Deterioration of Capital Productivity and Debt Accumulation

Key Insight

The massive stimulus program, while mitigating the immediate impact of the global crisis, masked China's underlying structural challenge: the 'resource mobilization' phase of growth was nearing its end, demanding a transition to an 'efficiency' phase. The Hu Jintao administration (2010-2012) struggled to implement significant structural reforms, failing to enforce solutions despite recognizing problems like the need to increase consumption's share in the economy. Instead, the government permitted a substantial buildup of debt by local governments and corporations. This debt primarily financed investment projects that superficially boosted reported growth during spending, but yielded very low future returns, thereby undermining long-term economic vitality.

Evidence of deteriorating investment efficiency became clear post-2008. The average return on capital, which had peaked at a spectacular 17% in 2006, plummeted to 9% by 2014, according to the OECD. Concurrently, the incremental capital output ratio (ICOR), indicating the amount of new investment needed for a dollar of GDP growth, rose from a steady 3-4 throughout the reform period up to 2007, to exceed 5 by 2013. Productivity's contribution to growth also severely shrank, from approximately 50% between 2000 and 2007, to an average of about 25% from 2008-2012, and a mere one-sixth of GDP growth by 2012. This decline is partly explained by the sharp fall in returns within state-owned enterprises (SOEs) after 2008, which, despite poor performance, maintained an disproportionately large economic share due to political connections.

A clear manifestation of China's productivity problem is the surging debt-to-GDP ratio, or 'leverage.' The total borrowings of households, nonfinancial companies, and the government, which had remained stable at under 140% of GDP before the financial crisis, surged by roughly 90 percentage points in five years, reaching 230% of GDP by 2015. This signifies that an increasing amount of debt is being incurred to finance projects with progressively lower returns, rather than reflecting improved financial sophistication. Most of this additional debt incurred since 2008 was by local governments and SOEs for low-productivity investments. This trend is unsustainable, posing a significant risk of either a financial crisis, as loans default, or a recession, as vast capital becomes tied up in unproductive endeavors. The economy's diminished productivity and increased reliance on debt since 2008 highlight the urgent need for a shift to efficiency-driven growth to avert a looming crisis.