment financing and fiscal space
- The central government resources are described as "their last line of defense," and "it appears increasingly evitable that the central government will need to step in to support investment financing during the transition period until a more durable growth model sets in."
- "The current stock indicates that the government has fiscal space to support local government investment during the transition period."
- The text highlights a challenge: "The challenge is to use this remaining fiscal space wisely to ensure that China can be placed on a new footing that will ensure another decade of successful economic growth."

### Composition of savings and reserves
- "A larger share of the pickup in investment in 2011 was financed from corporate savings."
- Consequence: "As such, net corporate savings fell sharply."
- "Household savings have been relatively stable throughout the last decade."
- "On the other hand, government net savings have been rising steadily."
- Caveat: this rising government net savings "ignores growing contingent liabilities (including from an aging population)."
- Despite the non-convertibility of the RMB, "China has significant financial resources saved up as official reserves (Figure 16)."
- Distinction in reserves: "While the non-sterilized component of the net foreign asset (NFA) accumulation has a counterpart in local liquidity, the sterilized component represents pure savings that can be used for any purpose both locally and abroad."

### Policy implications: shifting from investment-led to consumption-led growth
- Central policy objective: "ensuring strong and stable consumption will be the key to sustained growth in the coming years."
- Investment's future role: "By boosting productivity and raising household incomes, investment will also have a role to play, albeit diminished from the outsized influence it has been enjoying over the last decade."
- Structural change required:
  - "overall investment will have to be lowered and also reoriented by allowing consumption to guide what investments are made."
  - "expanding agriculture and servicesincluding investing in healthcare, education and financial servicesare likely to be more important instead of building more factories to supply steel, cement and appliances for foreign consumers."
- Risks of continuing current trends: "valuable resources are likely to be wasted and nonperforming assets will accumulate," while China's ability to finance investment is constrained by "dwindling land, labor, and government resources as well as risks associated with excess liquidity."

### Regional implications and investment efficiency
- Empirical finding: "Our empirical results uncover some degree of excessive investment in inland provinces."
- Policy guidance by region:
  - "Coastal areas on average appear to have reached a stage where consumption is self-sustaining and not dependent on contemporary investment."
  - "While arguments can be made to continue for a while longer an investment-induced growth strategy in some of the poorer provinces, inland regions on average would be better off cutting their overall investment, and reorienting a reduced amount of investment that would more effectively contribute to the capital stock and lead to more enduring beneficial impacts on consumption and economic activity."
- Sectoral preference: "we find investments in agriculture and services to be superior as a result of their more direct impact on household incomes."

### Urbanization and market development
- Urbanization stages described: "infrastructure investment, and construction of housing, putting in place the social services system, and then finally the creation of a market where further value-added will be generated and economic activity sustained."
- Policy warning: "the creation of a market will require a different set of skills that should be underpinned by transparent and simple rules for businesses. Otherwise, urbanization could lead to growth of the urban poor, which will be more difficult to tackle than rural poverty."

### Financial sector reform and growth sustainability
- Assessment: "increasing the efficiency of investment under the current top-down allocation model will be difficult given the increasing complexity of China’s economy and the uncertain nature of future growth engines amid a changing global landscape."
- Reform prescription: "Thus, a greater reliance on market signals would seem inevitable. This will be possible only through financial sector reform, making liberalization of this sector an urgent issue."
- Trade-off noted: "cutting investment, even if it is excessive, will inevitably slow growth. Here again, the only way to maintain relatively robust growth would be to raise capital efficiency."
- Risk if no reform: "large deadweight losses from wasted investment will arise that could become increasingly difficult to resolve."

*Source: _wp1383 - 2011. Their last line of*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2013/_wp1383.pdf_