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 which could harm many 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 have 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 the deviance of booms from the long-term growth trend, the sharper the corrective effect of the bust. And China's exchange-rate peg is worsening 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 percent, GDP rose by 9.7 percent from January through March this year. When comparing the economic data for the first quarter of this year with the same period last year, fixed investment rose 43 percent. And bank lending has risen by 40 percent over the past 24 months so that outstanding bank loans are equivalent to 140 percent of GDP, an exceptionally high proportion for a developing economy.
But bad news followed similar good news in 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 percent. Rising investment allowed growth to rally back to over 15 percent in 1984 before plunging to nearly zero after the Tiananmen massacre. In 1992, another round of double-digit GDP growth rates began slumping badly in 1994 before hitting bottom in 1998, when growth
was about 3 percent.
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 percent by last year. So now we wait 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 or stocks of state-owned enterprises 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 state-owned enterprises and homebuyers to repay debts.
The other principal contributor to measured economic growth is China's public-sector debt, with Beijing setting new records for the volume of domestic-bond issues for greater than 10 years. About US$203 billion in bonds was sold by the Ministry of Finance over the past three years, with most being held by domestic investors.
Of the total of US$280 billion in outstanding Treasurys, Bei-jing must pay off maturing domestic bonds worth around US$41 billion by the end of next year. 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 percent from 3.39 percent at the end of last year.
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 yuan is low, there will be speculative inflows of funds that can be destabilizing. As it is, China's foreign-currency reserves rose by US$64 billion up to the fourth quarter of last year.
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 normally hold in reserves with the central bank to restrain credit creation. Since central government ownership of banks and capital controls ensures 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.
Insolvencies associated with the end of the boom will also not be limited to state-owned enterprises.
A growing number of middle-class urban consumers has increased borrowing to buy
cars and homes, and they are increasingly exposed to the 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 Marroque in Guatemala and global strategist for eConoLytics.com.
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