If I could relate the concept of malinvestment to business administration I would do it using the concept of depreciation.
Depreciation is a term used in accounting and business to represent a writedown of a real asset on a company’s balance sheet to reflect its actual depreciation in value. If you build a building, it has a useful lifespan. You need to depreciate its value over that lifespan in order to make the balance sheet reflect this reality. In doing so, you encounter accounting-speak terms like depreciation guidelines, amortization schedules and depreciation methods to write down an asset. All of that is unimportant. What is important is the the end result, which is supposed to be that a balance sheet represents, not the cost of an enterprise’s assets, but their actual value today.
I used to work in the world of leveraged finance and this is the principal reason leveraged buyout companies use EBITDA (earnings before interest, taxes, depreciation and amortization) as a baseline metric for the earnings of any intended target investment. The goal is to get a realistic estimate of the GROSS earnings capability of the enterprise. To do so, you have to back out interest, taxes, and depreciation which can vary depending upon how and where the investment is financed.
When it comes to national income and product accounts, the numbers are already ‘grossed up.’ After all Gross Domestic Product is the name for the acronym GDP we all use to measure economic output. So, when we think about economic growth, we think of gross numbers, not net numbers. But net numbers are the ones that matter. We care about depreciation! As in any individual business, there is an economy-wide depreciation of fixed assets. And when investment resources are misallocated, this hidden malinvestment depreciation is not captured in the gross numbers.
What happens? Look at China for an example. Right now they are throwing hundreds of billions of dollars into the system. See my post “Construction in China’s Ghost Towns” for anecdotes on how crazy this all is. For example:
In Yingchuan, the capital of Ningxia province, 70 per cent of GDP growth last year was related to fixed-asset investment, according to the city’s officials.
"I can’t think of any economy where that rate of growth is sustainable," Bruce Richardson, an American businessman living in Yingchuan, said.
So, for the time being, all of this money is creating monumental increases in GDP in China. However, this huge investment in fixed assets in China also means massive amounts of asset depreciation. Roads and bridges need to be maintained too. That’s the reason you just can’t build to the sky. Eventually fixed assets need to be maintained and replaced. That’s why depreciation expenses exist. Unless all of these assets start earning an adequate return on investment, China will not be able to maintain or replace them and we are going to see China’s GDP slow dramatically at that point.
In the ghost town story, Patrick Chovanec, a professor at the School of Economics and Management at Tsinghua University, says many assets are not earning any return right now because they are sitting empty.
"I have seen houses and shops built in second and third-tier cities in Guangdong in 2005 that are still empty," he said. "Supply is much more than demand in these cities. Funding was easily available for developers, who went ahead and constructed, dis regarding demand.”
And you can see the same insane malinvestment in the videos in “Hugh Hendry: China – The Emperor has no clothes” and “China’s empty city: the emperor really has no clothes.”
Right now all of this investment is depreciating in China just as it has done in the U.S. I would argue the credit crisis in the U.S. was nothing more than a recognition of the malinvestment that was there all along but unaccounted for because everyone was thinking gross and not net. It was only when subprime imploded that the massive depreciation became real. Buildings need to be maintained, you know. Underneath the huge gross numbers were much less rosy net numbers. And at some point, this sort of thing catches up with you.