Headed For A Crisis?

China's economy is overheated, its banks are shaky, and hot money continues to pour in. Can the new leaders rein in a runaway financial system?

Scenes of prosperity, scorching expansion, commodity shortages, and speculative froth in the Chinese economy: In Beijing, local authorities are driving an unprecedented stadium-construction boom to prepare for the 2008 Olympic Games, an historic shot for the country to strut its stuff and showcase its economic ascendancy before a global audience. The capital city is spending $30 billion-plus on new subways, road construction, and glittering stadiums.

There's just one problem: not enough steel. China can't get enough of the stuff, and a supply crunch has sent prices soaring around the world. In early April, that prompted the Beijing Organizing Committee for the Olympic Games to cut steel use in the planned National Stadium, the Games' primary venue, by some 40%, to 45,000 tons, using other construction materials instead. It is also reducing the size of the planned National Swimming Center.

In some thriving coastal cities, 2004 is shaping up to be the year of the brownout, as construction of new factories and housing fuels ever greater demand for electricity. China's State Grid Corp. forecasts an electricity gap of some 30 million kilowatts this year. Power rationing has become a fact of life in Shanghai and in smaller towns in the provinces of Zhejiang and Anhui in the booming Yangtze River Delta.

Looking for a measure of how prosperous the Chinese are feeling? At one upscale Shanghai housing complex called Rainbow City, built by Hong Kong developer Shui On Properties, all 816 apartments were sold in three days last October, mostly to local Chinese. In a not-yet-completed luxury residential development near Shanghai's Xintiandi district, where apartments cost $325 per square foot, there's a waiting list of 2,200 prospective buyers. Meanwhile, infrastructure projects of dubious utility are popping up -- or in the case of a new train line in Shanghai, sinking. The city has a new $1 billion airport link that runs on German maglev technology -- the first of its kind in the world. But since opening last month, most trains are empty and the elevated tracks are sinking.

Then there are the car factories everyone wants to build. Ningbo-based Aux Group, maker of air conditioners and cell phones, is charging into the auto biz. Doesn't that seem a trifle, well, reckless? "I'm not worried," says spokesman Huang Jiangwei. "You go where the opportunities are."

The world has known for months that China is white-hot. What the world wasn't expecting was that it would keep getting hotter. The government of President Hu Jintao and Premier Wen Jiabao has been signaling since last summer that it's time to ease up on growth. People's Bank of China (PBOC), the central bank, has said it wants to crack down on reckless lending. But the numbers remain explosive. On Apr. 15, Beijing revealed that the economy grew 9.7% in the first quarter; the target was 7%. First-quarter loan growth grew 21% over last year, and the broadest measure of the money supply, or M2, rose 19.2%. Fixed-asset investment -- spending on plants, equipment, roads, and other infrastructure -- is up 43%. The average in Asia is more like 20%. Inflation of 2.8% doesn't look too bad -- until you consider that a year ago it was under 1%.

The oddest sign of stress: Because the yuan is fixed at a cheap rate of 8.27 to the dollar and the government so far has not let it appreciate, the Chinese are spending more and more to import increasingly dear raw materials, which mainland manufacturers turn into products to sell abroad at low prices. In other words, China is paying more and getting less in return. The result: China actually ran a first-quarter trade deficit of $8.43 billion. Some reports are surfacing of companies hoarding commodities as a speculative play. Only a hike in the yuan will cut the import bill, but too high a hike could put jobs at risk.

The system is clearly out of whack. Yes, China is regarded as a country with first-world manufacturing prowess, the planet's workshop. But that industrial might is hitched to a broken, third-world financial system. When the heat turns up, things can get ugly. And because it is so big, an overheated China takes on enormous global importance. Not since the boom-bust cycles of the fast-growing U.S. economy in the 19th century has the world seen such a phenomenon. As Fed Chairman Alan Greenspan told Congress on Apr. 20: "If [the Chinese] run into trouble, they will create significant problems for Southeast Asian economies, for Japan, and indirectly for us."

VORACIOUS APPETITE. The authorities are clearly getting nervous. Beijing has raised bank-reserve requirements for the second time in eight months, and a sell-off in Chinese bonds has been accelerating. With the yuan under considerable speculative pressure, PBOC Governor Zhou Xiaochuan seemed to signal on Apr. 18 that it might be time for the central bank to loosen its fixed-currency regime slightly to stem inflation and slow the economy. The markets seem to be taking such talk seriously. The one-year forward rate on the yuan is hovering at 7.8 to the greenback, suggesting a 5% future adjustment in the currency.

What if these attempts to cool things off don't work? That's what global investors and policymakers worry about. Why? A runaway China -- or a China hit by a temporary but dramatic crash -- would have far more impact on the global economy than it would have had 10 years ago, when the mainland had its last great crisis of overheating. The Chinese economy's share of global output has doubled, to 4%, in the last decade. China is devouring 7% of the world's oil supply, a quarter of all of its aluminum, 30% of iron-ore output, 31% of the world's coal, and 27% of all steel products. Last year, China-linked exports and industrial production accounted for about a third of the recent rebound in Japan's gross domestic product. China is the top destination for South Korean exports: Trade with China kept the Korean economy from slipping into outright recession last year. Emerging-market companies in Brazil, Russia, and elsewhere have benefited from the heavily China-influenced rise in global commodity markets. And China profits are coming in too. U.S. multinationals such as Motorola now rely on China for up to 10% of sales. General Motors Corp. just reported that first-quarter earnings from Asia quadrupled, to $275 million, thanks to soaring demand from the mainland.

That's why Beijing's ability to engineer a soft landing is possibly the most important issue in global finance this year. If the government can slow down growth to, say, 7%, commodity prices will ease worldwide, pressure on the yuan will subside, and Beijing will keep generating jobs for the 10 million Chinese who enter the workforce every year. "We believe the economy is developing too rapidly," says a senior government official. "But the last 25 years have proved the government capable of reining in these difficulties."

The authorities do have a plan. Under the general tutelage of the PBOC's Zhou and the State Council, 10 inspection teams drawn from various ministries and PBOC have been dispatched to seven provinces to examine industries that have gotten too much investment -- especially steel, cement, and aluminum -- to beat greedy borrowers away from the trough. The government also has instructed the Land & Resources Ministry to restrict land allocations to sectors that are overbuilt. Some analysts think such actions will slow the overinvestment soon, especially if coupled with a rate hike. Deutsche Bank (DB ) economist Jun Ma thinks a modest 50-basis-point rise in China's benchmark 5.31% lending rate will do the trick. "China will achieve a soft landing of GDP growth," he says, adding that inflation will likely end the year at an acceptable 3%.

It's also clear that Chinese officials don't want to choke off the job machine, for obvious political reasons. Says Li Yushi, vice-president of the Commerce Ministry's Chinese Academy of International Trade & Economic Cooperation: "I would rather that the economy overheat than be cold, because then there would be a lot of problems." Li thinks the economy will eventually use the excess capacity that's building up in areas such as steel, cars, and property. Some Western executives agree. There may be the start of a property bubble now, they say, but the long-term picture is bright, thanks to China's breathtaking urbanization. "There will be 345 million people making the move from rural to urban China in the next 20 to 25 years," says Guy Hollis, country head and international director for real estate consultant Jones Lang LaSalle in Shanghai.

DYSFUNCTIONAL SYSTEM. The other possibility, though, is much darker: a repeat of 1992-94, when runaway growth and inflation forced Premier Zhu Rongji to enforce draconian rules to stop rampant lending, curb double-digit inflation, and tame the economic beast. Zhu used higher rates and administrative diktat to cool things off. China kept growing, but at a slower pace, while joblessness mounted, the property markets crashed, and the four big banks found themselves saddled with mountains of bad loans they had extended during the bubble.

The biggest China pessimists see a repeat of this crash landing but on a much vaster scale -- one that would send global commodity prices spiraling down, hammer Asian economies, destabilize China's big banks again, and wound earnings at multinationals. "The current investment bubble is becoming bigger than the one from 1992-94," notes Morgan Stanley (MWD ) economist Andy Xie, admittedly the king of the China doomsayers. Xie says fixed investment is much larger now than 10 years ago and is laying the groundwork for a massive bust.

Soft landing or hard, only a gargantuan effort by central authorities will resolve the structural issues plaguing China's money system. The latest overinvestment scare is just a symptom of a deeper malady that afflicts China's hybrid economy, which blends elements of free markets with the heavy hand of a one-party state that still has a huge say in how credit gets allocated. For all of its glittering skylines, emerging space program, and love affair with cell phones and the Net, China is still burdened with a backward financial system that can't tell a good risk from a bad one -- and often doesn't seem to care. "There is no such thing as efficient capital allocation in China," says Carl E. Walter, chief operating officer for J.P. Morgan Chase & Co. (JPM ) in China.

The struggles of the Big Four -- Bank of China, Industrial & Commercial Bank of China, China Construction Bank, and Agricultural Bank of China -- to end decades of politically motivated lending are the most visible and best-known signs of this dysfunctional financial system. By some estimates, 45% of all bank loans remain underwater. Authorities are starting to recapitalize banks and professionalize credit operations, but it's a slow process -- and the banks keep lending.

Westerners have a vague idea that Beijing can still assert its authority over any aspect of Chinese life fairly quickly, as it used to. But China is much more decentralized than outsiders think. Local Communist Party cadres can bend the rules and get local branches of the big banks to lend when they shouldn't. And it's not just the banks that come under pressure from local notables. Seven regional commercial banks, 100-plus city commercial banks, and 1,200-odd rural cooperative lenders are all active -- often shelling out credit with nary a glance at a borrower's books. Standard & Poor's (MHP ) points out that in 2003, the loan portfolios of smaller lenders, especially city banks, grew at twice the pace of the Big Four's. Worse, lenders usually charge one fixed rate: Morgan Stanley's Xie say they should charge risky borrowers up to 500 basis points more. Meanwhile, many entrepreneurs can't get a cent of this abundant credit. "It's problematic," says Zhang Jian, co-founder of China Bright View, a promotion and marketing company that counts Oracle (ORCL ) and Eastman Kodak as clients. "Chinese banks don't support private enterprises; they support state-owned enterprises."

PROSPERITY IS ADDING FAT TO THE FIRE. Beijing may eventually wrestle these problems to the ground. "Remember, we are not a 100% market economy," says Frank Peng, professor at the School of Economics & Management at Tongji University in Shanghai. "If purely economic measures cannot be effective, then of course administrative measures can be taken." But as the system loosens up, it takes central authorities much longer to assert control. "China's banking system is really insolvent, and all the monetary tools they have to fix things are blunt," says Ping Chew, a Singapore-based credit analyst at Standard & Poor's.

Reckless lending isn't the only problem: Outright criminality is an issue, too. On Apr. 16, the U.S. deported Yu Zhendong, a former Bank of China branch manager in the city of Kaiping, who was recently convicted in a Las Vegas court of embezzling $485 million from 1992 through 2001. (Yu had fled to the U.S.) He was able to authorize loans and transfer assets with a single signature, without the supervision of higher-ups, according to court documents.

China's current prosperity is adding fat to this fire. Since the country joined the World Trade Organization, the economy's links with the outside world have accelerated. The result is a collision of global capital with a still-primitive financial system. Chinese lenders are awash with liquidity because China's closed capital account means huge inflows from exports -- about $438 billion last year. Add to that some $53 billion in foreign direct investment that must be flipped into yuan. Much of that extra yuan ends up in the money supply and banking system, where a good chunk of it is lent.

Then there's a growing class of speculators. Overseas Chinese, mainland residents who have set up offshore accounts, and others are undercutting monetary policy even more by snapping up yuan at current rates and betting that they will pocket profits when it eventually appreciates. Some $40 billion of last year's capital inflows came from such speculation, according to S&P. Some local companies even falsify the export sales they report to the government so they can take dollars they squirreled abroad and reinvest them back into yuan-denominated assets."Capital controls in China are very porous," says credit analyst Ping.

It's not just outside money flowing into the banks: Households piled up $350 billion in new savings last year, according to Morgan Stanley, while Chinese companies earned $100 billion. Even the uptick in reserve requirements at the banks will have a minor impact given the billions that keep flowing into their coffers. Last year, PBOC sold $79 billion in Treasury bills, mostly to the banks, to sop up the money supply. It was a good effort, but clearly not enough to stem the rise in credit.

The banks, which account for 85% of the credit created in China, might lend more sensibly if they had to compete with developed bond and stock markets for capital. But the country's 20-year-old corporate bond market has all of 24 issues listed, and daily trading is minuscule. Because interest rates are state-controlled -- and banks have always been eager to lend cheaply -- there has never been much of a need for companies to issue bonds. Only state-owned companies have bothered to issue them, and because of the implicit government guarantee they enjoy, virtually every company boasts a triple-A rating, no matter how ludicrous. In the West, a thriving corporate bond market gives bankers an idea of how the markets assess risk and what is an appropriate rate to charge. Such a yield curve doesn't exist in China.

The same is true of government securities. One foreign trader tells of a 30-year bond the Finance Ministry issued a few years ago that yielded only 2.9% -- barely above the rate for a one-year Chinese Treasury. "What kind of risk pricing is that?" he asks. He avoided the bond, which now trades under water.

The country's two domestic stock exchanges in Shanghai and Shenzhen, launched in the early 1990s, aren't much more successful at raising capital and offering an alternative to bank financing. The two bourses accounted for only 3.9% of the funds raised last year by Chinese companies, according to central bank data. Every time there's an initial public offering, investors depress market prices by selling existing holdings in other equities to raise cash to buy the new listing. The result: Offerings are always successful for those lucky enough to buy shares early, while many who buy on the secondary market get burned.

One reason the markets are so volatile is that they are illiquid since the government holds 70% of the shares: Thus, they're not traded. This year, China's all-powerful State Council announced that it wants to sell some of those state shares. That would depress current prices in the short term, but the government might offer to let existing shareholders buy the state shares at a discount to soften the impact. Beijing also wants to loosen investment rules to let pension funds invest more in stocks.

Other reforms are coming thick and fast. At the end of March, Hong Kong banks were given permission to accept deposits in yuan, an important step toward full convertibility down the road. And central banker Zhou wants to move faster in deregulating interest rates. "Due to the excessive regulation of rates, China's financial institutions don't have the ability to price financial products, particularly loans," he conceded in a policy speech last December.

WHAT CAN BE DONE? But those are long-term solutions, and there's a hot economy that needs to cool off now. So authorities keep leaning on lenders to tighten. Home buyers must now put down 30% instead of 20% for high-end properties. And to curb speculative "flipping" of properties, the government has banned the resale of new apartments until construction is finished.

Some think Beijing must do far more. Joan Zheng, China economist for J.P. Morgan Chase & Co. (JPM ) in Hong Kong, advocates an excise tax on domestic investment like the one Zhu used in the mid-'90s. That's better than a sharp rate hike, she says, since higher rates will just exacerbate the bad-loan problem and attract more speculative money to the yuan.

The government also wants to encourage consumer spending, which trails fixed investment. The Chinese have long been compulsive savers, and with the end of state-guaranteed lifetime jobs and retirement benefits, people save even more. The overall savings rate is an astonishing 43% of GDP. Sure, folks on the eastern seaboard are buying cars and spiffy mobile phones, but in the hinterlands people are socking away every yuan they can into saving accounts. And that's just giving banks more cash for iffy loans, especially to builders of factories, bridges, and roads. So Beijing wants banks to extend consumer financing beyond autos and mortgages to include vacations, white goods, home furnishings, and more. Some analysts think these measures are already starting to alleviate underconsumption. If done right, such a policy shift would keep growth strong while curbing the worst speculative excesses. If done wrong, though, it just substitutes one problem of easy credit for another while creating an inflationary bulge in the consumer economy.

There are no easy answers. Perhaps that's why so many Chinese just accept boom-and-bust cycles as part of the country's economic evolution. "There may be a waste of resources," says the Commerce Ministry trade institute's Li. "But that's been the case for years. This is how China has grown." Over the long term, he's right. But in the short term, China's ability to disrupt the world economy is growing to scary proportions. Let's hope Hu and Wen know what they're doing.

By Brian Bremner, Dexter Roberts, and Frederik Balfour

With Bruce Einhorn in Shenzhen and bureau reports

— With assistance by Bruce Einhorn

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