However, the fact that China is suffering diminishing economic returns from its investment does not mean the investment should not have occurred, nor that it should not continue. The important question is whether China is deriving any benefit from its investment spending. One way to judge that is to look at the marginal efficiency of capital (the return on the latest yuan of investment spending).
Figure 2 shows one such measure, as calculated by the European Commission (EC), along with our own calculations for China. Put simply, it shows the GDP gain for each unit of gross fixed capital formation, calculated as the change in GDP in year t divided by the average level of gross fixed capital formation in years t and t-1. It is naturally cyclical, with sharp declines during recessions, as is forecast for 2020, which is why we show a 10-year moving average (which we think reveals more than it hides). Sadly, the different methods of calculation render it hard to make comparisons between average productivity (Figure 1) and marginal productivity (Figure 2).
Though China’s marginal efficiency of capital has recently been less than half what it was in the 1980s and 1990s (and is trending down), it has remained positive and above that of comparator countries (our calculations suggest it will be close to zero in 2020, while EC calculations suggest it will fall into negative territory for our comparators).
This suggests that, while China’s use of capital is less efficient than it used to be, there is still scope to reap economic benefits from further investment (by movingrural populations into urban areas and making them more productive, for example). If our calculations are correct, China is better placed than our comparators to benefit from further investment spending, though the gap has closed.
All the above looks at investment spending from a total economy perspective, including the public sector. From an investor’s perspective, return on equity
(ROE) is another way to look at it (we use a five-year moving average of ROE derived from Datastream indices). On this basis, US ROE has been between 12% and 16% for most of the last 30 years and has consistently been at the top of the comparator country range. China’s ROE approached 20% in the early 1990s but averaged only around 10% in the late 1990s/early 2000s and has since averaged around 12% (and matched that of the US in the aftermath of the GFC). EU and Japanese ROE averaged 6%-10% over the last decade, with that of the EU falling from US levels in the early 2000s (when banks were profitable) and that of Japan gradually rising from the 4% average seen in the early 1990s. We expect ROE to be lower in 2020 in all countries.
Our conclusion is that China’s investment is less productive than it was but is still adding economic value. ROE may be lower than in the US but is higher than in the EU and Japan, which suggests to us that valuation ratios should be lower in China than in the US (lower PE for the same PBV, say) but higher than in other developed markets.