April 13 (Bloomberg) -- China's capital spending is spiraling out of control. The harder Beijing tries to dissuade local governments from wasting money on yet another unnecessary highway or town square, the more inclined they seem to do just that.

It's a classic case of ``moral hazard,'' a concept economists use to describe why some people burn their own houses.

Moral hazards are all about distorted incentive systems. A landlord finds it profitable to torch a house he owns when the insured value of his property exceeds its market value. By the same token, China's local governments have a perverse incentive to waste capital: They are judged by the growth they generate, and not by how much capital they use in the process.

The cost of their investment excesses is borne by a malleable banking system. It doesn't matter to provincial governors and city mayors that almost half the loans on the books of the four big state-run Chinese banks have already turned bad. Sure, bad loans are a problem -- Beijing's problem.

``Moral hazard,'' according to Paul Krugman, professor of economics at Princeton University, is ``any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly.

Construction Fallout

``Borrowed money,'' Krugman argues in his 1999 book ``The Return of Depression Economics,'' is ``inherently likely to produce moral hazard.''

In the first two months of 2004, fixed-asset investment by Chinese local authorities shot up 65 percent from a year earlier, more than five times the growth in Beijing's own capital spending.

China's construction spree is creating an unsustainable bubble in global commodity prices. Take copper. Chinese imports of the metal, which is used in plumbing and wiring, more than doubled in February. Copper futures on the London Metal Exchange have risen by three-fourths in the past year.

Lehman Brothers estimates that if overall fixed-asset investment in China grows at last year's 27 percent pace, domestic capital spending will account for half of China's gross domestic product in 2004. That's too high an investment ratio because it's leading to shortages of everything from raw materials to electricity.

Squeeze on Profits

Even worse, Chinese companies aren't able to pass on their rising costs to customers. In February, even as the local price of steel rose 35 percent from a year earlier, China's automobile prices fell 5.1 percent.

Higher raw material costs ``are squeezing the profit margins of China's producers,'' says Rob Subbaraman, Lehman's Tokyo-based economist. ``Rampant investment and production has taken its toll on the economy.''

Until mid-2003, the surge in China's capital spending was touted as an example of that country's insatiable appetite for investments. Increasingly, it looks like a bad case of bulimia. Chinese Premier Wen Jiabao vowed last month to block ``haphazard'' investments.

``Blind investment in some industries and low-efficiency, redundant construction haven't been effectively arrested,'' says Beijing-based State Development and Reform Commission, the top economic planning agency.

Tighter Credit

So far, Beijing has tried to douse the investment fervor by tightening credit. On Sunday, the central bank announced that it was raising the percentage of deposits that banks need to set aside as cash reserves to 7.5 percent from 7 percent starting April 25. The 0.5 percentage point rise in the reserve ratio will remove about 110 billion yuan ($13.3 billion) from the financial system.

The People's Bank of China last raised the reserve ratio to 7 percent from 6 percent in September, removing an estimated 150 billion yuan from circulation.

Still, too much money is sloshing about in the Chinese economy. M2, China's broadest measure of money supply, rose 19.4 percent in February. That's 2.4 percentage points higher than the central bank's target of 17 percent for 2004.

Analysts are veering around to the view that tougher measures may be needed, including higher interest rates.

Higher interest rates may save the day for now, although they won't really address China's moral hazard problem. Telling insurers they ought to provide coverage to fewer homeowners doesn't automatically solve the problem of landlords becoming arsonists.

Cutting Out Politicians

The moral hazard can only be eliminated if Beijing is able to push its banks to bolster their risk management practices, so politicians aren't able to influence lending decisions.

Until that happens -- and it will require substantial improvement in China's outdated banking systems -- party apparatchiks will keep starting financially unsound projects. In January, Credit Suisse First Boston predicted that among the 86 subway lines under construction or being planned in China, ``most of them (if not all) have no prospects of breaking even.''

``Local governments only care about their own interests and keeping the good times going in their own areas,'' Hu Yanni, an analyst at China Securities Research Co. in Beijing, said last month. ``They have power over banks,'' which fund the spending.

When party officials can't produce growth (even with virtually free capital), they invent it. A Bloomberg News report last year showed that, flouting the law of averages, China's 31 provinces and municipalities each reported 2002 growth rates higher than the central government's figure for the whole country.

`Hard Landing Inevitable'

``Local governments are working against the central government by setting up many new projects,'' says Morgan Stanley's Hong Kong-based economist Andy Xie. ``If China doesn't take more effective measures, a hard landing will be inevitable.''

First-quarter gross domestic product figures, which will be released on Thursday, may offer clues to just what kind of a landing it might be for China. If growth fails to cool down from last year's 9.1 percent, it may indeed be a sign that Beijing is losing its battle against moral hazard.

To contact the writer of this column: Andy Mukherjee in Singapore amukherjee@bloomberg.net.

Last Updated: April 12, 2004 14:57 EDT