Pursuing Lasting Progress in Emerging Markets

On the Importance of Sustained Capital Investment, Part 2

Last week’s commentary discussed a belief formed from experience: when investing in a developing market, it’s important to focus on companies that engage in sustained investment in fixed capital. I suggested that a common measure of capital efficiency – return on invested capital, or “ROIC” – is usually an important indicator of the quality of a company, but it can also mislead. I have seen companies exploit underdeveloped markets: by systematically under-investing, they can cultivate a degree of scarcity. This allows such companies to earn super-normal profits in the short run, and with limited capital investment, they also enjoy high ROICs. Yet the approach is ultimately problematic, as it fails to develop the underlying potential of the market. The resulting industry is sub-scale, is plagued by inefficiencies, and ultimately hampers long-term growth and economic progress.

This commentary revisits the topic. It presents basic evidence to support the idea that sustained capital investment is critical in the context of developing markets. The data presented below is gathered from several countries, so as to allow for comparison across emerging markets. Admittedly, the workings of macro economies are highly complex, and drawing detailed conclusions about them is tricky. Nonetheless, national statistics do reveal the general outline of an economy and its underpinnings. That’s how I intend to use the data here – to make broad inferences only. My aim is to compare the long-term investment patterns of several countries, and to examine whether such investment is linked to other indicators of development.

The table below presents data on the “BRIICS” (Brazil, Russia, India, Indonesia, China and South Africa). For the purpose of comparison, it also presents data from two developed markets – the U.S., which I use as a proxy for developed countries, and South Korea, which is a proxy for newly wealthy countries.

Cumulative Fixed Capital Formation as a % of GDP Compound Growth Rate in GDP / Capita, USD Terms Annualized Change in Consumer Price Index
1989 - 2009 1989 - 2009 1994 - 2009*
United States 18.2% 3.7% 2.5%
South Korea 30.9% 5.9% 3.5%
China 38.7%(1) 13.3%(1) 2.9%(1)
India 28.1%(2) 6.0%(3) 6.6%(3)
Indonesia 25.0%(3) 7.2%(2) 12.0%(5)
Russian Federation 19.8%(4) 4.8%(5) 28.7%(6)
South Africa 18.0%(5) 2.4%(6) 6.5%(2)
Brazil 16.9%(6) 5.3%(4) 10.2%(4)
* Data prior to 1994 not universally available / compatible
Ranking for "BRIICS" countries in parenthesis, displayed next to each country's corresponding value
Source: World Bank (World Development Indicators & Global Development Finance dataset), Seafarer

The first column offers a measure of cumulative capital investment for each country. The values represent the long-term rate of fixed capital formation (FCF) as a percentage of gross domestic product (GDP). FCF is a measure of gross capital investment across the economy; it represents the acquisition of fixed assets such as physical equipment and infrastructure.1 There is an important caveat regarding FCF data: it lumps together all forms of public and private expenditure, and thus it does not isolate corporate capital expenditure. Still, it is a decent measure of the aggregate capital investment for each economy. My aim is to measure the extent to which each country has engaged in sustained investment, so I have calculated the values in the table by taking the sum of twenty years’ worth of FCF, and dividing it by twenty years’ worth of GDP.

The second and third columns present two core indicators of progress and development. The second column measures annualized growth in GDP per capita over twenty years, measured in U.S. dollar terms. I use this indicator as a proxy for income growth, and because it is measured in nominal dollars,2 it offers a basic indication of tangible changes in global purchasing power.

The third column measures annualized inflation over the past fifteen years, expressed in local currency terms.3 I use this indicator as a proxy for the structural stability of growth. At its most basic level, inflation conveys information about how prices are changing over time; it is generally accepted that over the long run, the supply of money is the most important determinant of inflation. However, over the short-to-medium term, inflation may convey other information, notably the extent to which an economy’s capacity utilization is above trend.4 In the vernacular of markets, this condition is known as “overheating.”

When I think of “overheating,” I immediately equate it with my experience at the microeconomic level, working with individual companies. From what I have seen, overheating occurs when capacity fails to expand in step with demand, or when existing capacity is poorly configured such that it is easily strained by demand shocks. Sub-par infrastructure begets transportation bottlenecks; sub-scale production capacities boost marginal costs; narrow, concentrated industries prompt price gouging and other rent-seeking behaviors. I trace most of these problems back to underinvestment, which I believe leaves an economy poorly equipped to deal with potential growth. Thus ex-post inflation conveys a great deal about the quality of growth – it gauges not only price changes, but also reveals an economy’s capacity for steady growth.

Returning to the table: it is configured so that the “BRIICS” are listed in descending order, ranked according to the values presented in the first column. Each country’s ranking is visible in parenthesis next to its corresponding value. “1” represents the most attractive ranking (highest investment, highest income growth, lowest inflation), and “6’” the opposite. China is listed first, as it has sustained the highest level of investment; Brazil is the last.

The primary message of the table is clear: the countries that have sustained the highest rates of investment (China, India and Indonesia) fare much better on the other two measures of economic progress (higher income growth and lower inflation). China, in particular, stands well above the rest. For two decades it has maintained investment rates that surpass India by over 10% per annum. In this manner, China has among the BRIICS secured the most substantial gains in per-capita prosperity, and it has managed to do this without obvious overheating. China’s average inflation for the past fifteen years is only marginally higher than that of the U.S. Meanwhile, India (#2 on investment) and Indonesia (#3), fare relatively well on measures of development, also ranking generally above their peers on measures of income growth and inflation (Indonesia’s inflation is the sole exception).

I acknowledge my interpretation of the data may conflate correlation with causation. I also note there is a debate as to whether fixed capital investment spurs growth, or if it is only a coincidental occurrence.5 Nonetheless, I don’t think the rankings in the table arise by coincidence. My experience tells me that sustained capital investment matters. To me, investment is the critical factor that unlocks opportunity for individual companies, and for developing economies in the aggregate. Without sustained and serious investment, growth will fall short of potential.

The table reveals other interesting facts. Rates of investment in Russia, South Africa and Brazil are not very different from that of the U.S. This is surprising. All three are featured “BRIICS,” with vaunted potential; all three are operating from a “lower base,” with plenty of room for improvement and expansion. Yet this data suggests that none have invested much more than an established, “rich” country (which could be assumed to be investing and growing at a slower pace). Growth in per-capita income has not outpaced the U.S. by much (South Africa is notably lower), and the structural nature of inflation is higher. South Korea’s record puts the performance of these three countries in context. Korea is a relatively wealthy country, yet it has invested at an elevated rate, as if it was at an early stage of development. By doing so, it has produced a superior rate of income growth, accompanied by lower inflation.

My intent is not to knock Russia, South Africa and Brazil. Much has changed for the better in these three countries, and investment has also picked up, which portends well. However, I want to place those countries’ development records in proper context, which is essential given the hype that surrounds the BRIICS. My preference would be to see all three countries boost their rates of investment, at both the “macro” and the “micro” levels of the economy.

At the same time, I don’t wish to portray China’s investment record as unimpeachable. The command-control nature of China’s economy has facilitated aggressive investment, but it has come with high social and environmental costs. Nor will all of its investment turn out well: I have commented (along with others) that China’s banking system will soon wrestle with severe financial problems associated with excessive lending to provincial governments. More importantly, I think China’s era of elevated capital investment – and the very rapid growth associated with it – is drawing to a close.6 I will address these topics at length in an upcoming commentary.

However, despite these concerns, China’s achievement is remarkable. By investing in a sustained fashion, it managed to boot-strap its way out of endemic poverty. It generated 13.3% compound growth in per-capita GDP7 for two decades. In the span of just one generation, it increased average incomes from $307 to $3,744 for over 1.3 billion people.8 This is the sort of investment that lifts people out of despair, and creates a viable, large-scale middle class. There are pundits and market participants that predict a coming crash in China, predicated on wasted investment and rampant property bubbles. For the record: I have plenty of concerns about China, but I am not part of that crowd. I see moderation ahead, not a cataclysm. What’s more, I would never wish for a different history for China, even if doing so could magically reduce the risk of a bubble: its sustained investment has made all the difference.

Andrew Foster

The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect the writer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.

  1. International Monetary Fund, Monetary and Financial Statistics Manual September 2000, page 102.
  2. International comparisons of income are often made on the basis of purchasing power parity (“PPP”) rather than nominal (market) exchange rates. PPP is useful because it attempts to control for living costs that might vary between countries. However, PPP is only a theoretical construct. One can observe large and persistent differences between theoretical PPP exchange rates and actual, market-based rates. For the analysis presented above, I used market-based rates, mainly because I wished to demonstrate the tangible, factual changes in wealth that occurred, versus those that were estimated or supposed.
  3. I would prefer to use twenty years of history to gauge each country’s structural inflation, but unfortunately the data between 1989 and 1993 were either inconsistent or incompatible across countries. I have thus used the longest time horizon over which I felt comfortable with the data.
  4. There is a robust debate as to whether there is a stable relationship between capacity utilization and inflation. Apparently, Keynes first postulated the idea that production costs were linked to the intensity of capacity utilization (Dotsey and Stark, 2005). Empirical studies on the U.S. economy support the idea that excess capacity utilization was a consistent precursor to inflation, at least prior to 1982. However, post 1982, the observed relationship was less significant (Emery and Chang, 1997). It has since been postulated that productivity gains may disrupt the inflation-capacity utilization relationship such that it is not stable over time. Still, the idea that excess capacity utilization breeds inflation remains pervasive. As far as I am aware, no significant studies on this topic have been conducted with respect to the emerging markets (I welcome correction on this and any preceding point). For more on these topics, see Emery and Chang, “Is There a Stable Relationship Between Capacity Utilization and Inflation?” (1997) and Dotsey and Stark, "The Relationship Between Capacity Utilization and Inflation," (2005).
  5. For example, see: Ding and Knight, “Why has China Grown So Fast? The Role of Physical and Human Capital Formation” (2011); and Blomström, Lipsey, and Zejan, “Is fixed investment the key to economic growth?” (1996).
  6. Matthews Asian Funds 2010 Annual Report, Growth and Income Fund commentary, page 6; and Matthews Asia Funds, “A Roadmap for Asia,” page 3, commentary on “The Low Base Effect.”
  7. Measured in U.S. dollar terms, for purposes of international comparison.
  8. World Bank, World Development Indicators & Global Development Finance dataset.