Is China Growing Too Fast for Comfort?

The mainland's GDP has surged beyond forecasts. What's at stake if its economy doesn't slow? From investment curbs to crisis, here's a handy guide

Global inflation fears, Middle East war jitters, and oil prices hovering at $76 per barrel—hey, there is no shortage of worries right now on the minds of global investors. And here's one more: What if China's white hot economy overheats and then goes kaboom? After all, first-quarter growth came in at a torrid 10.3%. Then, on July 18, the Chinese government reported that second quarter gross domestic product actually accelerated even more to a mind-boggling 11.3% year-on-year pace. That blew away market expectations and is the fastest clip in more than a decade.

China's $2 trillion-plus economy is being stoked by rapid expansion in money supply, loan growth, and fixed investment. All these key metrics are clocking in over government targets and have proved resistant so far to efforts by Chinese President Hu Jintao's economic policy team to cool things off.

If Beijing can't wrestle this beast down, the Chinese economy is at risk of getting derailed by industrial capacity glut, property market corrections in Beijing and Shanghai, and fresh bad loan problems for the mainland's still fragile banking sector. Here is a guide to the issues and perils confronting the world's fastest-growing economy.

Wait a second, what's wrong with high-speed growth in China?

Nothing, as long as it's sustainable. There's no question China's run of economic prosperity has been great news for millions of Chinese who have seen their living standards improve, as well as for global trade and the broader world economy.

But a boom and bust cycle would hit a developing economy like China's especially hard, and maybe even threaten social stability. Big regional trading partners such as South Korea, Taiwan, Japan, and Australia would feel the chill immediately and even the U.S. and Europe could be affected.

Is China really big enough to cause problems for the global economy?

It's true that China's $2 trillion economy isn't all that hefty compared to Japan's (about $5 trillion) or that of the U.S., which is about five times as big as the mainland's. But you really miss the point if you think in terms of GDP only. China is now a powerful trading nation, and in recent years has been a voracious consumer of industrial commodities such as copper, iron ore, and steel to fuel its rapid industrialization.

Though it represents about 5% of the world's economic output, this hungry dragon devours about 20% of global aluminum, about 30% of steel, iron ore, and coal, and 45% of cement produced each year. A significant slowdown in China would pound global commodity prices and hurt stock markets and economies from Brazil to Australia.

Can't a tough-minded and authoritarian government such as China's just order its industries and banks to throttle back?

A decade ago it probably could have, but it would be a lot tougher now. China's economy is a far more complex animal and is now plugged into global capital flows that are really beyond Beijing's control.

Huge amounts of money—from export earnings, direct foreign investment flows, and speculative "hot money" rushing into mainland stock and property markets—is rapidly expanding the money supply. Chinese banks, with plenty of excess cash, are lending at furious rates. Loan growth, for instance, ballooned 70% during the first quarter this year vs. the same period in 2005.

Regional governments are ignoring Beijing's entreaties to cool it and instead continue to plow money into questionable public works projects. Fixed investment in public infrastructure, plants, and equipment—heavily influenced by regional economic planners—shot up 31.3% during the first half vs. the year-ago period.

That's astounding given that Hu's government has set an 18% target for 2006, and China's Vice-Finance Minister Li Yong declared at an Asian Development Bank conference in India in early May, "We have to control investment among local governments (see, 5/16/06, "Controlling China's Runaway Growth")."

Yet China is home to 1.3 billion consumers. Won't deep domestic demand put all these new investments to efficient use?

Not as much as one would think. Years of generous lending have already created some disturbing industrial gluts. And that makes China even more reliant on exports which is exacerbating diplomatic tensions with the U.S. over the mainland's surging global trade surplus.

The Chinese auto industry can produce about eight million cars annually, but sells just 5.5 million or so at home. Car exports almost doubled during the first quarter. The steel, aluminum, and coal industries face similar gluts. Last year, China's global trade surplus tripled to $102 billion, and is on track to hit $130 billion in 2006.

Why doesn't China's central bank just raise interest rates or let the yuan appreciate to moderate growth?

In April, the People's Bank of China raised bank lending rates modestly by 27 basis points, and last month raised reserve requirements imposed on mainland lenders to drain some excess cash from the banking system.

Chinese monetary authorities, however, have let the yuan appreciate only a little more than 1% since the country abandoned its fixed dollar peg currency regime last July. There has also been plenty of jawboning and other measures by Beijing to curb lending to high-end real estate projects and already overcrowded industrial sectors. Money supply and loan growth did moderate in June, but are still above government targets.

To really get economic growth under control, most economists think it will take far higher interest-rate hikes and yuan appreciation to get the job done—and China is under international pressure from the U.S., Europe, and Japan, and international outfits such as the World Bank, to do so. Yet Beijing is reluctant given the economic pain it would cause. Standard & Poor's figures that a 25% appreciation of the yuan and 200 basis point increase in lending rates would cause Chinese corporate net profits to fall by 34%.

That in turn could produce $212 billion in additional non-performing loans—or almost double, to 18%, the ratio of bad loans to total loans now on the books of Chinese banks, according to S&P calculations. If that happened, global investors who have bought up huge chunks of recently listed mainland lenders such as China Construction Bank and Bank of China could be in for a tough ride (see, 5/31/06, "Golden Age for China's Banks").

So China is heading for some sort of economic crisis?

With any luck, it won't come to that. It will take a sustained effort by Beijing economic authorities to clamp down on excess investment—plus increases in interest rates and yuan appreciation—to bring the Chinese economy back down from its current and unsustainable trajectory. An economy growing in the 8% to 9% range would be ideal.

Yet China is just like any other government in this respect. It 's always politically tough to trade a little short-term austerity for long-term gain to a citizenry accustomed to dazzling economic statistics and high-speed growth.

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