China’s Excess of Capital: Causes and Consequences

The Chinese economy reached a major turning point in the mid-1990s as it developed a market economy under the reform and opening policy. Until then the authorities had employed a fiscal and monetary system giving local governments a great deal of discretion in management, but since then they have sought to strengthen the central government’s control. They implemented reforms to provide economic management with a controlled orientation through specific rules, as symbolized by the introduction of a tax sharing system in 1994. Another noteworthy change also began at that time. Whereas the Chinese economy used to have an insufficiency of capital, as is normal in developing countries, it gradually shifted toward what economists call an “overaccumulation of capital” against a backdrop of blazing economic growth and vigorous domestic investment.

A set of economic policies adopted under Chinese President Jiang Zemin (Communist Party of China general secretary 1992–2002; president 1993–2003) set the stage for the transition from an economy with insufficient capital to one with an overabundance of it. Significant factors were the active attraction of capital investment by overseas companies, the promotion of urban development through the sale of the right to use state-owned land, and the shift to market-supplied housing, which traditionally had been supplied by such entities as state-owned enterprises. At the same time, subsidies were provided to launch full-fledged infrastructure construction in the inland region.

Signs that China had become a country with an overaccumulation of capital did not become conspicuous, however, until after the arrival of a new administration under President Hu Jintao (CPC general secretary 2002–present; president 2003–present), who succeeded Jiang early in the twenty-first century. Government intervention in the market became particularly pronounced in and after 2008, when in response to the global financial crisis, China introduced a set of stimulus measures. Characterized by some economists as guojin mintui (国进民退), a Chinese expression that means, “the state advances as the private sector retreats,” these measures were not designed to provide basic remedies for the overabundance of capital stock. The government intervention instead completed the excessive fixed capital investments backed by regional governments, putting the problem off.

Overaccumulation of Capital and Its Consequences

Let me begin with a brief review of what it means for an economy to accumulate too much capital, drawing on the theory of macroeconomic dynamics. A state of capital overaccumulation can be defined in simple terms as one where the returns on fixed capital investment have fallen to the point where it would clearly be better for economic welfare to rein in investment and expand consumption, and yet capital investment is sustained nonetheless while consumption remains repressed.

Here, the relationship between the “rate of time preference for consumption” and the “return on investment” is important. The rate of time preference, a measure of the preference for consumption today over consumption tomorrow, can be expressed as the ratio between one unit of consumption at present and the same value of consumption in the future. When the rate of time preference exceeds the return on investment, reducing current investment and increasing consumption will enhance economic welfare.

An economy can be judged to have capital overaccumulation when an adequate capital stock has been built up, with the result that the return on investment is already below the rate of time preference, and yet investment momentum does not diminish, leading to the accumulation of yet more capital. In this situation, the decline in real investment returns is offset by the expectation that because asset prices are rising, capital gains can be earned in the future. There is thus a close affinity between capital overaccumulation and the formation of asset bubbles.

The consequences for the Chinese economy of its overabundance of capital can be summed up in three points: (1) the manifestation of real estate bubbles, (2) the widening of asset disparities among economic actors, and (3) the advent of a more obvious dual economic structure.

Real Estate Bubbles and Widening Disparity

Institutional reforms lie behind point 1, the emergence of real estate bubbles. As a result of the land system reform in the second half of the 1990s, local governments became able to allow real estate developers to transfer land use rights to entrepreneurs for value. At the same time, government corporations became able to sell housing to employees. This paved the way for progress toward the transformation of housing into a market and a commodity.

In this light, the institutional origin of rapidly rising property prices, which are frequently characterized as bubbles, can be plainly traced to the years of the Jiang Zemin administration. At the time, however, supervision under Premier Zhu Rongji kept collusive ties between local government officials and entrepreneurs in check. Thus we may say it was not until the restraints weakened under the Hu Jintao administration that serious problems moved to the fore in the form of repeatedly occurring property bubbles.

With housing assets being privatized and marketed, asset prices overall, including land use rights, spiraled upward. As a result, the gap between people with and without assets grew wider. According to a study by the Institute of Sociology of the Chinese Academy of Social Sciences, the Gini coefficient was 0.496 for household income, 0.653 for asset ownership of households, and the top 20% quintile held assets as much as 72.4 times greater than the bottom 20% (Li, Chen, and Li 2006).(*1) It may be readily understood that widening disparities in the stock of assets held by families produce a growing gap in income from capital, which translates into widening differentials in the flow of income to families.

Dual Economic Structure

I would add a word here about point 3, the emergence of a more conspicuous dual structure. The industrial structure can be divided between large corporations with close ties to the central and provincial governments on one side, and smaller private companies on the other. When markets have a monopolistic or oligopolistic structure, corporations backed by governments can benefit from growing rents (profits). In the private sector, however, profits are held down by vigorous competition. Such is the context in which critics complained about the guojin mintui previously mentioned, where authorities have favored the public sector and penalized the private sector. The stimulus measures adopted to deal with the global financial crisis caused government intervention in the market to become especially intrusive, and differentials in profit rates between state-owned enterprises and other businesses grew yet wider.

It may also be noted that smaller private companies will be seriously hurt by moves to tighten the monetary reins when there are inadequacies in the infrastructure they need to sustain a solid credit position. One example of this is the credit crisis that hit the coastal city of Wenzhou in the autumn of 2011, disrupting lending and borrowing among private financial institutions and businesses. This caused a breakdown in private financing, which touched off a spate of corporate bankruptcies and drove entrepreneurs into hiding.

Causes of the Overabundant Capital

As I commented at the start, the shift from insufficient capital stock to an overaccumulation moved into full swing after Hu Jintao became China’s leader. A number of features can be seen in an economy in which the capital stock has become too large. In China’s case, the key phenomena reached critical proportions during the Hu administration and included (1) vigorous investment behavior led by local governments, (2) a trend of decline in labor’s slice of the economic pie, (3) growth in companies’ internal reserves, and (4) a high savings rate in the household sector. In the following, I will discuss each of these aspects in turn.

Vigorous Investment Led by Local Governments

In the course of China’s development under the reform and opening policy, a government and business complex took shape among large groups of local public bodies, banks, real estate developers, and other actors, and it behaved in the fashion of corporatism. As I argue in a book I wrote (2011), this cast of actors drove China’s rapid growth forward by means of brisk investment activity at a time when consumption demand was sluggish.(*2)

Of China’s total investment, the share under the jurisdiction of local governments, which has exceeded 50% since the 1990s, continued to climb and is now at a level close to 90%. In a situation where society still lacks an adequate safety net, high-speed growth has lifted income levels without providing a corresponding boost to domestic consumption. Among the components of domestic demand propping up economic growth, the main one has been fixed asset investment backed by local governments.

But has this energetic investment encouraged by local authorities really led to efficient utilization of the available resources? Reports on a number of empirical studies have been published, and they tend to be skeptical. There is an interesting research project showing that over the period from 1980 to 2002, when expressway construction moved rapidly forward, the development of regional roads needed by local communities lagged behind (Fan and Chan-Kang 2008).(*3) The researchers first divided roads into two groups—high-ranking and low-ranking roads—to elucidate road supply by type, and next they compared the extent to which the two classes of roads contributed to productivity improvement in urban and rural areas, as well as to the alleviation of poverty. What they found was that by each method of estimation they used, the roads with the largest economic effect were the low-ranking ones, that is, roads closely connected to community life. Why is it that expressways and other trunk roads were targeted for development, while work on local roads that would have had a greater economic impact was put off? Their conclusion was that because high-ranking roads produced more short-term returns, local governments had a strong incentive to give them priority.

The influence of this government-led investment activity extends far beyond the sphere of infrastructure, where road construction takes place. As can be seen in the 4 trillion yuan stimulus package implemented in response to the global financial crisis, plant and equipment investment by state-owned enterprises is also strongly affected by the policy objectives of the central and local governments. Depending on the region, moreover, large disparities exist in the effectiveness of this government-led investment in fixed assets. A number of empirical studies have demonstrated that under the grand strategy of the Hu administration, which made the creation of a “harmonious society” part of its policy and placed priority on investment in the interior of the country, capital has been distributed inefficiently. It is highly likely that this has aggravated the overaccumulation of capital.

The Downward Drift in Labor’s Share of Income

From a macroeconomic perspective, a trend of decline in labor’s share of income has been in evidence since the 1990s. Slumps in household consumption are closely connected to a downward movement in the percentage of income distributed to workers. And when consumption demand is sagging, it should be easy to persuade public officials to prop growth up by stimulating investment demand. We should note, however, that there are good reasons for questioning how accurate the estimates of labor’s share of income in the overall economy are when macroeconomic methods are used. To derive more reliable estimates, one needs to work with microeconomic data, such as statistics on the manufacturing sector. One useful technique here is to assess the extent to which labor’s share has been overestimated by comparing it with labor’s marginal productivity.

In the second half of the 1980s a reform of state-owned enterprises got underway. At the time, it was often asserted that wage payments to employees were too large in corporations that had no need to pursue profits. And the excessive wages, it was charged, were tying the hands of management. Over subsequent years, however, the situation reversed. The trend in labor’s share of income shifted from the overly generous to wages at levels below the contributions workers were making.

In particular, a study by Fleisher and others (2011) leaves one with a memorable impression of the change in circumstances.(*4) The researchers estimated the gap between labor’s marginal productivity and wages in the 1998–2000 period for 425 mining and manufacturing companies nationwide. Among employees with a good education (skilled workers), they found a wage level in 2000 amounting to only 7.5% of marginal productivity, and among employees with relatively little education (unskilled workers), the wage level was 19.2%. In both cases, wages were lagging far behind what these workers were contributing as measured by marginal productivity. Pioneering research of this type leaves one with little doubt that labor’s share of income in manufacturing has fallen below labor productivity since the turn of the century.

Growth in Corporate Internal Reserves

Chinese data on gross saving rates by sector show that the rate in the corporate sector has moved to a remarkably high level since 2000. The rise in the rate can be seen as the result of a situation in which managers, finding it hard to line up loans from formal financial institutions, have held down wages and built up internal reserves. Particularly among smaller companies, which are exposed to stiff competition, this pattern of behavior has probably been normal. And with ample internal reserves on hand, managers have undoubtedly been motivated to channel even larger sums into fixed capital investment. In other words, a chain of causal relationships has been at work, with the decline in labor’s share of income leading to larger internal reserves, which in turn have fueled active capital accumulation by the corporate sector.

The Household Sector’s High Savings Rate

In the meantime, the household sector has continued to put money into savings at a fast pace. One of the main causes of the high savings rate is an inadequate social security system, particularly in rural regions. Families have had no choice but to build up their savings as insurance against future risks. Over the years since the second half of the 1990s, the authorities have worked to remove companies from the social security system as part of the reform of state-owned enterprises, and they have also encouraged families to acquire their own homes. But because they did not put a reliable safety net into place, the household sector exhibited a strong propensity to save, which was motivated by its need to ensure safety by itself.

This completes my review of the four main features lying behind China’s excessive capital stock. Rather than seeking to identify which among them was the main cause, we should think of them as factors that work in a complementary fashion. For instance, decisions reached by managers of manufacturing companies to augment internal reserves would have put pressure on wage income, causing labor’s slice of the economic pie to shrink. The managerial decisions, in short, became one of the main causes of sluggish consumer spending. The central and local governments, meanwhile, wanted to sustain rapid growth and maintain employment stability at times when consumption demand in the household sector slumped, so they had a good reason for relying on brisk investment in fixed capital.

Even in such a situation, it should have been possible to invigorate consumption and restrain capital accumulation if the public sector had acted to improve pensions and other social insurance arrangements and provide an expanded supply of services. By strengthening social security, the authorities could have facilitated an income transfer from the working population to people in retirement, who have a high propensity to consume. Such measures would have resulted in more restrained capital accumulation. But what the Chinese government elected to do instead was to address the immediate problem of gaps that opened up between supply and demand. Putting off work on construction of a better social security system, it made use of fiscal and monetary tools to stimulate fixed capital investment by the public and private sectors. In this context, the trend toward an overabundance of capital could not be held in check, and the economy could not be extricated from its dynamically inefficient operation.

Issues That Need to Be Addressed

According to Barry Naughton (2011), one of the foremost American scholars of the Chinese economy, the economic policies implemented by the Hu administration as it sought to create a “harmonious society” and respond to the financial crisis can be summarized in the following points.(*5) First, to improve life in rural regions, reforms of the medical-care system, the pension system, and other components of social security were carried out, and calls were made to make housing affordable. Second, expenditures on subsidies were stepped up for rural communities, agriculture, and the inland region. Third, the reform of state-owned enterprises slowed down while monopolistic arrangements advanced, and resources were concentrated on designated industries, such as energy, natural resources, and communications. Fourth, more energetic industrial and technological policies were instituted to support strategic industries and “megaprojects” and promote the development of basic technologies.

With the exception of the steps taken to strengthen social security, these policies did not offer a fundamental solution to the oversupply of capital. They instead led to greater government intervention in the market and postponed action on the huge capital stock. In some respects, moreover, the stepped-up intervention caused the contradictions of the capital overaccumulation to become more critical. As a result, we may say that China has been caught in a kind of trap, one that encourages the state to strengthen its controls step by step without dealing with the underlying contradictions.

The credit crisis that hit Wenzhou in the autumn of 2011 that I mentioned earlier can be seen as the localized collapse of an asset bubble, and more such phenomena are to be expected as long as the overabundance of capital stock lasts in China. But an overaccumulation of capital is not a problem that can be put off indefinitely. When the country’s potential growth rate begins to drop as a result of contraction in the working population, action will become imperative.

Such is China’s situation on the eve of the inauguration of a new administration, in which Xi Jinping is the most likely candidate for paramount leader. To head off a disaster, the new administration must tackle tasks on a wide range of fronts. It needs to improve the social security system in rural regions, promote what is called “rural-urban integration,” restructure incentives for regional governments to remove constraints on the supply of efficient infrastructure, construct a competitive financial system to assist the rise of private companies, and reduce asset disparities through the introduction of a system of asset taxation (property taxes).

In some respects, all such policies will force the government to intervene yet more actively in the market. In other respects, however, they will force it to withdraw from a position of excessive intervention. In short, the government will have a policy agenda requiring it to apply the accelerator and the brake at the same time. The management of the new administration will obviously not be easy.

(Originally written in Japanese.)