The reliance on investment to drive growth in China has been so extensive that the risk of a downturn in capital spending has become China’s key vulnerability, according to recent research by Experian.

'China has relied mainly on a boom in capital spending to drive growth in the past decade, for a much longer period and to a much greater extent than exports,' comments Dr Tapan Datta, Experian’s global economist and co-author of the report.

'Though there is some doubt and debate about the rate at which investment has been growing, the capital spending boom has been too intense and too prolonged to leave any room for doubt about its potential risk.

'Whether this growth in investment has been merited by the demand for extra capacity or whether it has turned into a bubble is a big question but it is a very difficult one to answer,' adds Dr Datta.

In a set of macroeconomic stress tests posed for the Chinese economy by economists at Experian, a slowdown in investment growth led to the deepest and most prolonged downturn in the economy, leading to a halving of the GDP growth rate from the 10-11 per cent rate seen this year to 5.5 per cent by 2009. A more drastic slowing in investment would proportionately have a far worse impact.

The report argues that one of the plausible triggers for a downturn in investment would be if China’s trading partners put a cap on the growth rate of Chinese exports to their countries, set at a level much lower than the past few years. This could potentially bring about a sharp downturn in capacity in China’s export sector. The ripple effects on employment and incomes could then create a second round slowdown in broader domestic investment.

By comparison, a stress test that imposed a faster revaluation of the exchange rate was found to have quite a small negative effect on the rate of economic growth. The benefits from cheaper imports and downward pressures on the price level resulting from the revaluation were found to cushion the economy from any strong adverse effects on competitiveness. The message from this stress testing was that the frequently argued for stepping up in the revaluation of the exchange rate, which can only work by cheapening imports and raising export prices, may be off the mark.

The rewards from China’s investment boom are rarely discussed, argue the authors. These have come from the inland investment push which the government has used as a policy tool to prevent what could otherwise have been a strong trend towards widening regional differentiation. The report points out that the government’s control of the economy’s `commanding heights’ and the nexus of state control in the new hybrid ownership structures that have evolved since the late 1990s have allowed the authorities considerable freedom to direct and redirect investment. The investment push to inland regions, usually poorer than the rich coastal ‘dragons’, has already started to reap rewards by gradually boosting their relative economic growth rates. If this continues – and there is a high probability that it will, if only because these regions happen to satisfy China’s resource hunger by being mineral/energy resource rich like the Shanxi-Shaanxi duo and Inner Mongolia – these provinces could very well move to the top of China’s growth league.

The report forecasts that this ‘equalising’ characteristic of the investment boom, alongside the expected gradual slowing of China’s process trade, could now be puncturing the stereotype of the coastal regions always being in the lead. Guangdong, Shanghai and Jiangsu (Shanghai’s hinterland region), which had led China’s economic transformation in the past couple of decades, are forecast by the authors of the report to lose their lustre in a relative sense over the coming decade This does not mean that they would become poorer – these wealthy enclaves would just not be getting richer at the same rate as in the past and a number of other regions would make significant headway in catching up with them.