For developing countries, investment in local companies and projects are essential to fostering growth. However, while most focus on the quantity of investment flowing into a country, less attention is paid to where the money is going. Big problems arise when there is too much money to go around, and China has become somewhat of a poster child for profligate spending and irresponsible investment.
Thought transportation infrastructure was always good? Not when you end up with so many airports that fourth-tier towns are planning them, even though the ones in bigger cities are failing. What about investing in local companies? You get Chinese pharmaceutical companies such as the state-owned Harbin Pharmaceutical Group, renovating their headquarters into a French Palace. When the going is good and growth is roaring higher, it’s easy to make business cases for almost anything modeled on future demand (although even with double digit growth, it’s hard to imagine what was going through their heads with the Palace).
In an excellent post by Michael Pettis, a Beijing professor, on a brief history of China’s development, he compares China’s growth to the US when it was in a similar part of its development cycle. One of the key “pillars” of success for America was its investment in infrastructure, an area that China has likewise poured money into:
For me the interesting question, especially in the Chinese context, is not whether the state should build infrastructure but rather how much it should build. In fact this is one of the greatest sources of confusion in the whole China debate. Most China bulls implicitly assume that infrastructure spending is always good and the optimal amount of infrastructure is more or less the same for every country, which is what allows them to compare China’s per capita capital stock with that of the US and Japan and conclude that China still has a huge amount of investing to do because its capital stock per capita is so much lower.
But this is completely wrong, and even nonsensical. Infrastructure investment is like any other investment in that it is only economically justified if the total economic value created by the investment exceeds the total economic cost associated with that investment If a country spends more on infrastructure than the resulting increase in productivity, more infrastructure makes it poorer, not richer.
In other words, more money does not guarantee more growth – quality over quantity.
But what about a potential industry that has a large capital cost to entry, but with low future operating costs, the opportunity to create many jobs, and a reputation as the next big thing? That actually sounds like a great investment. Throw in the fact that it addresses strategic national concerns and it’s a no-brainer.
That industry was solar. And China poured money into it, breaking its stereotype as a low-tech polluting nation of factories in the process. It was brilliant, with the potential to save the environment and provide energy in one fell swoop, so they continued to pour money into the industry, with Suntech Power emerging as a world leader. Ironically, it was the sheer quantity of money they poured into this industry that killed it and led to the bankruptcy of the Chinese subsidiary of Suntech yesterday.
Could this eventual failure be foreseen? It’s hard to say, especially in an industry like solar that addressed so many issues. However, there are some warning signs that can be identified for the future.
Pettis mentions interest rate subsidies as a huge warning sign; if a project can only be green lit using an artificially low interest rate, a lot of the costs are not seen until much later. This was the case with Suntech and the solar industry, where there was overcapacity due to the large amount of factories built on borrowed funds.
Another warning sign is viewing the investment in capital through it’s impact to labour saved:
In countries with very low levels of productivity, each hour of labor saved is less valuable than each hour saved in countries with high levels of productivity. For this reason less productive countries should have much lower capital stock per capita than more productive countries.
It is always tempting to pour money into extremely promising investments. But like in the case of the solar industry and Suntech, more money does not guarantee higher productivity and overcapacity will actually hamper growth.
Finally, he touches on the importance of social capital:
If a country has low levels of social capital – if it is hard to set up a business, if less efficient businesses with government connections can successfully compete with more efficient businesses without government connections, if the legal and political structure creates problems in corporate governance (the “agency” problem, especially), if the legal framework is weak, if property rights are not respected, if intellectual property can easily be lost – then much infrastructure spending is likely to be wasted.
These are all things investors should keep in mind next time they read a flashy press release from a government flush with commodity-related money (we’re looking at you, Azerbaijan). Not all investment is a good investment, no matter how much money a country may have at the time.