TCS Daily

China's Syndrome

By Christopher Lingle - June 9, 2004 12:00 AM

Despite China's enviable economic performance, a reality check indicates that such high growth rates are unsustainable. The worse news is that there is also likely to be a sharp reversal could harm many of the neighboring countries whose economies have become more closely integrated with China's.

This is because China's high economic growth rates are based upon flows of cheap credit and growing public-sector borrowing that has prompted an investment bubble and instability in prices. Economic euphoria seems to induce people to forget that busts follow booms in the way that night follows day.

Or at least they do when macroeconomic policies push interest rates artificially low and promote increased deficit spending to create temporary growth spurts. A similar logic dictates that the greater is the deviance of booms from the long-term growth trend the sharper must be the corrective effect of the bust. And China's exchange rate peg is worsening the macroeconomic imbalances and hastening the day of reckoning.

It seems hard to argue against such storied economic performance. With industrial production growth of 19.4%, GDP rose by 9.7% from January through March of this year. When comparing the economic data for the first quarter of 2004 with the same period last year, fixed investment rose 43%. And bank lending has risen by 40% over the past 24 months so that outstanding bank loans are equivalent to 140% of GDP, an exceptionally high proportion for a developing economy.

Yet bad news followed similar good news over China's previous boom and bust cycles. An initial double-digit growth spurt in response to economic reforms that began in 1978 ended with a sharp fall in 1981 to 5%. Rising investment allowed growth to rally back to over 15% in 1984 before plunging to nearly zero after the Tiananmen massacre. Then in 1992, another round of double-digit GDP growth rates slumped badly in 1994 before hitting bottom in 1998 when growth was about 3%.

In the face of financial turmoil in much of the rest of East Asia, an orgy of spending and cheap credit pushed the official growth rate to at least 9% by 2003. And so we are now waiting for the other shoe to drop.

The bad news is that there is not much chance that China's economy will experience a soft landing. Despite real adjustments and improvements in the Chinese economy resulting from liberalizations, a great deal of the frenzied activity is built upon sand. Cheap, easy credit and fiscal deficits create a weak foundation in that something is created out of nothing.

While private ventures struggle to find capital, much of the hard-earned savings of the Chinese population is diverted toward wealth-destroying state enterprises and schemes. As it is, capital controls give the Communist Party leadership total control over the financial system. People have few choices but to put their savings into bonds in SOEs or stocks of SOEs or hold deposits in state-owned banks.

With the People's Bank of China setting all interest rates in China, it will soon face irresistible pressures to raise domestic borrowing costs for the first time since 1995 to cool off the economy. With much of the recent growth attributed to investment in residential and commercial buildings, factories and other fixed assets, higher interest rates will surely take their toll.

To avoid seeing prices spiral out of control, curbs have been announced on spending for construction, factories and equipment. But a slowdown in economic activity will weaken the ability of SOEs and homebuyers to repay debts.

The other principal contributor to measured economic growth is China's public-sector debt that has grown significantly with Beijing setting new records for the size of its domestic bond issues for more than 10 years. About $203 billion of bonds were sold by the Ministry of Finance over the past three years with most being held by domestic investors.

Of the total of $280 billion of outstanding Treasurys, Beijing must either pay off maturing domestic bonds worth around $41 billion by the end of 2005. If it does not, it will surely face much higher refinancing costs.

In this sense, rising interest rates will contribute to the coming bust. Yields on China's Treasury bonds have risen sharply and now exceed the yields on US Treasurys. In the past few weeks, benchmark seven-year Chinese Treasurys rose to 4.76% from 3.39% at the end of 2003.

A high tide of net capital inflows has also been influential in pushing China's high economic growth rates. But this happy story has a limited shelf life due to the imbalances created by the exchange rate peg that has kept the yuan undervalued relative to the US dollar.

As long as Chinese and foreign investors believe that downside risk on the renminbi is low, there will be speculative inflows of funds that can be destabilizing. As it is, China's foreign currency reserves rose expanded by $64 billion up to the fourth quarter of 2003.

Under the current exchange rate regime, foreign currencies must be exchanged for yuan by the central bank. Normally, central banks auction off bills to remove excess liquidity from the system to "sterilize" such inflows and prevent rising reserves from inflating the domestic money supply.

At the same time, they can increase the proportion of deposits that banks must hold in reserves with the central bank normally to restrain credit creation. Since central government ownership of banks and capital controls insure that domestic banks take in such large deposits, pushing up reserves is of no great consequence.

Such attempts to cope with such large inflows eventually create instability. Either public-sector debt balloons to soak up liquidity or the money supply is allowed to be inflated with the latter contributing to bubbles and higher consumer and input prices.

Eventually, Beijing must raise interest rates and cut deficit spending while allowing a rise in energy prices and limiting credit to dampen the speculative bubbles in property and construction. But these attempts to curb rising prices are likely to bring about widespread loan defaults.

And the insolvencies associated with the end of the boom will not be limited to SOEs. A growing number of middle-class urban consumers have increased their borrowing to buy cars and homes and are exposed to greater risk of personal bankruptcy.

An important lesson to be drawn here is that state-mandated investment and cheap credit cannot overcome economic gravity. In the end, macro policy is subject to the same flaws evident in central planning in that policy is driven by political expediency rather than by market logic. Therefore, recent increases in China's demand for power, steel and cars over the past year should not be extrapolated to forecast demand for imports from its trading partners.

Christopher Lingle is Professor of Economics at Universidad Francisco MarroquĂ­n in Guatemala and Global Strategist for


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