Capital Stock….and Flow

Nicholas Borst (Federal Reserve Bank of San Francisco)



Recently there have been several articles written on China’s capital stock. The argument in most of these pieces is that China’s capital stock per capita is low and thus claims of overinvestment in China are incorrect.

Just to recap, the capital stock is a broad measure of the existing physical capital in an economy. Economic theory says that a country’s capital stock should increase as it develops and grows richer. Capital stock is usually calculated using the perpetual inventory method.  This method picks a base year where the capital stock was quite low and then adds gross fixed capital formation and subtracts some deprecation allowance.

HSBC and Dragonomics have both put forward capital stock estimates that show China still has much room for investment. Dragonomics shows that China’s capital stock was 82 trillion renminbi in 2010, a number that translates into a lower per capita amount than the United States in 1930s. The implicit conclusion here is that China’s capital stock is low when compared to the United States when it was at a similar level of development. HSBC has a higher number for China’s capital stock, 93 trillion in 2010. HSBC concludes that because China’s capital stock compared to the United States is quite low, only one-third the amount, and there is room for higher levels of investment.

There are a lot of assumptions packed into these conclusions, not all of which should be accepted unquestioningly.  The capital stock per capita in the United States in the 1930s may be of limited value in evaluating current conditions given the immense changes in technology since then. HSBC’s comparison of the United States and China in judging whether China has over invested is not very helpful. The key issue is over what period of time we should expect China’s capital stock to converge to US levels. While the per capita capital stock seems quite low, the capital-output ratio (capital stock to GDP) is not.  Using this ratio, China’s capital stock is comparable to countries at a much higher level of development (Japan, South Korea, and the United States).

Before we get too bogged down in all the details, let’s do quick thought experiment. Let’s assume that the capital stock estimates calculated by Dragonomics are correct. An important question is the speed and environment in which the capital stock has accumulated.  China’s capital stock has grown quite rapidly over the past decade, with close to two-thirds of the capital stock having been created since 2003. In 2003 there was a marked change in China’s interest rate policy where the real lending rate fell by 5 percentage points to extraordinarily low levels.

In other words, the large part of China’s capital stock has been created during a period of highly distorted interest rates.

Let’s assume that the capital stock continues to grow at the same pace as the last several years, around 15 percent. This is a fair assumption given that the 2011 GDP expenditure numbers show that investment as a share of GDP is still rising.

This would mean that China’s capital stock will double in the next five years. If you believe that prices (i.e., interest rates) are important for ensuring the efficient allocation of resources, then the fact that almost all of China’s capital stock has been created in an environment of highly distorted prices should be quite worrying.  This low lending rate contributed to the significant increase in capital formation as a share of GDP, from 41 percent in 2003 to 49 percent in 2011.

Whether China’s capital stock is appropriate given the size of its economy and level of development is a subject where there are legitimate arguments on both sides and much more research to be done. What’s not open to debate is that unless China quickly adjusts its interest rate policy, the vast majority of its capital stock will have been created in an ultra-low interest rate environment, raising the possibility of malinvestment on a massive scale. This is one example in economics of the “flow” being just as important as the “stock.”

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