China's economy rides the razor's edge
By Dinkar Ayilavaraparu

Over the past 20 years, the world has witnessed one of the most remarkable economic transformations in human history. China, home to 1.3 billion people, has been expanding its economy by more than 8 percent every year since 1980 in its endeavor to pull its millions out of millennia of poverty.

If it succeeds it would be the greatest leap to prosperity ever, to be emulated elsewhere. But what if it fails?

The Chinese government is clear on its strategy for uplifting its people - chanting the mantra of growth and doing its best to deliver. And successfully so. The Communist Party government has been running really fast just to keep ahead of burgeoning unemployment - 30 million former public-sector employees are out of work, 150 million former rural citizens are between jobs in the cities at any given time, and about 200 million have no work at all.

Thus the Party, which like all authoritarian systems hates instability and social turmoil, has to create jobs. And jobs are created through growth and investment. So China has an undervalued currency and low interest rates and has now started to build an impressive fiscal deficit as well. With 150 billion yuan (US$18.14 billion) in treasury bonds in the 2002 fiscal a year coming into place, China's budget deficit is set to rise 19.24 percent to 309.8 billion yuan ($37.46 billion), or 3 percent of gross domestic product (GDP), an internationally recognized alarm level. In this quest of 8 percent growth, China might just have bitten more than it can chew. The Chinese economy may be overheating.

Overheating economies 101
An overheating economy is one that has too much domestic demand for its own good. To grow, an economy needs investment. Growth achieved is a function of savings and the capital output ratio. Savings are invested and output produced for each unit of investment is the growth in the economy's output. This investment creates jobs and puts more money into the hands of more people.

An economy rapidly growing over a period of time tends to run short of workers. In such a situation, employers tend to bid up wages, which leads to even more money in the hands of the people, which happened at the peak of the US information-technology boom in the late 1990s.

People have a tendency to spend money they earned. So the extra money they earn creates greater demand for goods and services. Investments typically take time to bear fruit and increase supply at home, so this demand for goods is serviced by importing them. This distorts the current account (we are importing way more than we are exporting).

And since services (restaurants, takeouts, bowling alleys, etc) can't be imported, they tend to become costlier, and there is inflation. Thus two big ways of telling whether an economy is overheating is to look at its current account, where it should be running a deficit, and look at the inflation it is facing.

In addition to these two, the third big symptom of a heating economy is the expansion in credit extended by domestic financial institutions. As investment increases, it needs to come from people's savings or through other people's savings (aka foreign investment).

These savings are typically locked up in financial institutions and banks, which lend this money to entrepreneurs, companies or government agencies that invest and create the boom. Thus for an economy to overheat, there has to be lending of money by the banks that creates a drastic growth in credit.

Is China overheating?
How does China perform on these three tests? On the current account, China comes out with flying colors, having ended the previous year with a current-account surplus of 2.86 percent of GDP. So obviously China's demand is not so high as to merit more imports. In addition, China is a savings-surplus economy, allowing it to export capital and thus run a current-account surplus.

On credit growth, China flunks the test badly. In the first seven months of the year more than 995.3 billion yuan ($119 billion) in loans came into being. Fueled by a 20 percent increase in M2 (broad money), total loans in the first half of this year beat the figure for the whole of last year. Loans are out of control. The rapid growth in broad money also reflects a rapid expansion in domestic demand as well.

On the inflationary front, it gets an A-plus, with the national retail price index falling by 0.6 percent from last year overall, and down by1.1 percent in urban areas. More interestingly, large-scale domestic-use manufactured goods such as electric appliances prices deflated by 6 percent over the past year.

Other indicators such as unemployment (when overheating, economies typically work at full employment - 96 percent for the US currently) can't even be brought into consideration when there are 380 million without a regular job in China. This has been China's biggest defense. A country with a loan-to-deposit ratio of 77 percent and unemployment statistics reading like those mean China cannot be overheating. China defenders claim that when the Chinese economic miracle hasn't even started touching the millions in the vast hinterland, then how can we start talking of too much demand or an overheating economy?

Is China deflating?
The answer is broadly yes. For deflation to happen, either demand has to fail or supply has to zoom. A 20 percent monthly money-supply growth definitely is not an indication of slowing demand. So the obvious answer to the question is that China is overproducing. China's National Bureau of Statistics says that 90 percent of domestic goods manufactured are in oversupply. Chronic oversupply has made China a cauldron of industrial competition, with the result that those who survive can survive anywhere in the world and compete, especially on price.


And all this excess supply has to go somewhere, and it goes abroad. That is the reason, when US Treasury Secretary John Snow came to Beijing, the Chinese conceded on minor points of trade but said "no way" to revaluing the yuan. If the yuan had been revalued it would have become tougher to export all that excess supply, which would have led to factory closures, creating even more unemployment and social instability.

Why is China producing too much?
Since the Asian financial crisis of 1997-98, China has cut interest rates six times. In addition to this monetary loosening, the party has resorted to fiscal pumping all through these six years. In its bid to keeping the yuan pegged to the US dollar, the People's Bank of China, the country's central bank, has been busy buying all the dollars that are flowing in. For every dollar entering China, 8.3 yuan are pumped into the market by the central bank.

With China attracting the most foreign investment in the world, there is more money flowing into a market already awash with liquidity. As a result, there is too much easy money around for everyone to gorge on. As we saw earlier, growth is a function of investment in the economy. And this is how the Chinese have achieved it.

Where do all these yuan go? They find their way into the Chinese banking system. At the height of the boom in 1993, the banks had lent 113 percent of their deposits. Then the Chinese thought the pace was too fast and applied the brakes to the economy. By 2002 the lending ratio had fallen to 77 percent, with the banks now having another 4.3 trillion yuan ($520 billion) to lend.

All this money is not necessarily a good thing, especially in the Chinese banks. China traditionally hasn't had a functioning market capable of pricing capital. In a healthy system, the risk of a project is represented by the rate of interest used to discount it. So the more risky the project, the more expensive it becomes and thus the tougher it is to finance it. Also, the lender gets the benefit of a greater return in compensation for greater risk. In China the government fixes interest rates, so loan officers cannot price for the risks of the project involved. Thus there are no means for the banks to pick safe projects, especially in these money-surplus times.

In addition, the banks are state-owned. And, as in all state-owned systems, for years loans were granted on the basis of Party loyalty or to China's staggering state-owned enterprises (SOEs). When financial and economic considerations aren't responsible for extending credit, the banking system gets saddled with a large number of bad loans. There is no way for these bad investments to get flushed out of the system - bankruptcies in China (in proportion of the economy) are fewer than 10 percent of those in the United States.

Officially, non-performing loans (NPLs) constitute about 20 percent of all loans, but outside observers such as Standard & Poor's put that number more in the vicinity of 45 percent. China has by far the weakest banking system among all big economies. In such an atmosphere, more money into the hands of the banks leads to falling interest rates.

With more than 4.3 trillion yuan to lend, any project makes the cut, driving the investment boom.

So what?
In economics there are two types of goods - tradable and non-tradable. Tradable goods are, as the name suggests, traded, and any shortage or glut of these can be exported or imported, balancing the domestic market. If there are too many cars, they can be exported without depressing the car market. If there are too few, they can be imported without creating inflation. But non-tradable goods can't be traded, and so any excesses are stuck in the domestic economy and tend to depress the local market. Houses obviously can't be exported, and thus their prices fall. The housing companies lose money.

China's national bird, the joke goes, is the crane - they are all over urban China. Unfortunately, this points to a harsh truth. Too much money has flowed into non-tradables such as real estate and huge state-backed projects such as dams and highways. Investment in fixed assets this year was 42 percent of total investments, way above 1993, when the Chinese dramatically braked the economy, and similar to pre-bust 1997 figures in Thailand and Malaysia.

Some 34 percent, a 32 percent increase over last year, of all Chinese investment so far in 2003 has flowed into real estate. This kind of investment has fueled the Shanghai and Beijing real-estate boom. With excess supply in these markets, falling prices would make these booms into bubbles, driving up bad loans. So when the real-estate market realizes its excess capacity, it might be doomsday.

In addition, this investment is creating huge excess capacities in tradable goods. Despite free trade (which again is not guaranteed in an election year in the United States), these capacities promise to push prices down further, pushing more enterprises over the edge. To cite an example, accounting firm KPMG states that China has capacity to produce 2.7 million cars, more than a million more than it can consume.

Big foreign manufacturers, facing a worldwide auto glut, are staking their fortunes on China's allegedly underserved market. They have more capacity expansion plans lined up. Ford Motor Co plans to invest $1.5 billion over the next five years in augmenting capacity, and Ford is just one example - Volkswagen, General Motors, Honda and Nissan have launched expansion plans as well.

On the flip side, the Chinese like to point out that incomes in China are rising. Urban incomes have risen by 8 percent and rural ones by 4 percent over the past year. This leads to more government revenues to handle any fallout of a banking crisis. More important, income growth puts more money in the hands of the burgeoning middle classes, who consume a lot of what is produced by industrial China. Also, with more than $380 billion in the vaults of the central bank, anybody worrying about a crisis of confidence leading to a run on the yuan is surely smoking something. And then there are exports. But the deadly cocktail of falling prices, phenomenal overcapacity and a weak banking system saddled with bad loans still has the potential to bring the 20-year Chinese economic miracle to an end.

The mandarins have awakened
The Chinese seem to have finally got around to tackling the current bout of overinvestment. The National Development and Reform Commission has recently put in place new restrictions on the investment coming in. This was done in an effort to check any new capacities being added in the economy.

The financial czars of China have also started curbing monetary expansion. In September they increased the rate of required deposit reserves (RRDR) from 6 percent to 7 percent. That move in effect took more than 150 billion yuan ($18 billion) out of circulation. This came after a June move to take the air out of the Shanghai and Beijing bubbles when the bank cracked down on commercial bank lending to property developers. In addition, the central bank then announced new regulations on luxury-real-estate investment, including a hike on the required down payment on loans for high-end developments.

Unlike in the 1997 Asian crisis, China is the only bright spot in the world economy. China's 8 percent GDP growth contributed to 15 percent of the growth in the world. In the trade arena, 60 percent of the world's export growth and as much of its import growth came from China.

China is also an important consumer. Last year, it consumed 21 percent of the world's traded aluminum, 24 percent of its zinc, 28 percent of its iron ore, 17 percent of its copper and 23 percent of its stainless steel, according to Deutsche Bank research.

In this environment, if the Chinese fail to deflate their bubble economy gently, the bursting of the bubble might just be felt around the world.

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