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This article discusses the flaws in Mr. Xu and Mr. Wang’s ICOR calculations for China, which claim that China has wasted $6.8tn on worthless investments.
ICOR, or incremental capital-output ratio, is a measure of the amount of investment needed to produce an extra unit of GDP in an economy. It is calculated by (investment/incremental GDP). The higher the figure, the less efficient it is.
Mr. Xu and Wang’s calculations show 2.59 as the ICOR from 1979-1996 and 4.03 as the ICOR from 1997-2013. Using 2.59 as the base ICOR, they calculate the difference between the ICOR of another year and the base years to arrive at the amount of worthless investments of that year.
For example, in 2009, the ICOR was 5.01, which is about 48% less efficient than 2.49. Messrs Xu and Wang conclude that 48% of all investment in 2009 – or 7.9tn yuan – was wasted. This is done for every year since 2009 to arrive at a total of 6.8tn USD.
The author, S.R., cites two problems with this method:
1) Why are the base years 1979-1996? If we were to calculate the ICORs for every decade rom 1980, it shows that China’s investments were 21% less efficient from 2009-2013. While this is still a shockingly high figure, it is only about half their original estimate.
2) ICOR is not a measure of wasted investment spending. If you invest in something that produces $100 return in one day and $50 in the other, nobody says that $50 was wasted in the investment – it just means that the return on investment has reduced.
While S.R.’s conclusions do not suggest that China’s economy is doing well, it does mean that $6.8tn is an unfounded number.
1. While this point is not integral to this article, it is very important to know. Very near the end of the article, S.R. mentions “China’s stimulus package”. What is this? After the 2008 global financial crisis, China tried to help its economy recover by investing in its economy. The pros and cons about investments during a recession can be read about here. China spent around $0.5tn in investments. It is the aftermath of these investments that we are seeing and trying to measure now, which is why S.R. is especially concerned with the period from 2009-2013: this was when the stimulus package really began.
2. This article deals with analysing the return on investments. The last phrase of the article provides one way to measure the returns “looking at average ICORs over a longer period”. The word ‘average’ is integral here to measuring investments. Consider this scenario: You invest in a coffee making factory in 2014. After one year, you measure the return on the investment, and it comes to -2%. Does it mean that there was no point in investing in the coffee factory? No, because in 2016, the return might be 0.2%, and in 2017, it might be 5%. How do we see the general return on investment? The answer is a rolling average. A rolling average measures the average of the return on investment for a set number of years (usually investments show returns after 3 to 4 years). This is much more accurate in seeing the ICOR.
This blog post is supplemented by another one written by Paul Krugman, who shows the graphical representation of S.R.’s points.