China's economy rides the razor's edge
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
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
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
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
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
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.
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
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
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.
(Copyright 2003 Asia Times Online Co, Ltd. All rights reserved.
information on our sales and syndication policies.)