Investment-driven growth no longer a viable option

With no end in sight for Europe's prolonged debt crisis, many are now worrying that the financial turmoil roiling the Continent may trigger a recession in China. While uncertainties in the eurozone indeed pose a major challenge for the world's financial markets, the more immediate threat facing China's economy comes not from abroad, but from the country's heavy dependence on investment.

Of course, to many observers the dangers posed by an influx of investment may seem relatively minor at present. During the first four months of 2012, the growth rate of China's fixed asset investment stood at 20.2 percent, the slowest pace since 2003, according to the National Bureau of Statistics.

However, as the country's economy decelerates, there have been renewed calls to again increase investment as a way to propel growth. Actually, a research fellow from the State Council recently announced that the government will likely ramp up investment this year with the construction of several new airports, water management facilities and rail projects.

With the country's financial markets flush with liquidity thanks to a recent reserve requirement ratio cut, a return to China's old strategy of leaning on investment to drive the economy looks even more probable.

This time around though, adopting such a strategy would be an extremely risky gamble for the country. After decades of fixed assets investment, the marginal returns from such investments and the benefits they bring to the economy have both decreased. By this, I mean that investment capital currently contributes much less to economic growth now than in years past.

To support this claim, we need only look to China's incremental capital output ratio (ICOR), an index that assesses the amount of investment needed to generate the next unit of production. Essentially, the higher the index reads, the less productive investment capital becomes for a particular enterprise or, in this case, country. By dividing fixed asset investment figures with GDP results at several points over the last three decades, China's ICOR ratio has been climbing steadily since 2003.

At China's current stage of economic development, the country would actually have to shell out more in capital to achieve a lower return than in the past. With bank credit now servicing as the country's main source of capital, a spike in capital demand would inevitably lead to a sharp expansion of bank loans, which would not only deteriorate assets and capital adequacy ratios at the nation's lenders, but push up the inflation rate and create bubbles in speculative sectors.

Rather than pushing the country to the brink of disaster for the sake of short-term gains, government planners need to focus their attention on transforming China's economic growth engine by adopting strategies to promote domestic demand and support enterprises which contribute to the real economy.