China: Beware The Bust

China as a growth machine is an awesome spectacle. In the middle of a global slump, it has by itself driven up shipping rates tenfold in a decade and ratcheted up commodity prices by 40%. The reason is pretty clear: China is moving into another heavy investment stage.

Multinationals are pouring money into everything from new chip plants to expanded auto facilities. Suppliers to the auto and electronics industries are following right behind. With the Summer Olympics a little more than four years away, massive infrastructure projects are also going up around Beijing and Shanghai. Adding to the frenzy is a new decentralization policy that allows regional leaders to go on their own real estate spending sprees, fueled by ample credit from banks that are really agents of the state.

The heady combination of public and private largesse is probably setting up the next bust. If that happens, an oversupply of autos, chips, and other components is likely to spill out on world markets, slamming prices. At the same time, empty buildings will put more pressure on tottering state banks and raise the level of bad loans to unimaginable limits. What's the solution?

It may be too late to avert the next crash. But there is time to build more controls to temper the boom. First, China's financial authorities need to get serious about stripping out bad loans from good ones and setting up clean banks. Then those banks need Federal Reserve-style supervision. Right now, bank lending is constrained mainly by hiking reserves, a crude mechanism that comes into play too late in the process. The government needs to work toward a more interest-rate-regulated market. Unfortunately, for most of the nation's leaders, this reform is incidental to reliable growth rather than the regulator of it.

China also needs to stop hoarding dollars at its current rate of almost $100 billion a year. This huge surplus creates the illusion that China is rich and stable and drives more money into China's currency in the hopes the nation will soon revalue the yuan. Yet most of this hoard is invested in U.S. government securities, which helps fund America's deficit and keeps U.S. interest rates low but provides little benefit to China's people. Unwinding the surplus will be tricky. But spending some of it on projects in rural China would help balance out the boom-bust growth in the cities and, over time, would add to the nation's social stability. This decade is likely to be the one in which the world learns to live with China's scale. As its internal market grows and incomes rise, China will absorb more of the goods that it makes. But until then, a boom-bust cycle for China is bad for the world. It's time for China's leaders to invest in some controls.

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