Investment and saving in China

41852 WORLD BANK CHINA OFFICE RESEARCH WORKING PAPER NO. 1 INVESTMENT AND SAVING IN CHINA by Louis Kuijs 1/ Abstract An analysis of sectoral patterns of investment and saving in China--over time and compared to other countries--sheds light on the factors driving high investment and on how saving is channeled into investment. Key findings include: (i) investment by enterprises distinguishes China from other countries and explains most of the variation over time; (ii) high household saving explains only a part of the large difference in national saving between China and other countries--the majority is explained by high saving of the government and enterprises (through retained earnings); and (iii) currently only about one-third of enterprise investment is financed via the financial sector, a lower share than in the early 1990s. Explanations behind the high saving of the government and enterprises are traced back. There are several policy implications. The identified financing patterns put in perspective the exposure of the financial sector to investment- related risks but, against the background of concerns about suboptimal allocation of capital, bring to the fore corporate governance and dividend policy. The findings suggest policy adjustments that would help achieving the government's goals of improving the quality of growth and increasing the role of consumption. Finally, long term saving prospects, and its implications, are discussed. Keywords: Investment; saving; financing; demographics, corporate governance, China. World Bank China Research Paper, No. 1, May 2005 1/ World Bank Office, Beijing, China (EASPR). Email: akuijs@worldbank.org. Acknowledgements: I thank Bert Hofman for encouragement and comments, and Homi Kharas and Tao Wang for comments on an earlier draft. The World Bank China Research Paper series disseminates the findings of research on China to encourage discussion and solicit feedback. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in these papers are those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. 1  Introduction With China's investment and saving high--in historical context and compared to other countries--questions on investment and saving continue to arouse interest of policymakers and researchers. However, knowledge about the underlying patterns of investment and saving is limited. This paper attempts to answer the following questions. What are the factors driving China's high investment? How is saving channeled into investment? In particular, how is enterprise investment financed, and what is the role of the domestic banking sector, enterprise saving, and the government? Answers to these questions are important for several reasons. First, they inform the current debate on the types of risks and policy challenges stemming from China's high investment, including on what policies are needed to mitigate risks and improve the efficiency of capital allocation. Second, they facilitate the understanding of China's pattern of growth. High investment and saving are key features of China's pattern of growth. A better understanding of their determinants could improve the understanding of the pattern of growth; its sustainability; and medium and long-term prospects. Third, they help identifying the policy implications of the projected saving and investment developments, also in light of identified tensions and the intended change in the policy stance, including the planned shift in government spending from investment to social spending and increased role of private consumption. To answer these questions, the paper analyses sectoral trends in investment and saving and the resulting sectoral saving-investment balances over time and relates them to cyclical and structural developments, to better interpret current developments. It also compares these trends to those in other countries to identify China's special features. The paper uses--apparently for the first time--time series data from the Flow of Funds (FoF) from the national accounts.1 The advantage of these data is that they reflect financial flows between sectors. Moreover, the "above the line" flow data is mapped with "below the line" data on financing. The conclusions based on this data are verified by looking at data from other sources, including from the financial sector, on the financing of investment from the Statistical Yearbook (SYB), and the household survey.2 This paper does not look into potential problems with data on investment and GDP, reflecting a belief that, in addition to any data problems--most of which are pertinent in other countries too--, there are economic explanations behind the developments on investment and saving in China. 3 1The FoF accounts show for households, enterprises, the government, and the "rest of the world" the sources and uses of financial resources. The "above the line" flows show the composition of income, consumption and saving, physical investment, and the resulting net external financing. The "below the line" flows show how each sector's net external financial balance is invested and/or financed. 2The FoF data is only available up until 2001, and, for some parts, 2002. Some estimates are made for 2002 and 2003, but these are meant to be only indicative. For instance, household saving is estimated using the year-on-year change in household saving from the household survey. 3Data on Fixed Asset Investment in China (FAI) includes land sales. National accounts data on Gross Capital Formation (GCF), which does not include such sales, is better comparable internationally. 2  We find that since the early 1990s investment by households and direct investment by the government have been relatively steady at levels comparable to other countries, while investment by the enterprise sector distinguishes China from other countries and explains most of the variation of China's total investment over time. We also find that high household saving explains only part of the difference in total saving between China and other countries; the rest is explained by high saving of the government and enterprises, the latter particularly in recent years, as profitability has improved. Net external financing of enterprise investment--from the banking sector and via net foreign direct investment (FDI)--is high compared to other countries but, at about one-third, constitutes only a modest part of enterprise investment. High government saving is the result of a policy favoring government-financed investment over government consumption. Reasons for relatively high saving by enterprises include a high share of capital-intensive industry in GDP and a traditional policy of low (or no) dividends. These findings lead to three sets of policy implications. First, the financing patterns indicate a lower degree of bank financing to enterprises and associated financial sector exposure than is usually thought. By the same token, though, against the background of concerns about the suboptimal allocation of capital, the high degree of financing by retained earnings and government transfers bring issues of (corporate) governance and dividend policy to the fore. Second, the planned shift in government spending from investment toward social spending and increased role of private consumption could be brought about by reducing the high share of government revenue traditionally devoted to investment and changing the policy framework away from the promotion of capital- intensive industry. Third, saving is projected to decline in the long-term, with the speed depending on policy adjustments. A. Findings in existing literature about saving in China Domestic saving finances the bulk of any country's investment. Questions about levels of investment are therefore closely linked to questions on saving. The theoretical literature on the determinants of saving is rooted in consumption theory and, consequently, largely centers on factors affecting households. Loyaza, Schmidt-Hebbel, and Serv