China's Wasted Investment

This story has been making the rounds. There's nothing surprising about the conclusion, but hard numbers are impossible to estimate with any accuracy.

China wasted $6.9 trillion on bad investment post 2009
China wasted an approximate 42 trillion yuan ($6.9 trillion) on "ineffective investment" in the five years from 2009, with the problem worsening in the past two years, a government official and an economist were quoted as saying in the local media.

From relying too much on investment to lift the economy to supplying state firms with cheap loans that fueled unnecessary spending, the two pressed China to face up to its problem of making investment with low or no efficiency.

I've seen some people saying that China's investment wasn't wasted. The problem with that argument is that we cannot see investments that didn't take place. We can see that private businesses are willing to pay interest rates well in excess of 10%. Throw in the fact that SOEs did not invest in their core business and instead redirected money directly into real estate via newly created real estate subsidiaries or indirectly via high interest shadow banking loans. Mix in rehypothecated collateral by speculative and ponzi borrowers, a credit bubble and housing bubble......

The Economist points out that the estimates aren't losses, but lost profit: China's $6.8-trillion hole?
Sticking to Mr Xu and Ms Wang’s approach, this would mean that 21% of all investment over the past five years – 22.6 trillion yuan ($3.7 trillion) – had been wasted. That is still a lot of money to burn through, but it is almost half their headline-grabbing estimate.

That leads to the second and even bigger flaw – namely, this is a lousy method for calculating wasted investment. ICOR serves as a rough guide to the efficiency of investment. It does not, however, show how much money was been wasted, only that it is generating smaller or bigger growth returns compared with previous years.

Final verdict: the $6.8 trillion in wasted investment is not wasted investment or malinvestment. It's more of a poor measurement of opportunity cost because investment rates fall over time in the absence of major technological breakthroughs. It takes more and more investment to return smaller and smaller returns as Dr. Tainter has shown. That said, We know for a fact that China misallocated capital based on interest rates in the shadow banking system, and from common sense. The government forced banks to lend to SOEs that didn't have a need for the money in 2009. That wasn't a private market economy distorted by cheap credit, it was a step backwards towards central planning. Unfortunately, the private economy was also distorted by central bank and government policy.

Trying to estimate the wasted investment is a fool's errand. If the bill never comes due (gets socialized), then people will claim, as they have, that the investment wasn't wasted. If the bill does come due, the losses will be far higher due to systematic losses. What was the total wasted investment in the U.S. housing market next to the Global Financial Crisis?

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