9/18/2018 Is China investing too much in infrastructure?

China
June 1st 2018

Is China investing too

much in infrastructure?
China's economy has a strong reliance on state-led infrastructure spending, which
accounted for nearly 30% of the country's total investment in 2017. With the costs of
this approach increasingly apparent—notably on the strained accounting books of
regional administrations—government support for such expenditure will soften. Barring
a rise in private-sector participation, this will act as a drag on the economic growth rate
in the coming years.
China is often associated with high levels of infrastructure spending. Much of the liquidity
released in the wake of the 2008-09 global financial crisis ended up backing GDP-
boosting infrastructure projects. In more recent years, infrastructure investment has again
been stepped up to offset a moderation in property development investment, traditionally
a key driver of the economy. In 2017 fixed-asset investment (FAI) in infrastructure reached
Rmb17.6trn (US$2.6trn), accounting for 27.8% of total FAI. We estimate that such
expenditure contributed 0.7 percentage points to real GDP growth of 6.9% in that year.

The focus of infrastructure investment has varied. After the global financial crisis,
infrastructure spending mainly went into transportation, especially (high-speed) railways.
In the 2013‑15 period, emphasis was placed on municipal engineering, such as road and
pavement construction and maintenance, water supply networks and sewage facilities. In
the last few years transportation infrastructure has re-emerged as a priority, but with a
focus on national road and warehousing networks, driven by demand created by the
e‑commerce boom. While such policy turns do not preclude the possibility of "white
elephant" projects, they show that the authorities have some sensitivity to the changing
nature of infrastructure demand.

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9/18/2018 Is China investing too much in infrastructure?

Such aggressive spending on infrastructure has nevertheless raised questions about its
sustainability. By international standards, China is investing much more in the sector than
most of its developing-economy peers. The IMF estimated its public capital stock per
capita, comprising economic and social infrastructure, at just under US$20,000 (at
constant 2011 prices) in 2015. This was similar to the level in advanced economies such as
the UK and Germany, and far above that in Russia, Brazil and India. China's public capital
expenditure was estimated to be the equivalent of 13.4% of GDP in 2015, compared with a
average in the other BRICS countries of just 3.2%.

However, the data also suggest there is still room for more spending on infrastructure.
China's public capital stock per capita is still much lower than that in the US and Japan—
arguably appropriate comparisons for a country with a large and diverse geography. China
is also still urbanising. Moreover, most international sources recognise that the country's
infrastructure development remains sub-par. China ranked 47th overall in the World
Economic Forum's 2017 Quality of Infrastructure Ranking, scoring poorly in all subsectors
other than railways.

This analysis suggests that while China is investing too much in infrastructure for its level
of development, there will still be a need for more infrastructure construction and the
upgrade of existing physical assets in the future.

Traditional funds for infrastructure are diminishing

Most of the risks attached to China's high infrastructure spending relate to heavy reliance
on local-government entities to implement it. Despite a lack of funds following fiscal
centralisation in the mid-1990s, they have been motivated to back infrastructure projects
by the priority placed on delivering short-term economic growth. This has, in turn, given
rise to worrying financing and debt strains.

Local governments fund their infrastructure spending through fiscal means as well as
market mechanisms. Fiscal financing includes central and local budgetary revenue, fees
and taxes. Market financing includes bank loans, bonds and foreign direct investment. The
majority of infrastructure spending is derived from fiscal resources.

Problematically, the resources that local governments have used to fund their
infrastructure spending are diminishing. Land sales represent by some margin the most
important fiscal source for their funding; we estimate that in 2016 this avenue provided
around 55% of fiscal funding for investment in urban service facilities, which accounted for

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9/18/2018 Is China investing too much in infrastructure?

around 25‑30% of total infrastructure FAI. Other sources of fiscal revenue that can be
deployed for infrastructure investment are modest in comparison.

However, concerns that land sale activity is inflating land prices, to the disadvantage of
local industrial activity, are prompting policy tightening by the national authorities. Forced
relocations from land due to be sold are also a source of social instability. In addition, land
holdings are the primary form of collateral used by local government financing vehicles
(LGFVs), which are primarily engaged in infrastructure construction, when borrowing from
banks. Efforts to tighten controls over land sales are thus also having an impact on market
channels for infrastructure fundraising, such as bank borrowing.

As such, local governments face the likelihood of diminished access to funds. There have
already been several media reports in 2018 about cancelled infrastructure projects,
especially in regions with troubled economies, such as Inner Mongolia. At the national
level, infrastructure FAI growth eased to 7.5% in January-April 2018, based on our
calculations, down from the 13.5% growth recorded in whole-2017.

New financing channels are slow to develop

It therefore seems likely that future infrastructure spending will necessarily involve private
capital to a more significant extent than is the case at present. Endeavours in this direction
are already under way. Since 2014 the Ministry of Finance has encouraged the
establishment of public-private partnerships (PPPs) to finance infrastructure.

However, flaws in the progamme have resulted in it struggling to build momentum, with
private firms reluctant to participate given a lack of control over user prices in the public
sector. Most participants in PPPs appear to be LGFVs, with local governments using the
scheme as a means to raise funds from banks. The finance ministry is currently in the
process of overhauling the initiative.

Other developments include allowing local governments to issue special bonds for specific
infrastructure projects. This promises a more market-oriented approach, but the scale of
the financing is currently very small. Social security funds and insurance companies are
also playing a more active role in the sector.

With the outlook for infrastructure financing appearing more troubled than in the past,
China's investment in the area is likely to recede from the heady growth of recent years.
This will act as a drag on the rate of economic expansion. More positively, steps towards
more market-driven financing for infrastructure also promise more efficient spending and
could help to ensure that projects better meet future demand. 

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