July 27, 2006


China's economy is out of control: China is growing so fast -- using cheap money to build steel mills, highways and textile factories it doesn't need – that the coming crash grows uglier by the day (Jim Jubak, 7/27/06, MSN Money Central)

In a train wreck, there comes the moment when it's no longer possible to avert disaster. Pull the brakes as hard as you can, the momentum of the train is so great that disaster is unavoidable.

I fear that China's economy passed that point of no return in the second quarter of 2006.

Today, I'm going to tell you why I think China's economy is headed for a train wreck. Not tomorrow, but in the reasonably near future. I'd say 2009. [...]

The government seems extremely reluctant to tackle the root causes of these bubbles. Despite the People's Bank of China's April increase in the benchmark one-year interest rates to 5.85% -- the first rate increase in 18 months -- interest rates for borrowing are still ridiculously low. Companies can borrow at an after-inflation rate of about 3.5%.

On the other hand, the People's Bank left the one-year interest rate that depositors get paid at 2.25%. That worked to bolster the profits of the big Chinese banks that the government is interested in taking public with Western investors as major buyers. It also created a massive disincentive for companies to save their cash. Instead, companies are reinvesting their cash, adding to the growth of fixed assets and to capacity gluts in some industries. According to the World Bank, retained corporate earnings accounted for more than half of new investment last year. That's about double the ratio in the United States.

Such corporate reinvestment has completely negated government efforts to shift more of China's national economy from investment and exports to buying by consumers. In 2005, the investment and export share of the economy actually increased and the consumer share fell to an all-time low of just 38% of GDP, according to the Institute for International Economics. And this corporate investment in fixed assets is largely unaffected by any changes in banking regulations or bank interest rates.

An increase in the value of the yuan against the dollar would damp corporate profits, slow the speed of investment in fixed assets and reduce speculative inflows from overseas investors who anticipate a yuan appreciation. Hiking the one-year benchmark interest rate again and again, and raising the interest rates paid to depositors would have similar effects. But such actions would also slow the economy and reduce the number of jobs that the economy is creating. China needs GDP growth north of 7% a year just to stay even with the number of new job seekers thrown up by its massive population every year. Reducing unemployment and underemployment -- categories that take in about 40% of the Chinese population by some counts -- requires even faster growth.

A significant portion of China's small ruling inner circle has fought efforts to attack the problem at the source to a standstill. Commerce Minister Bo Xilai, for example, has complained that any appreciation in the yuan will cripple profits in marginal industries such as textiles, where the profit margin is just 3%. A purely rational economic analysis would say that if Chinese textile makers can't compete after the yuan is appropriately revalued, then the least-efficient companies in the sector should go out of business and the jobs should flow to countries, perhaps Vietnam, where lower labor costs would allow textile makers to make a profit.

That would mean shipping jobs out of China, however, and advocating that is political death in a country that needs to create 20 million jobs a year to keep the population governable by the Communist regime.

Sure, cheesy jobs will calm those millions of single young men....

Posted by Orrin Judd at July 27, 2006 3:02 PM
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