Economic Growth - Capital Investment and Growth in China

China is a country where a high rate of capital investment as a % of GDP has been a key driver of fast growth over the last twenty years

Evidence for this is provided in the chart above and it shows that capital spending as a % of GDP grew from less than 30% in the 1970s to over 40% in the mid-1990s – rising further still since 2000. In most advanced OECD countries it is now around 20-25% of GDP or less.

A rise in capital spending will have important effects on both the demand and supply-side – including a positive multiplier effect on national income.

• Demand side effects: Increase spending on capital goods boosts demand for industries that manufacture the technology / hardware / construction sector
• Supply side effects: Investment is linked to higher productivity, an expansion of a country’s productive capacity, a reduction in unit costs (e.g. through the exploitation of economies of scale) – and therefore a source of an increase in potential national output
• One way to remember the importance of investment is to consider the 3 Cs - capacity, costs and competitiveness. Higher investment should allow businesses to lower their production costs per unit, increase their supply capacity and become more competitive in overseas markets.

Limits to investment-driven economic growth

• Although investment is important – not least capital spending to boost a nation’s infrastructure, it is important to consider too the quality of investment. Poor quality capital projects do little for growth.
• A high level of investment on its own may not be sufficient to create an increase in LRAS since workers need appropriate training to work the new machinery and there will be time lags between new capital spending and the final effects on output and productivity.
• Saving can be difficult to increase in lower income countries. Investment might have to be financed through borrowing leading to a rise in external debt
• If there is insufficient consumer demand for goods and services, a growing capital stock may lead to excess capacity putting downward pressure on prices and profits i.e. a risk of price deflation
• Investment might be unbalanced – for example too much capital going to speculative real estate (housing) projects rather than investment in new businesses
• There might be a risk of diminishing returns to extra investment – i.e. a given increase in capital spending leads to a smaller rise in a nation’s GDP
• When growth is capital intensive, higher profits flow to owners of this capital and to businesses than produce the investment goods. The result can be an increase in income and wealth inequality as other sectors of the economy do not see the same benefits from growth. The real incomes and spending power of millions of consumers may be little affected by the capital investment being injected into the economy