India and China refute the myth of ‘overinvestment’

It is by now well known that the two countries which have come most strongly through the financial crisis are China and India.  China’s year on year growth to the third quarter of 2009 was 8.9%. India’s was 7.9%.

Such a result of course has many economic lessons. But one is to decisively refute the myth that high levels of investment are a cause of economic crisis and underperformance. On the contrary China and India have the highest levels of investment of any major economies - as shown in Figure 1 (a comparison to the US is given). The percentage of China’s GDP devoted to gross domestic capital formation (fixed investment) in 2008 was 41.4%.(1) India's was 34.8%.(2) In 2008 China generated 9.6% annual growth and India 6.7%.

Figure 1

 

It is, of course, possible to have inefficient investment – i.e. high levels of investment that fail to generate high levels of economic growth. Classic examples of this are countries pursuing inward facing import substitution strategies whether of a market (Argentina) or non-market (the former USSR) type.  However medium and long term trends econometric studies clearly demonstrate investment is the single most important source of economic growth after increasing participation in the national and international division of labour.

For the G7 economies as a whole, and the US economy, econometric studies show that more than 50% of economic growth, that is the majority of growth, is accounted for by investment. In consequence these economies cannot grow at more than twice their rate of investment - i.e. the rate of increase in investment determines the rate of increase of GDP. But, far from being inefficient, recent studies show China has among the highest rates of growth of total factor productivity in the world, showing the efficiency of its investment, while Dale Jorgenson and Khuong Vu also found India has a high rate of growth of total factor productivity.

China and India, however, also demonstrate something about the short term and the business cycle. Their very high investment levels were not only the main determinants of their rapid economic growth but also clearly allow them to most adequately confront the cyclical economic downturn.

The Indian Prime Minister Manmohan Singh has repeatedly stressed that the key to growth for both India and China is their very high levels of savings and investment. He has been shown to be entirely right. The two major countries with the highest level of investment in GDP have both the fastest growth rates and have most successfully dealt with the financial crisis.

Those who claim there is a problem of 'overinvestment' should simply look at China and India. They confirm on the practical field what is shown by econometric studies to follow from economic theory. They bury the theory of 'overinvestment'.

Notes

1. Calculated from China Statistical Yearbook 2009.

2. Calculated from IMF International Financial Statistics.