China faces downside risk from over-investment: S&P

Investment levels in China have run ahead of returns on investment over the past five years, increasing the risk of an economic correction in the country, according to a report released by Standard & Poor's on Thursday.

The report — titled The Investment Overhang: Despite China's Rebound, $800 Billion Of Downside Risk Abounds — examines the correlation between China’s investment-to-GDP ratio and GDP growth during the 1990s to early-2000s, and explores a China downside scenario arising from excessive investment.

It says that China's rate of return from its huge fixed-capital investments appears to be diminishing compared to prior periods.

"China's heavy dependence on fixed capital-led growth magnifies its economic sensitivity to a correction in investments," said S&P credit analyst Terry Chan. "As fixed capital becomes less productive, the high growth rates of investment in China may be harder to sustain. Such a potential drop could have a significant impact on China's GDP growth."

According to the report, the downside scenario for China assumes the investment-to-GDP ratio easing to 46 percent in 2013, which is 1.6 percentage points down from the 2012 estimated level. This modest drop could drag China's GDP growth rate down to 6 percent, compared to S&P's base case of 8 percent for 2013.

"We predict a one-in-five likelihood of the downside economic scenario occurring," Chan added.