In the upcoming summit between President Trump and Xi Jinping, China's economic strength will undoubtedly be a topic of discussion. However, I believe it's time to shift our focus from the traditional GDP growth rate to a more nuanced metric: the Incremental Capital Output Ratio (ICOR).
The ICOR provides a deeper insight into an economy's health, measuring the efficiency of investment conversion into growth. A rising ICOR, as seen in China, indicates increasing inefficiency and a potential economic vulnerability.
The Rising ICOR: A Cause for Concern
China's ICOR has been on an upward trajectory since the 2008 stimulus. From a steady 3.9 during the high-growth years to a staggering 8.5 (or even higher, according to some estimates), this ratio suggests that China's economy is becoming less productive with each additional unit of investment.
The Role of Subsidized Credit
One key factor contributing to this inefficiency is the role of subsidized credit. State-owned enterprises and politically connected developers borrow at rates that don't reflect the risk, leading to investments that fail commercial return tests. This results in an overproduction of goods that Chinese consumers don't demand, which are then exported at below-cost prices, effectively offloading losses onto trading partners.
Implications for the US-China Trade Relationship
The standard narrative of a resilient China and a declining US is challenged by the ICOR data. While the US maintains a relatively stable ICOR, China's economy is becoming increasingly dependent on credit expansion and export revenues to sustain its growth and political legitimacy.
This presents an opportunity for the US to apply strategic pressure through tariffs and economic statecraft tools. By targeting the mechanisms Beijing uses to manage domestic stability, the US can influence China's economic trajectory. However, a more effective long-term strategy involves working with allies to address the dumping of underpriced Chinese exports, rather than unilateral action which may isolate the US.
A Managed Deterioration
China's system has proven adept at managing deterioration by hiding losses and extending timelines. But this should not be mistaken for strength. Beijing's celebration of its 5% GDP growth target ignores the rising cost of producing that growth, a cost that is becoming increasingly unsustainable.
Conclusion
As we navigate the complex dynamics of the US-China relationship, it's crucial to look beyond the headline GDP figures. The ICOR provides a more accurate picture of China's economic strength, and by extension, its ability to withstand external pressures. By understanding this metric, we can better assess the risks and opportunities that lie ahead.
