How will China's saving-investment balance evolve?

41857 WORLD BANK CHINA OFFICE RESEARCH WORKING PAPER NO. 5 HOW WILL CHINA'S SAVING-INVESTMENT BALANCE EVOLVE? Louis Kuijs 1/ Abstract This paper investigates how China's saving, investment, and the saving-investment balance will evolve in the decades ahead. Household saving in China is relatively high, compared to OECD countries. However, much of China's high economy-wide saving, and the difference between China and other countries, is due to unusually high enterprise and government saving. Moreover, our cross-country empirical analysis shows that economy-wide saving and investment in China is higher than what would be expected, even if we adjust for differences in economic structure. Combined, these findings suggest that much of China's high saving is the result of policies particular to China. Looking ahead, our econometric results suggest that purely on the basis of projected structural developments--including development, changes in economic structure, urbanization, and demographics--saving and investment would both decline only mildly in the coming 2 decades, with ambiguous impact on the current account surplus. On the other hand, the potential effect on saving, investment, and the saving-investment balance of several policy adjustments could be large. These policies are identified and their likely impact assessed and quantified. This exercise suggests that rebalancing along these lines should reduce both saving and the current account surplus over time, although the surplus is unlikely to turn into a deficit soon. Keywords: Investment; saving; financing; demographics, corporate governance, China. World Bank China Research Paper, No. 5, May 2006 1/ World Bank Office, Beijing, China (EASPR). Email: akuijs@worldbank.org. This version (June 2006) has benefited a lot from comments by Bert Hofman and participants at workshops in Beijing and New Delhi. 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 it represents. The papers are available online at www.worldbank.org.cn/english. 1  I. INTRODUCTION AND MAIN FINDINGS As China is integrating in the world economy, questions arise about the impact of the integration of this large country on the world economy and the world financial system. One key question is whether China will become a large net provider or user of capital in the decades ahead. More immediately, with China now running large current account surpluses, the question is how the external balance will evolve and what factors, including policies would bring the surpluses down. This issue is of course important for China's policy makers, who are currently aiming at rebalancing the composition of demand and the pattern of growth and who face the implications of the large external surplus for monetary policy. It is also important for the world economy. China is large and growing larger rapidly. It became the fourth largest economy in 2005 (at current exchange rates) and may overtake the US as the largest economy in less than 4 decades.1 Moreover, China's economy is open. Its regime for trade and FDI is open, and external trade and FDI are quantitatively important in the economy, amounting to 64 and almost 3 percent of GDP in 2005, respectively. This means that shocks can trigger large external imbalances, as in 2005, when the current account surplus surged by $ 90 billion to around $ 161 billion. To answer this question, this paper analyzes the current and projected future determinants and patterns of saving, investment, and the saving-investment balance (the external current account balance) in China, since these will be the driving force of capital flows. The paper has two main contributions to the literature. First, it provides a systematic look at the sources and composition of saving and investment in China.2 Second, on the basis of the observed patterns and the--largely policy-related--explanations proposed for them, as well as an enhanced empirical estimation of cross-country patterns of saving and investment, the paper assesses the prospects for China's saving, investment, and the saving-investment balance in the decades ahead. The key findings are as follows. China's saving and investment are high. Reflecting China's high investment rate, China's growth has been relatively capital intensive. The bulk of investment is financed with domestic saving, with foreign direct investment playing a relatively modest role. Much of China's high saving and investment, and the difference between China and other countries, is due to unusually high enterprise and government saving. Moreover, rising enterprise saving has driven the increase in economy-wide saving in the last decade. Our empirical analysis of the determinants of economy-wide saving and investment patterns across countries and over time finds that saving and investment in China are significantly higher than what would be expected on the basis of these determinants. This is so given the set of determinants in the literature. This remains so if we try to improve 1According to our preliminary projections. 2Preliminary findings were reported in Kuijs (2005). 2  the explanation of the cross country patterns in saving and the impact of structural changes by extending the set of determinants. Combined, the latter two findings imply that China's high saving are largely the result of policies particular to China. Looking ahead, purely on account of projected structural change and development-- including development, demographics, urbanization, and changes in the economic structure--saving and investment would decline only mildly in the coming two decades, with ambiguous impact on the current account. We find this by feeding our projections for the determinants of saving and investment in the equations derived with our empirical analysis. This is also true for the impact of demographics, which may not be very significant until 2025. On the other hand, the potential effect on saving, investment, and the saving-investment balance of several policy adjustments that would address the specific features and patterns identified above could be large. Rebalancing along these lines should reduce the current account surplus. It may take some time before they sort large effect, and it is unlikely to change China's current account surplus into a deficit soon. But, some of the policy reforms could affect the structural saving-investment balance relatively quickly. The rest of this paper is structured as follows. Section II discusses key findings on China's pattern of growth and levels of economy-wide saving and investment. Section III analyzes the composition of saving and investment and provides explanations for high saving by households, enterprises, and the government. Section IV looks ahead, assessing trends in saving, investment, and the saving-investment balance in the decades ahead. After discussing the relevant existing literature, the section first looks at what would be expected to happen to saving and investment based on cross country patterns and projections of the determinants of saving and investment. Subsequently, the section looks at the possible effect of policy changes. II. BACKGROUND: FINDINGS IN THE LITERATURE ON CHINA'S PATTERN OF GROWTH AND LEVELS OF SAVING AND INVESTMENT Studies into China's pattern of growth and its level of saving suggest that: (i) growth has been relatively capital intensive, thus requiring high savings; (ii) the bulk of investment is financed with domestic saving; and (iii) economy-wide saving in China is significantly higher than what would be expected on the basis of standard determinants. II.1. China's capital-intensive growth Several studies have used growth accounting to analyze the sources behind China's rapid growth of the past 25 years. Assuming a certain production technology, these studies 3  assess what factor accumulation and total factor productivity (TFP) have contributed to growth. Heytens and Zebregs (2003) summarize these studies, which includes Chow (1993), Hu and Khan (1997), and Wang and Yao (2002)). Although estimates differ because of variations in assumptions, the studies have converged on several findings. TFP growth has contributed significantly to GDP growth, having increased since the introduction of reforms at the end of the 1970s. Estimates of TFP growth during the reform period range between 2 and 4 percent per year. However, the contribution of physical capital accumulation has been large and growing, reflecting a high and increasing investment to GDP ratio. Consistent with slowing overall employment growth, the contribution of labor growth has been modest, especially over the last decade. Using "consensus assumptions", Kuijs and Wang (2005) did such an exercise for 1978-2004 and found similar results.3 They found that, compared to 1978-1993, in 1993-2004 the contribution of capital accumulation to GDP growth increased, as the capital