The Fire This Time In China

Raging growth means Beijing must raise rates or revalue the yuan. Both are risky

In recent weeks, investor worries about rising interest rates and an economic slowdown in the U.S. have sent shares across the globe into a tailspin. But another potentially more substantial concern is lurking in the background: an overheating China.

The mainland economy isn't out of control just yet, but the financial data are alarming. First-quarter growth hit a torrid 10.3% and industrial production in May surged by nearly 18%, the fastest rate in two years. China's global trade surplus, meanwhile, hit $13 billion for the month, up from $9 billion a year earlier, and exports climbed 25%. When those export earnings are converted into yuan, they produce a tidal wave of excess cash that feeds ultraloose bank lending. That in turn leads to real estate bubbles and too many new factories, office buildings, and highways.

The magnitude of the flood became clear on June 14. That's when the People's Bank of China announced that the money supply jumped 19% year-on-year in May, well above the central bank target of 16%. Even more troublesome, banks lent some $26 billion in May, nearly double the level a year ago. A big chunk of those loans could go sour if the real estate market heads south. "There was a lot of pressure [from local governments] on banks to lend in the first quarter," says Standard Chartered Bank economist Stephen Green. The numbers are "going to cause some nail-biting among economists."

With good reason: China is now the third-largest trading nation and is a voracious consumer of commodities. It devours some 20% of the globe's annual output of aluminum, 30% of steel, iron ore, and coal, and 45% of cement, Morgan Stanley (MS ) estimates. So a repeat of China's bust in the early 1990s, when runaway growth and inflation forced Beijing to take draconian measures to cool things down, could reverberate far beyond the mainland's borders. Already, China tremors have helped push Asian stock prices to near their six-month lows.

FEW OPTIONS

The real worry is that there may not be much China can do to slow the economy without triggering a crash. Zhou Xiaochuan, the seasoned governor of the PBOC, can try to jawbone banks and local government officials into calling off yet another trophy highway or gleaming skyscraper. But Beijing's ability to wrest control of its $2 trillion economy by administrative fiat is fast eroding. To really slow growth to a more sustainable 8% or so, Zhou needs either to boost the value of the yuan vs. the dollar or to raise interest rates sharply. Neither option is appealing.

Although the yuan has edged up lately, nobody expects Beijing to sign off on the 20%-plus appreciation some say is needed to really dent the trade numbers and curb those huge dollar inflows. The mainland's export-oriented manufacturers would be outraged, and a slowdown at their factories could spur massive layoffs at a time when China needs to create 10 million new jobs annually. Just as bad, a stronger yuan could spur a big increase in foreign food imports, devastating China's farm sector, which employs more than 300 million poor Chinese.

Raising interest rates could be risky, too. A huge chunk of Chinese savings is tied up in the overextended property market, which might crater if credit started to tighten. PBOC Deputy Governor Wu Xiaoling says investment in real estate hit 8.6% of gross domestic product last year, up from 2.5% in 2001. "Real estate bubbles will affect the economy and people's lives seriously," Wu said at a housing conference in Beijing in late April.

The government does have a few options. In June, Beijing rolled out a series of decrees aimed at containing the luxury real estate market, where most of the speculative excess occurs. And it could boost the levels of reserves that banks must keep with the central bank. But without some mix of higher rates and a stronger yuan, China appears likely to keep growing almost uncontrollably -- and ultimately to crash. If that happens, global investors may find higher rates in the U.S. to be the least of their worries.

By Brian Bremner

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