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Economy gathers steam again: Bad news
By Jamil Anderlini

SHANGHAI - While the highest levels of China's government gathered over the weekend to witness a crucial leadership transfer, everybody - from the country's economic mandarins to traders on Wall Street - was asking the multibillion-dollar question: Is the overheated economy on track for a soft landing, or could the government's attempts to rein in rocketing growth be propelling it straight into the ground?

The high-drama struggle for control of the helm resulted in Jiang Zemin eventually relinquishing his last official post of commander-in-chief of the military on Sunday, but for those interested in the government's economic policies, the display was merely of entertainment value. An ostensibly insignificant speech made by Premier Wen Jiabao in the run-up to the Chinese Communist Party plenum in Beijing was probably far more significant. The crux of that speech centered on an apparent pledge to maintain and extend the government's current austerity measures and included hints that the first interest-rate rise in nine years is in the cards.

Until a week ago, most people thought cooling measures were working pretty well. Investment in overheated industries, especially new property projects, had fallen sharply, as had attendant indicators such as steel demand and imports - bad news for global steel producers but a good sign that rampant, unsustainable investment in certain sectors was being reined in.

There were even those who voiced concern that the government's cooling measures were proving too effective and would push the economy into a hard landing. The loudest of these voices were probably local government officials, disgruntled at having pet prestige and infrastructure projects put on hold at a time when pressure to provide jobs to the growing army of unemployed urban workers is mounting.

But last week, when the government released industrial-output figures for August that showed a higher-than-expected growth rate, concern quickly switched to whether the government's tightening has been effective enough. Industrial output rose 15.9% year-on-year in August, up from the 15.5% growth in July, reversing a six-month slowdown and leading to speculation that the government's cooling methods were no longer working.

Meanwhile, gross domestic product (GDP) growth was still an astounding 9.7% in the first half and in late August, the International Monetary Fund (IMF) raised its 2004 GDP growth projection for China from 8.5% to 9% - well above the government's stated goal of about 7%.

Fixed investment grows too fast
The figures for fixed-asset investment growth were also released and though they showed a drop from July, fixed investment was still growing uncomfortably fast, at 26.3% in August and 30.3% for the first eight months.

What these numbers basically mean is that companies in China are producing stuff and investing in construction, factory equipment and other fixed assets faster than is sustainable and though the government has been trying to slow things down since late last year, the latest evidence seems to show that things have started to pick up again.

Almost everyone agrees that the problem is not so much that the Chinese economy as a whole is overheating (at least not yet) but rather that there has been a rush of blind and unsustainable investment into certain "hot" sectors of the economy. First among these is property. As a drive through any Chinese city immediately makes clear, the country is undergoing a construction boom on a scale unprecedented in history.

Gazing out over a growing skyline of upscale apartment and office complexes in Shanghai or Beijing, you can't help wondering where the developers expect to find enough people who can afford to live in them. The same goes for the industries that provide the fuel for the construction boom. Steel mills, concrete factories, aluminum smelters and car producers have sprung up all across China's countryside. The problem is not the sheer scale of investment, which is enormous, but the redundant and speculative quality of those investments - many of them will never find customers for the low-volume, poor-quality products they hope to produce - and the associated economic risks such as inflation and the eventual non-payment of bank loans.

The danger for China lies in the potential for the wider economy to catch the fever that is running through these scorching industries. The consumer price index inflation figure for August was 5.3%, the same as in July (when it hit a seven-year high). This is not yet a real cause for concern, according to Jonathan Anderson, chief economist for Asia at UBS Securities in Hong Kong, considering that most of the increase is due to higher food and energy prices, which have a tendency to be excessively volatile.

Although Anderson says the risk is currently quite low, China has a history of moderate inflation exploding into high inflation within one or two quarters, and the "hard landing" of the mid-1990s, when the country underwent a period of sustained double-digit inflation, is uppermost in many minds. After the last excessive boom and the economic tightening introduced by then-premier Zhu Rongji, Chinese growth decelerated sharply through the second half of the 1990s - to a real rate as low as 3% by UBS estimates.

Slow, but not so slow
While it barely registered on most countries' radars in the mid-1990s, China's economy is now the world's seventh-largest and far more integrated than it was back then. The entire Asian region, and indeed much of the globe, relies on China as the engine responsible for up to a third of the global economic growth in recent years, and a slowdown to 3-4% would wreak widespread economic havoc.

And the repercussions could be far worse within China. The central government openly states that if annual GDP growth were to fall too far below 6-7%, the social costs and the ensuing instability would be more than the current political system could bear. If the country were to descend into widespread political turmoil, the economy would be the least of anyone's concerns.

"We should reduce the speed but not have a sudden slowing," are the wise words of Premier Wen Jiabao. "The most important thing is that we have to control the two valves: one is credit, the other is land."

Going by the latest figures on money-supply growth, the government is doing a reasonable job in slowing down credit. The 13% growth in money supply in August was down sharply from July's 15.3%, but Northwestern University political economist Victor Shih says there is concern that money-supply growth could pick up again in the next couple of quarters. He says this is what happened in 1993 after the first round of Zhu's austerity measures when, after a few months of tough central bank policies, local governments began to borrow at a torrential rate again, causing the high inflation in 1994.

The collapse of retrenchment at that time was brought about by former paramount leader Deng Xiaoping's displeasure with Zhu's policies. "Similarly, we hear stories today of elite division over Wen's austerity measures, which might trigger a fresh wave of lending and investment on the east coast," Shih said.

China is walking, or perhaps cycling, an economic tightrope. A soft landing is urgently needed now to avoid a much harder one later, but if cooling measures go too far they could bring about the hard landing they are meant to forestall.

The government's initiatives have so far been targeted primarily at suppressing the overheated industries - such as property, steel, cement and automobile manufacturing - while allowing others to flourish. This has been done using a unique mixture of economic levers and regulatory decrees, a sort of "macroeconomics with Chinese characteristics".

On three occasions since August last year, the central bank, the People's Bank of China, raised the amount of money that commercial banks needed to hold in reserve to slow credit growth. At the same time, the government made it clear which industries it did not want to receive easy credit. From the start of July, new listings on the stock exchange have been restricted and a high-profile bid by property developer Beijing Capital Land to raise 3 billion yuan (US$360 million) by listing on the Shanghai market was denied.

Beijing check on adrenaline
The central government's Ministry of Land and Resources has applied closer scrutiny this year to projects that previously required approval from just local governments. State media reports say the ministry has re-examined 70,600 fixed-asset projects across the country with a total investment of 17.2 trillion yuan and of those, 4,150 projects worth 844 billion yuan had been canceled, including steel and cement projects, office blocks, golf courses and a large number of "economic development zones".

As Shih points out, these cutbacks come at a price. The banks that provided the loans for the canceled projects will see little or none of their money returned. Looking back again to the mid-1990s, there was a similar period of development-zone fever after which Zhu Rongji was obliged to close about 8,000 of them and point out that there wasn't enough money in the hands of all the overseas Chinese in Southeast Asia to develop these zones. A huge proportion of the non-performing loans (NPLs) that still weigh heavily on China's banking system today were generated in that retrenchment. "I suspect a new wave of NPLs is being produced by the current austerity period," said Shih.

The ability of the banking system to handle another huge influx of bad loans is dubious, to say the least, but that is more of a long-term concern. Right now the problem is whether the government's macro-tinkering is paying off. The evidence is that in the overheated sectors things are starting to cool. Along with significant slowdowns in the property and steel industries, sales of vehicles increased just 9.8% from a year earlier in August, compared with a frenetic growth level of 49% for April.

In a survey of economists conducted for Asia Times Online, the mood was generally one of cautious optimism that China was in the process of pulling off a soft landing despite the many potential potholes along the runway. Austerity measures were introduced comparatively much earlier than they were in the mid-1990s, good growth in China's retail sales and exports are providing a cushion for a slowdown in capital spending and Beijing still has some options left up its sleeve.

The central bank has been saying for several months that it would probably raise benchmark interest rates - something it hasn't done in nine years - if headline inflation rose above 5%. We've now had two months with inflation sitting above 5% and there is a growing expectation that a rate rise is in the pipeline. Officials have been strongly hinting at a liberalization of interest rates, and UBS's Jonathan Anderson is expecting a mild increase of about half a percentage point in the next couple of months to combat inflation and further slow investment spending by making borrowing more expensive.

So while the government prepares to tap the brakes, it's time for the Chinese to fasten the seatbelts and prepare for what is shaping up to be a rather bumpy landing.

Jamil Anderlini is the former editor of China Economic Review. He can be reached at

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Sep 21, 2004

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