Reason v emotion in China’s growth story

In the far north of China last weekend, thousands of Chinese tourists streamed to Harbin’s famous ice festival where they forked out $25 a head to view replicas of the Great Wall and the Forbidden City carved out of gigantic blocks of ice. The spectacle of China’s new middle class on holiday was impressive, if hardly scientific, evidence of the vigour of an economy that last year grew by 8.5 per cent as much of the rest of the world crumbled.

This year, the consensus is for China to grow even faster, by at least 9.5 per cent, as exports pick up and record investment continues. Yet there are more than a few dissenters who warn that, like the ice palaces of Harbin, the seemingly solid Chinese economy is sooner or later bound to melt. Are they right?

Nicholas Smith, strategist at MF Global FXA Securities, articulates the sceptical position well. Citing “incandescent money supply growth” and the appearance of bubbles in property and manufacturing capacity, he writes: “Fixed asset investment, at half gross domestic product, is the most of any major economy in modern history and must slow. Consumption is the lowest of any major nation in modern history, and can’t cover the shortfall. Trade disputes are smouldering and China won’t be permitted to export its excesses. A slowdown seems unavoidable.”

One’s head tells you that Mr Smith is right. There is a lot about the nature and composition of Chinese growth to cause unease. Consumption, while growing in double digits according to (unreliable) retail sales figures, remains a lowly 37 per cent of GDP. As incentive schemes are withdrawn, sales of cars and electronics, which zoomed last year, could stall.

In the absence of higher exports – which could be slowed by either a revaluation or foreign protectionism – that would leave investment as the economy’s main motor. The concern is this will result in dangerous overcapacity. Abroad, that could provoke trade conflicts as China tries to dump an even greater supply of cheap goods on a world only beginning to recover from a disastrous credit binge. At home, the reckless addition of bridges, ports, airports and steel mills will burden banks with non-performing loans.

There are already signs China’s authorities are worried that the unprecedented surge in money supply will cause asset bubbles and inflation. Regulators on Tuesday ordered banks temporarily to halt lending after loans in the first two weeks of the year surged to an unprecedented Rmb1,100 ($160bn, €114bn, £99bn). At that rate loans would triple from last year’s record, which at Rmb9,600bn was already double the level of 2008. Beijing this month started tweaking reserve requirements in an effort to cool things down.

Authorities are right to be concerned. House prices, especially at the luxury end, have leapt after sales of homes in 2008 rose by three-quarters. There are also signs of food and wage inflation. Arthur Kroeber of Dragonomics, a research company, reckons consumer price inflation could be much stronger than expected, reaching as high as 5 per cent by April. If he is right, Chinese authorities may slam on the brakes, even at the risk of putting the economy into a skid.

Intellectually, there is much to suggest that China’s economy can’t go on like this. But one’s gut tells you it can, not least because the Communist party needs it to. Wensheng Peng, head of China research at Barclays Capital, says people have for years been predicting imbalances will lead to catastrophe. Yet nothing has yet knocked the economy decisively off course.

Mr Peng also makes a reasonably convincing case that concerns over high investment and low consumption are overdone. With an urban population of just 47 per cent, China is at roughly the stage of development Japan reached in the 1950s when it was building as if cement were running out. Many Chinese residents heat their homes with gas canisters because there are no pipelines. Some have no sewerage or running water. Much else, beyond such basic needs, can be built. Take the high-speed railway now strung across the nation. Within a few years, it will connect 70-80 per cent of Chinese cities with a population over 500,000. In terms of travel times, the entire country will shrink by three-quarters. Shanghai and Beijing will be five hours apart. There will be potentially enormous productivity gains.

Mr Peng argues that China would do well to build while it can. Because of its one-child policy, from 2015 its population will begin to age. Savings will begin to dwindle as retirees run them down. That will help consumption, which should also benefit from rising wages as the labour market tightens. In other words, the internal imbalances should begin to self-correct.

That is a medium-term story. But even in the shorter term, evidence of rising prices should help allay concerns about a generalised excess capacity. Indeed, it is hard to reconcile simultaneous fears about the Scylla of overcapacity and the Charybdis of inflation. There must be a chance that China will sail – if not smoothly, then at least safely – through the middle of those two monsters.   David Pi

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