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The trouble with China's economic bubble

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By David Ignatius
Thursday, March 11, 2010

The bubbly enthusiasm that many analysts express about the Chinese economy reminds me of the old-time variety show host Lawrence Welk, who banished worries each week with soothing sounds from his Champagne Music Makers.

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China watchers should turn off the music and listen to Premier Wen Jiabao, who has been surprisingly frank in warning that overinvestment and lack of domestic demand are producing an economic bubble in his country.

"The biggest problem with China's economy is that the growth is unstable, unbalanced, uncoordinated and unsustainable," Wen cautioned at a March 2007 news conference during the National People's Congress. That comment had about as much effect as then-Fed Chairman Alan Greenspan's 1996 concern about the stock market's "irrational exuberance."

Wen again voiced concern last week to the National People's Congress. "We still face a very complex situation," he said, given the twin dangers of overheating at home and the global recession abroad. He pointed to a "precipitous rise" in housing prices in some Chinese cities and said that because of the danger of overinvestment, "the launching of new projects must be strictly controlled."

The rise of China is one of the blessed miracles of modern economic history. But Chinese leaders know they cannot repeal the economic laws of gravity. As the economist Herbert Stein observed decades ago, "If something is 'unsustainable,' that means it won't be sustained." That is surely true with the unbalanced, export-led growth that has powered China's ascent.

"China's dependence on export-led growth . . . is unsustainable over time," Robert Zoellick, president of the World Bank, says in a forthcoming article in the journal the International Economy. He cites a recent International Monetary Fund analysis saying that for China to maintain its trend of 8 percent annual growth with the current pattern of trade, it would have to double its share of world exports by 2020. That isn't going to happen.

So the question isn't whether the Chinese economy will change, but how. The optimistic view is that Chinese leaders will slow their investment and credit boom, and at the same time transition to a consumer-led economy that doesn't depend so much on exports.

The scale of China's growth is so overwhelming it can make analysts giddy: A compilation of "15 facts about China that will blow your mind" by the Web site Business Insider enthuses: "By 2025, China will build TEN New York-sized cities." It's a vision of a perpetual cash machine.

The problem with these straight-line extrapolations is that they are notoriously unreliable in predicting the future. Recall the forecasts about the Soviet Union in the 1960s or Japan in 1990.

My favorite analyst of bubble economies is David M. Smick, who predicted the U.S. financial mess in his book "The World Is Curved." He notes some worrying statistics: Until the global financial crisis, Chinese exports represented 43 percent of its gross domestic product. To make up for collapsing foreign demand once the recession hit in 2009, China launched a $1.8 trillion stimulus and lending program -- amounting to about 38 percent of its GDP. This money was supposed to reach consumers, but Smick estimates that 85 percent of the subsidized loans went to state-run companies and banks -- pumping the investment bubble even larger.

Not to worry, say China enthusiasts: A country with more than $2 trillion in foreign reserves doesn't have to worry about debt problems. But those reserves (mostly in dollars) aren't quite the safety net some imagine, because China couldn't liquidate them without hurting itself badly, as economist Michael Pettis argues in his blog, China Financial Markets.

China has a larger problem of questionable loans on its domestic balance sheet. Smick notes that $1.2 trillion of the Chinese stimulus package last year came in soft, subsidized loans. And Victor Shih, a professor at Northwestern University, has been gathering information about murky, off-books borrowing by local investment companies that he reckons could amount to as much as $1.7 trillion, or about 34 percent of China's GDP.

The most reassuring fact about China is that the country's leaders see the problem and are trying to put on the brakes, ever so gently. For a reminder of the dimensions of the overcapacity problem they're facing, consider that China has enough steel-making capacity to meet the demands of the United States, Russia, Japan and Europe combined.

For a country addicted to export-led growth, transitioning to a sustainable economy won't be easy. People who assume that an ever-expanding China will inexorably replace America as the world economic superpower should take a close look at the numbers.

davidignatius@washpost.com


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