China's Toughest Great Leap Forward

The latest case of scientific fraud out of China may be an indicator of bigger economic problems to come. On May 12, 2006, leading Chinese computer scientist Chen Jin was fired from his post as a dean of Shanghai Jiaotong University, one of the country's top schools, after the computer chip he supposedly invented turned out to be a fraud.

By itself, this scandal is not a big deal. But the story -- a promising researcher who tries to deliver more than is possible -- may mirror the situation of the whole Chinese economy. China has been trying not just to climb the development ladder, but to vault it. The country has made the very impressive first step to an industrial economy, able to manufacture and assemble almost anything. This has made China one of the great economic success stories of all time.

But now the Middle Kingdom is trying to make the next, even bigger, step up the ladder to a technological economy, able to create complicated systems such as microprocessors, nuclear power plants, and cars, which must all work with a high degree of reliability. And the country's leaders want China to go even further and become an "innovation society," capable of creating its own new technologies.


  Yet trying to compress 100 years of economic progress into 20 may be taxing the Chinese economy. Innovation is a lot harder than it looks. Even major industrialized countries such as Japan, Germany, and France have a difficult time sustaining cutting-edge science and technology.

What's more, signs of financial stress continue to build. In early May, global accounting firm Ernst & Young issued a report that nonperforming loans in the Chinese banking system could be as high as $911 billion, up from $480 billion in 2002. This report had special authority, since E&Y is the auditor for one of China's four major commercial banks. Moreover, the need to protect against that level of nonperforming loans would help explain why China has worked so hard to build up its foreign exchange reserves, now at the astounding level of $875 billion.

However, after protests from the People's Bank of China, Ernst & Young retracted its report. The press release said, in part: "Upon further research, Ernst & Young Global finds that this number cannot be supported, and believes it to be factually erroneous."


  Other reports, however, paint a similar picture as the one that Ernst & Young took back, though without the eye-popping number. A new report from the McKinsey Global Institute says that wholly and partially state-owned companies, which have very low productivity, still absorb most of the available capital funding, accounting for 73% of bank credit. These are loans that have great potential for either going bad, or showing very small returns. And a new paper from the International Monetary Fund says, in part, that "it remains unclear the extent to which currently reported data reflect the true credit risk in loan portfolios."

Assuming that the original number was anywhere near true, the Chinese economy looks more and more overstretched. The basic achievement of becoming an industrial economy is very real and solid and won't disappear. But the next rungs of the development ladder may be further away than they look.

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