Does China Have a Transportation Bubble?

Chinese officials announced last week that their nation's GDP growth in the first quarter of 2012 was the weakest since early 2009, back when the global economy was at a standstill. This has sparked widespread fear.

Indeed, markets around the world have relied heavily upon China and other emerging market countries for growth given the limping nature of the U.S. and European economies the past few years. Since one of the main drivers of China's economic success story has been its public works projects, it is a good time to revisit China's longer-term commitment to its transportation infrastructure and ask whether the debt used to finance its highways and mass transit systems will contribute to sustainable growth, or become an economic drag.

The concern isn't casual. China has plowed $240 billion into more than 57,000 miles of expressway and plans to spend another $12 billion annually on its network through 2020, according to the Ministry of Transport. The National Trunk Highway System is larger than the U.S. Interstate system and consists of 32 major corridors connecting dozens of major metropolitan areas.

Simply put: China's investment in its transportation infrastructure is unprecedented on a global scale.

Is it too much, too fast?

On a national level? Perhaps not. More than 275 million people are expected to move into Chinese cities over the next 25 years. That should bring China's total urban population to at least 950 million people, more than triple the size of the U.S. as a whole. The sheer size and number of China's major cities will create unprecedented demand for mobility.

Unfortunately, the productivity of China's transportation investments may be waning as policymakers increasingly move away from user fees and market-based mechanisms, such as tolls. They are more and more opting for less efficient and more politically palatable approaches such as fuel and vehicle taxes which are more common in the U.S.

As China opened its economy to markets and international trade in the late 1970s and early 1980s, national and provincial leaders had little choice but to invite private capital to build their roads and highways. Also, since the same governments lacked the financial resources to pay for the infrastructure projects through taxes, virtually all the roads were priced using tolls (including many non-expressways).

A little recognized but critical benefit of tolling is the ability to more efficiently manage highways. Tolling effectively prices roads and thus serves a more important function than simply paying off debt. Pricing ensures the right roads are in the right place at the right time. By reducing the role of tolling, China risks moving away from a system of market-accountability in transportation precisely at a time when the land of dragons needs to embrace it.

Compounding these potential inefficiencies in transportation finance is the continued reliance by provincial governments on state-owned banks and tollway authorities to manage, operate and finance these facilities. While the Chinese enterprise model, like independent toll agencies in the U.S., has many virtues compared with conventional transportation bureaucracies, it is largely insulated from the discipline and transparency of the private market. The benefit of private capital is to shift risk from the public sector to the private sector and institutionalize incentives for lowering costs and achieving efficiency. By excluding foreign and truly private capital, the Chinese risk relying too much on state-owned enterprises that are already widely recognized as a drag on the broader economy.

A harbinger of what might come may not be as much in highway finance as in mass transit. China is also on track to build 176 urban rail lines spanning 7,254 miles by 2020 with a price tag of about $470 billion. Twelve rail transit systems are in operation, another 17 are under construction, and 18 more are planned.

Most cities now adopt low average fares that don't adjust by the level of use or ability to pay. In an effort to dramatically increase ridership, Chinese cities are significantly underpricing fares when they could be embracing technology that allows them to generate more revenue from customers who can afford to pay. Of course, Western systems, for the most part, don't operate on this system either. But China is in a unique position where it can adopt existing technology to use fare levels to optimize the use of its transit and road networks while generating more revenue through this kind of variable pricing strategy.

Ironically, China built its infrastructure backbone by relying on market-based approaches, including tolling, public-private partnerships, and foreign capital. This transportation infrastructure will be crucial to its long-term growth and success, but only if the investments are in the right place and managed at peak efficiency. If China continues to retreat into a more Western-style tax funding system that ignores the virtues of market-based pricing and finance, its investments may well turn into an economic burden rather than a smart investment that sustains economic growth over the long term.