China's Overinvestment and International Trade Conflicts

• DOI: http://doi.org/10.1111/cwe.12293
• Published date: 01 September 2019
• Author: Gunther Schnabl
• Date: 01 September 2019

©2019 Institute of World Economics and Politics, Chinese Academy of Social Sciences

China & World Economy / 37–62, Vol. 27, No. 5, 2019

37

*Gunther Schnabl, Senior Fellow, Institute of Economic Policy, Leipzig University, Germany. Email:

schnabl@wifa.uni-leipzig.de. The author thanks Nils Sonnenberg and Tim Sepp for excellent research

assistance and the Friedrich August von Hayek Foundation for nancial support.

China’s Overinvestment and International

Trade Conicts

Gunther Schnabl*

Abstract

For a long time, China’s impressive growth performance has been driven by investment

and high productivity gains. Based on a discussion of possible overcapacities and

overinvestment in China, this paper investigates the sustainability of China’s investment

and export-driven growth model. Since the turn of the millennium, buoyant capital

inows and low interest rates have been at the root of overinvestment and misallocation

of capital, which necessitated export subsidies to clear markets. The overinvestment

boom is argued to have ended around 2014. Since then, the overcapacities have

weakened China’s bargaining position in the US–Chinese trade conflict and have

tempted Chinese authorities to postpone the restructuring of the Chinese economy by

providing low-interest credit. The gradual reemergence of quasi-soft budget constraints

is seen to undermine China’s long-term growth potential.

Key words: credit growth, overinvestment, rebalancing, soft budget constraints, trade policy,

zombication

JEL codes: E22, E43, E58, F13

I. Introduction

Given impressive growth performance, the literature has hailed China as the new global

economic hegemon. Fogel (2007) predicts that China’s GDP per capita will reach

US$85,000 by 2040, with the share in global GDP (40 percent) dwarfing the US (14

percent). It has been argued that the Chinese currency is challenging the leading role

of the dollar as an international currency (Prasad, 2018). By 2018, the real growth rate

of China was 6.6 percent, substantially above the US growth rate of 2.9 percent and far

beyond Japan, the largest Asian rival, at 1.1 percent.

While Chinese growth has remained high compared to industrialized countries, the

momentum has slowed, from 14.2 percent in 2007 to 6.3 percent in 2019, with ofcial

Gunther Schnabl / 37–62, Vol. 27, No. 5, 2019

©2019 Institute of World Economics and Politics, Chinese Academy of Social Sciences

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numbers occasionally being put into question. At the same time, vulnerabilities have

emerged. Concerns about overcapacities in industrial production (European Chamber,

2016) have triggered a discussion about rebalancing the Chinese economy toward

domestically oriented, consumption-based growth (Fukumoto and Muto, 2012; Yu,

2012; Zhang, 2016).1 Glaeser et al. (2017) identied the potential for an unsustainable

real estate bubble.

From an international perspective, the Chinese current account surplus, in particular

versus the US, has been regarded as unfair (Bergsten, 2010) and has been used by the

US government as a justification to impose punitive tariffs, thereby risking a trade

war and putting the international free trade system at risk (Ha and Deng, 2019). Given

accelerating capital outows from China, takeovers of enterprises in the industrialized,

emerging and developing countries are increasingly understood as economic

colonialization. At the same time, the global slowdown of growth makes China’s

investment in developing countries and emerging markets look risky (Page, 2019).

To evaluate the growth perspectives and bargaining position in the trade conflict

with the US, this paper scrutinizes potential overinvestment in China from a theoretical

perspective. In contrast to previous papers, which have analyzed the role of investment

for Chinese growth empirically (Zhang, 2003; Wang and Hu, 2007; Ahuja and Nabar,

2012), the focus of this paper is on the build-up of overcapacities in the industrial sector,

their repercussions on growth and the adequate policy response.

II. Investment, Growth and Economic Catch-up

Like Japan and other East Asian countries, the economic catch-up process in China

has been based on industrial production and exports to the prosperous markets of the

industrialized economies (export-led growth). The upgrading of capital stock and the

technological level of industrial production is at the root of increasing productivity and

real wage increases (Solow, 1956; Swan, 1956; Balassa, 1964; Samuelson, 1964). Yet

macroeconomic stability and an efcient allocation of capital are prerequisites for the

positive impact of investment on growth (McKinnon, 1973).

1. Microeconomic Reforms and Macroeconomic Stabilization

The catch-up process in China is based on market-oriented reforms initiated by Deng

Xiaoping in the 1970s (Chang, 1988). During the first stage in the 1970s and 1980s,

1Zhang (2016) distinguishes four dimensions of rebalancing: external, internal, environmental and

distributional. This paper focuses on the rst two dimensions.