Nomura On China's Challenging GDP Maths

Nomura's economists in their "Global Weekly Economic Monitor" address the challenges of China's GDP arithmetic. Paul Sheard in the Global Letter writes:

When the crisis broke in September of last year, policymakers moved quickly and forcefully to kick-start a surge in domestic investment growth. On top of its own big fiscal stimulus package, the central government (in a classic demonstration of how command-economy-style dynamics can sometimes work well) effectively gave local
governments and state-owned enterprises the green light to ramp up investment and gave the banking system the go-ahead to finance it. A credit-fuelled investment boom ensued.
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The reason for this relates to China’s challenging GDP arithmetic: an economy that has a very high share of investment in GDP – as a result of investment growth having outpaced GDP growth for a long time – is inherently vulnerable to a collapse in growth when the investment boom stops, as it eventually almost certainly will.

To illustrate, suppose an economy has an investment share of GDP of 50%, investment grows at 20% in a given year, consumption growth is assumed to contribute 5 percentage points to growth and net exports are assumed to detract 5pp: the overall growth rate is 10% per annum. Now suppose investment growth in the next year slows to zero and (unrealistically) the other components of GDP again net out to a zero contribution – the growth rate collapses to zero. If investment were to fall, say by 10% (all else equal), growth would turn negative, to around -5%, with the year-to-year swing in GDP growth being a hefty 15pp. In such a scenario, it is virtually inconceivable that consumption growth could accelerate sufficiently in the short run to offset the downturn in investment. For instance, if private consumption were 35% of GDP, its growth rate would have to accelerate by about 29pp to offset the impact on growth of flat-lining investment growth (43pp in the investment slump case).

Note that, after a prolonged investment boom, even if investment were to fall by 10-20%, let alone just flat-line, having increased for so long and having become such a large chunk of economic output, the absolute level of investment would still be quite high. But the challenging GDP arithmetic implies that even investment taking a well-earned breather in growth could result in a devastating impact on overall growth in such an economy.
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Our illustration, while stylised, is not that different from China’s situation. China’s investment share of GDP in 2008 was 43.5% and, according to our forecasts, is set to rise to 49.6% by 2011; the consumption share was 35.3%.

Do not worry, "but policymakers and investors alike should be cognizant of the risks".