New Paper Claims Infrastructure Investment Destroys Wealth

Infrastructure investment has high positive returns when starting from a low base. Backwards economies lack infrastructure, typically lack rule of law and basic institutions. A government or large entity can achieve a great deal of positive economic development with a centrally planned infrastructure buildout because the low hanging fruit is truly low. In a country with no roads, there's a lot of room for error in building the first road and you would have to try hard to fail at making the first road successful. As the low hanging fruit is eliminated however, the choice of which projects to pursue, and where to put them, becomes far more important. The lack of market signals and perverse incentives (such as political promotion being determined by GDP growth) steer the planner away from making sound investments.

In China, infrastructure development is mainly driven by local governments. They have been building vanity projects (empty airports, train stations to rival the Summer Palace) for at least a decade. Worse than empty airports is the wholesale redevelopment of cities which led to mismatches between private developers and public planners, as developers put up apartments and government failed to build the infrastructure. Ghost cities/neighborhoods litter China as a result, the nation's capital stock literally frozen in concrete. Ghost cities may be a less worse outcome than if the cities were completed, since building the infrastructure would likely destroy even more capital.

The collapse in fixed asset investment in China is a good thing. It signals the destruction of capital is slowing. This will lead to a recession if it continues, but a recession and financial collapse in China would not be a disaster, it would reveal the ongoing disaster of the past 10 years. A recession is like chemotherapy for the economy, but economists blame the chemo for causing the cancer. Probably because they are the cancer in so far as they advise governments on how to misallocate capital.

Does infrastructure investment lead to economic growth or economic fragility? Evidence from China
China’s three-decade infrastructure investment boom shows few signs of abating. Is China’s economic growth a consequence of its purposeful investment? Is China a prodigy in delivering infrastructure from which rich democracies could learn? The prevalent view in economics literature and policies derived from it is that a high level of infrastructure investment is a precursor to economic growth. China is especially held up as a model to emulate. Politicians in rich democracies display awe and envy of the scale of infrastructure Chinese leaders are able to build. Based on the largest dataset of its kind, this paper punctures the twin myths that (i) infrastructure creates economic value, and that (ii) China has a distinct advantage in its delivery. Far from being an engine of economic growth, the typical infrastructure investment fails to deliver a positive risk-adjusted return. Moreover, China’s track record in delivering infrastructure is no better than that of rich democracies. Investing in unproductive projects results initially in a boom, as long as construction is ongoing, followed by a bust, when forecasted benefits fail to materialize and projects therefore become a drag on the economy. Where investments are debt-financed, overinvesting in unproductive projects results in the build-up of debt, monetary expansion, instability in financial markets, and economic fragility, exactly as we see in China today. We conclude that poorly managed infrastructure investments are a main explanation of surfacing economic and financial problems in China. We predict that, unless China shifts to a lower level of higher-quality infrastructure investments, the country is headed for an infrastructure-led national financial and economic crisis, which is likely also to be a crisis for the international economy. China’s infrastructure investment model is not one to follow for other countries but one to avoid.
The conclusion:
VIII. Summary and conclusions

The question of whether infrastructure investment leads to economic growth must be answered in the negative. Owing to uncertainty surrounding costs, time, and benefits parameters, a typical infrastructure project fails to deliver a positive risk-adjusted return. There is a common tendency for the benefit-to-cost ratio of major infrastructure investments to fall below 1.0. Such unproductive projects detract from economic prosperity. We thus reject the orthodox theory that heavy investment in infrastructure causes growth.

There is an even more detrimental boomerang effect of overinvestment in infrastructure. Unproductive projects carry unintended pernicious macroeconomic consequences: sovereign debt overhang; unprecedented monetary expansion; and economic fragility.

The primary findings from our datasets are as follows.

– In line with global trends, in China actual infrastructure construction costs are on average 30.6 per cent higher than estimated costs, in real terms, measured from the final business case. The evidence is overwhelming that costs are systematically biased towards underestimation.

In terms of absolute construction time and schedule overrun China performs better than rich democracies. In democracies politicians seem to have an incentive to over-promise and then under-deliver. China has built infrastructure at impressive speed in the past but, it appears, by trading off due consideration for quality, safety, social equity, and the environment.

– With respect to traffic performance, demand in China represents two extremes. A majority of the routes witness paltry traffic volumes but a few routes are highly congested. Too little and too much traffic of this magnitude both indicate significant misallocation of resources.

The pattern of cost overruns and benefit shortfalls in China’s infrastructure investments is linked with China’s growing debt problem. We estimate that cost overruns have equalled approximately one-third of China’s US$28.2 trillion debt pile. China’s debtto-GDP ratio now stands at 282 per cent, exceeding that of many advanced economies, such as the United States, and all developing economies for which data were available, such as Brazil, India, and Nigeria. Because many corporations and financial institutions in China are state-owned, our revised calculation of China’s implicit government debt as a proportion of GDP suggests that China’s is the second-most indebted government in the world. Extraordinary monetary expansion has accompanied China’s piling debts: China’s M2 broad money grew by US$12.9 trillion in 2007–13, greater than the rest of the world combined. The result is increased financial and economic fragility.

We conclude that, contrary to the conventional wisdom, infrastructure investments do not typically lead to economic growth. Overinvesting in underperforming projects instead leads to economic and financial fragility. For China, we find that poorly managed infrastructure investments are a main explanation of surfacing economic and financial problems. We predict that, unless China shifts to a lower level of higher-quality infrastructure investments, the country is headed for an infrastructure-led national financial and economic crisis, which—due to China’s prominent role in the world economy—is likely to also become a crisis internationally. China is not a model to follow for other economies—emerging or developed—as regards infrastructure investing, but a model to avoid.
The trillion dollar question is how does China recognize the losses? The most logical outlet is the currency because a collapse in the renminbi preserves the debts and allows for a system reset. Since many party members do not want to change the balance of power in the economy, a currency collapse is the least disruptive method. If instead Xi Jinping has total control and wants to wipe out any opposition, allowing the collapse and bankruptcy of SOEs would provide a great pretext for kicking people out of the Party.

1 comment:

  1. 'The trillion dollar question is how does China recognize the losses?'
    No, the trillion dollar question is, is the author blowing smoke up our asses?
    China's infrastructure investments have been immensely profitable and will continue to be for some time (there is no 'collapse').
    Anyone with a serious interest that goes beyond the usual 'the sky is about to fall on China' b.s., would do well to read the only serious, well-funded studies of their strategy:

    James White's report: http://www.cfsgam.com.au/au/insto/Insights/How_investment_transformed_China/

    And the Federal Reserve's: "Is Government Spending a Free Lunch? Evidence from China”. Federal Reserve Bank of St. Louis. https://research.stlouisfed.org/wp/2013/2013-013.pdf