Scenes
of prosperity, scorching expansion, commodity shortages, and
speculative froth in the Chinese economy: In Beijing, local authorities
are driving an unprecedented stadium-construction boom to prepare for
the 2008 Olympic Games, an historic shot for the country to strut its
stuff and showcase its economic ascendancy before a global audience.
The capital city is spending $30 billion-plus on new subways, road
construction, and glittering stadiums.
There's just one problem: not enough steel.
China can't get enough of the stuff, and a supply crunch has sent
prices soaring around the world. In early April, that prompted the
Beijing Organizing Committee for the Olympic Games to cut steel use in
the planned National Stadium, the Games' primary venue, by some 40%, to
45,000 tons, using other construction materials instead. It is also
reducing the size of the planned National Swimming Center.
In some thriving coastal cities, 2004 is shaping up to be the year of
the brownout, as construction of new factories and housing fuels ever
greater demand for electricity. China's State Grid Corp. forecasts an
electricity gap of some 30 million kilowatts this year. Power rationing
has become a fact of life in Shanghai and in smaller towns in the
provinces of Zhejiang and Anhui in the booming Yangtze River Delta.
Looking for a measure of how prosperous the Chinese are feeling? At one
upscale Shanghai housing complex called Rainbow City, built by Hong
Kong developer Shui On Properties, all 816 apartments were sold in
three days last October, mostly to local Chinese. In a
not-yet-completed luxury residential development near Shanghai's
Xintiandi district, where apartments cost $325 per square foot, there's
a waiting list of 2,200 prospective buyers. Meanwhile, infrastructure
projects of dubious utility are popping up -- or in the case of a new
train line in Shanghai, sinking. The city has a new $1 billion airport
link that runs on German maglev technology -- the first of its kind in
the world. But since opening last month, most trains are empty and the
elevated tracks are sinking.
Then there are the car factories everyone wants to build. Ningbo-based
Aux Group, maker of air conditioners and cell phones, is charging into
the auto biz. Doesn't that seem a trifle, well, reckless? "I'm not
worried," says spokesman Huang Jiangwei. "You go where the
opportunities are."
The world has known for months that China is white-hot. What the world
wasn't expecting was that it would keep getting hotter. The government
of President Hu Jintao and Premier Wen Jiabao has been signaling since
last summer that it's time to ease up on growth. People's Bank of China
(PBOC), the central bank, has said it wants to crack down on reckless
lending. But the numbers remain explosive. On Apr. 15, Beijing revealed
that the economy grew 9.7% in the first quarter; the target was 7%.
First-quarter loan growth grew 21% over last year, and the broadest
measure of the money supply, or M2, rose 19.2%. Fixed-asset investment
-- spending on plants, equipment, roads, and other infrastructure -- is
up 43%. The average in Asia is more like 20%. Inflation of 2.8% doesn't
look too bad -- until you consider that a year ago it was under 1%.
The oddest sign of stress: Because the yuan is fixed at a cheap rate of
8.27 to the dollar and the government so far has not let it appreciate,
the Chinese are spending more and more to import increasingly dear raw
materials, which mainland manufacturers turn into products to sell
abroad at low prices. In other words, China is paying more and getting
less in return. The result: China actually ran a first-quarter trade
deficit of $8.43 billion. Some reports are surfacing of companies
hoarding commodities as a speculative play. Only a hike in the yuan
will cut the import bill, but too high a hike could put jobs at risk.
The system is clearly out of whack. Yes, China is regarded as a country
with first-world manufacturing prowess, the planet's workshop. But that
industrial might is hitched to a broken, third-world financial system.
When the heat turns up, things can get ugly. And because it is so big,
an overheated China takes on enormous global importance. Not since the
boom-bust cycles of the fast-growing U.S. economy in the 19th century
has the world seen such a phenomenon. As Fed Chairman Alan Greenspan
told Congress on Apr. 20: "If [the Chinese] run into trouble, they will
create significant problems for Southeast Asian economies, for Japan,
and indirectly for us."
VORACIOUS APPETITE. The authorities are clearly
getting nervous.
Beijing has raised bank-reserve requirements for the second time in
eight months, and a sell-off in Chinese bonds has been accelerating.
With the yuan under considerable speculative pressure, PBOC Governor
Zhou Xiaochuan seemed to signal on Apr. 18 that it might be time for
the central bank to loosen its fixed-currency regime slightly to stem
inflation and slow the economy. The markets seem to be taking such talk
seriously. The one-year forward rate on the yuan is hovering at 7.8 to
the greenback, suggesting a 5% future adjustment in the currency.
What if these attempts to cool things off don't work? That's what
global investors and policymakers worry about. Why? A runaway China --
or a China hit by a temporary but dramatic crash -- would have far more
impact on the global economy than it would have had 10 years ago, when
the mainland had its last great crisis of overheating. The Chinese
economy's share of global output has doubled, to 4%, in the last
decade. China is devouring 7% of the world's oil supply, a quarter of
all of its aluminum, 30% of iron-ore output, 31% of the world's coal,
and 27% of all steel products. Last year, China-linked exports and
industrial production accounted for about a third of the recent rebound
in Japan's gross domestic product. China is the top destination for
South Korean exports: Trade with China kept the Korean economy from
slipping into outright recession last year. Emerging-market companies
in Brazil, Russia, and elsewhere have benefited from the heavily
China-influenced rise in global commodity markets. And China profits
are coming in too. U.S. multinationals such as Motorola now rely on
China for up to 10% of sales. General Motors Corp. just reported that
first-quarter earnings from Asia quadrupled, to $275 million, thanks to
soaring demand from the mainland.
That's why Beijing's ability to engineer a soft landing is possibly the
most important issue in global finance this year. If the government can
slow down growth to, say, 7%, commodity prices will ease worldwide,
pressure on the yuan will subside, and Beijing will keep generating
jobs for the 10 million Chinese who enter the workforce every year. "We
believe the economy is developing too rapidly," says a senior
government official. "But the last 25 years have proved the government
capable of reining in these difficulties."
The authorities do have a plan. Under the general tutelage of the
PBOC's Zhou and the State Council, 10 inspection teams drawn from
various ministries and PBOC have been dispatched to seven provinces to
examine industries that have gotten too much investment -- especially
steel, cement, and aluminum -- to beat greedy borrowers away from the
trough. The government also has instructed the Land & Resources
Ministry to restrict land allocations to sectors that are overbuilt.
Some analysts think such actions will slow the overinvestment soon,
especially if coupled with a rate hike. Deutsche Bank (DB
) economist Jun Ma thinks a modest 50-basis-point rise in China's
benchmark 5.31% lending rate will do the trick. "China will achieve a
soft landing of GDP growth," he says, adding that inflation will likely
end the year at an acceptable 3%.
It's also clear that Chinese officials don't want to choke off the job
machine, for obvious political reasons. Says Li Yushi, vice-president
of the Commerce Ministry's Chinese Academy of International Trade &
Economic Cooperation: "I would rather that the economy overheat than be
cold, because then there would be a lot of problems." Li thinks the
economy will eventually use the excess capacity that's building up in
areas such as steel, cars, and property. Some Western executives agree.
There may be the start of a property bubble now, they say, but the
long-term picture is bright, thanks to China's breathtaking
urbanization. "There will be 345 million people making the move from
rural to urban China in the next 20 to 25 years," says Guy Hollis,
country head and international director for real estate consultant
Jones Lang LaSalle in Shanghai.
DYSFUNCTIONAL SYSTEM. The other possibility, though,
is much
darker: a repeat of 1992-94, when runaway growth and inflation forced
Premier Zhu Rongji to enforce draconian rules to stop rampant lending,
curb double-digit inflation, and tame the economic beast. Zhu used
higher rates and administrative diktat to cool things off. China kept
growing, but at a slower pace, while joblessness mounted, the property
markets crashed, and the four big banks found themselves saddled with
mountains of bad loans they had extended during the bubble.
The
biggest China pessimists see a repeat of this crash landing but on a
much vaster scale -- one that would send global commodity prices
spiraling down, hammer Asian economies, destabilize China's big banks
again, and wound earnings at multinationals. "The current investment
bubble is becoming bigger than the one from 1992-94," notes Morgan
Stanley (MWD
) economist Andy Xie, admittedly the king of the China doomsayers. Xie
says fixed investment is much larger now than 10 years ago and is
laying the groundwork for a massive bust.
Soft landing or hard, only a gargantuan effort by central authorities
will resolve the structural issues plaguing China's money system. The
latest overinvestment scare is just a symptom of a deeper malady that
afflicts China's hybrid economy, which blends elements of free markets
with the heavy hand of a one-party state that still has a huge say in
how credit gets allocated. For all of its glittering skylines, emerging
space program, and love affair with cell phones and the Net, China is
still burdened with a backward financial system that can't tell a good
risk from a bad one -- and often doesn't seem to care. "There is no
such thing as efficient capital allocation in China," says Carl E.
Walter, chief operating officer for J.P. Morgan Chase & Co. (JPM
) in China.
The struggles of the Big Four -- Bank of China, Industrial &
Commercial Bank of China, China Construction Bank, and Agricultural
Bank of China -- to end decades of politically motivated lending are
the most visible and best-known signs of this dysfunctional financial
system. By some estimates, 45% of all bank loans remain underwater.
Authorities are starting to recapitalize banks and professionalize
credit operations, but it's a slow process -- and the banks keep
lending.
Westerners have a vague idea that Beijing can still assert its
authority over any aspect of Chinese life fairly quickly, as it used
to. But China is much more decentralized than outsiders think. Local
Communist Party cadres can bend the rules and get local branches of the
big banks to lend when they shouldn't. And it's not just the banks that
come under pressure from local notables. Seven regional commercial
banks, 100-plus city commercial banks, and 1,200-odd rural cooperative
lenders are all active -- often shelling out credit with nary a glance
at a borrower's books. Standard & Poor's (MHP
) points out that in 2003, the loan portfolios of smaller lenders,
especially city banks, grew at twice the pace of the Big Four's. Worse,
lenders usually charge one fixed rate: Morgan Stanley's Xie say they
should charge risky borrowers up to 500 basis points more. Meanwhile,
many entrepreneurs can't get a cent of this abundant credit. "It's
problematic," says Zhang Jian, co-founder of China Bright View, a
promotion and marketing company that counts Oracle (ORCL
) and Eastman Kodak as clients. "Chinese banks don't support private
enterprises; they support state-owned enterprises."
PROSPERITY IS ADDING FAT TO THE FIRE. Beijing may
eventually
wrestle these problems to the ground. "Remember, we are not a 100%
market economy," says Frank Peng, professor at the School of Economics
& Management at Tongji University in Shanghai. "If purely economic
measures cannot be effective, then of course administrative measures
can be taken." But as the system loosens up, it takes central
authorities much longer to assert control. "China's banking system is
really insolvent, and all the monetary tools they have to fix things
are blunt," says Ping Chew, a Singapore-based credit analyst at
Standard & Poor's.
Reckless lending isn't the only problem:
Outright criminality is an issue, too. On Apr. 16, the U.S. deported Yu
Zhendong, a former Bank of China branch manager in the city of Kaiping,
who was recently convicted in a Las Vegas court of embezzling $485
million from 1992 through 2001. (Yu had fled to the U.S.) He was able
to authorize loans and transfer assets with a single signature, without
the supervision of higher-ups, according to court documents.
China's current prosperity is adding fat to this fire. Since the
country joined the World Trade Organization, the economy's links with
the outside world have accelerated. The result is a collision of global
capital with a still-primitive financial system. Chinese lenders are
awash with liquidity because China's closed capital account means huge
inflows from exports -- about $438 billion last year. Add to that some
$53 billion in foreign direct investment that must be flipped into
yuan. Much of that extra yuan ends up in the money supply and banking
system, where a good chunk of it is lent.
Then there's a growing class of speculators. Overseas Chinese, mainland
residents who have set up offshore accounts, and others are
undercutting monetary policy even more by snapping up yuan at current
rates and betting that they will pocket profits when it eventually
appreciates. Some $40 billion of last year's capital inflows came from
such speculation, according to S&P. Some local companies even
falsify the export sales they report to the government so they can take
dollars they squirreled abroad and reinvest them back into
yuan-denominated assets."Capital controls in China are very porous,"
says credit analyst Ping.
It's not just outside money flowing into the banks: Households piled up
$350 billion in new savings last year, according to Morgan Stanley,
while Chinese companies earned $100 billion. Even the uptick in reserve
requirements at the banks will have a minor impact given the billions
that keep flowing into their coffers. Last year, PBOC sold $79 billion
in Treasury bills, mostly to the banks, to sop up the money supply. It
was a good effort, but clearly not enough to stem the rise in credit.
The banks, which account for 85% of the credit created in China, might
lend more sensibly if they had to compete with developed bond and stock
markets for capital. But the country's 20-year-old corporate bond
market has all of 24 issues listed, and daily trading is minuscule.
Because interest rates are state-controlled -- and banks have always
been eager to lend cheaply -- there has never been much of a need for
companies to issue bonds. Only state-owned companies have bothered to
issue them, and because of the implicit government guarantee they
enjoy, virtually every company boasts a triple-A rating, no matter how
ludicrous. In the West, a thriving corporate bond market gives bankers
an idea of how the markets assess risk and what is an appropriate rate
to charge. Such a yield curve doesn't exist in China.
The same is true of government securities. One foreign trader tells of
a 30-year bond the Finance Ministry issued a few years ago that yielded
only 2.9% -- barely above the rate for a one-year Chinese Treasury.
"What kind of risk pricing is that?" he asks. He avoided the bond,
which now trades under water.
The country's two domestic stock exchanges in Shanghai and Shenzhen,
launched in the early 1990s, aren't much more successful at raising
capital and offering an alternative to bank financing. The two bourses
accounted for only 3.9% of the funds raised last year by Chinese
companies, according to central bank data. Every time there's an
initial public offering, investors depress market prices by selling
existing holdings in other equities to raise cash to buy the new
listing. The result: Offerings are always successful for those lucky
enough to buy shares early, while many who buy on the secondary market
get burned.
One reason the markets are so volatile is that they are illiquid since
the government holds 70% of the shares: Thus, they're not traded. This
year, China's all-powerful State Council announced that it wants to
sell some of those state shares. That would depress current prices in
the short term, but the government might offer to let existing
shareholders buy the state shares at a discount to soften the impact.
Beijing also wants to loosen investment rules to let pension funds
invest more in stocks.
Other reforms are coming thick and fast. At the end of March, Hong Kong
banks were given permission to accept deposits in yuan, an important
step toward full convertibility down the road. And central banker Zhou
wants to move faster in deregulating interest rates. "Due to the
excessive regulation of rates, China's financial institutions don't
have the ability to price financial products, particularly loans," he
conceded in a policy speech last December.
WHAT CAN BE DONE? But those are long-term solutions,
and there's
a hot economy that needs to cool off now. So authorities keep leaning
on lenders to tighten. Home buyers must now put down 30% instead of 20%
for high-end properties. And to curb speculative "flipping" of
properties, the government has banned the resale of new apartments
until construction is finished.
Some think Beijing must do far more. Joan Zheng, China economist for
J.P. Morgan Chase & Co. (JPM
) in Hong Kong, advocates an excise tax on domestic investment like the
one Zhu used in the mid-'90s. That's better than a sharp rate hike, she
says, since higher rates will just exacerbate the bad-loan problem and
attract more speculative money to the yuan.
The government also wants to encourage consumer spending, which trails
fixed investment. The Chinese have long been compulsive savers, and
with the end of state-guaranteed lifetime jobs and retirement benefits,
people save even more. The overall savings rate is an astonishing 43%
of GDP. Sure, folks on the eastern seaboard are buying cars and spiffy
mobile phones, but in the hinterlands people are socking away every
yuan they can into saving accounts. And that's just giving banks more
cash for iffy loans, especially to builders of factories, bridges, and
roads. So Beijing wants banks to extend consumer financing beyond autos
and mortgages to include vacations, white goods, home furnishings, and
more. Some analysts think these measures are already starting to
alleviate underconsumption. If done right, such a policy shift would
keep growth strong while curbing the worst speculative excesses. If
done wrong, though, it just substitutes one problem of easy credit for
another while creating an inflationary bulge in the consumer economy.
There are no easy answers. Perhaps that's why so many Chinese just
accept boom-and-bust cycles as part of the country's economic
evolution. "There may be a waste of resources," says the Commerce
Ministry trade institute's Li. "But that's been the case for years.
This is how China has grown." Over the long term, he's right. But in
the short term, China's ability to disrupt the world economy is growing
to scary proportions. Let's hope Hu and Wen know what they're doing.
By Brian Bremner, Dexter Roberts, and
Frederik Balfour
With Bruce Einhorn in Shenzhen and bureau reports
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