Geopolitical Diary:

China's Economy, Out of Control

Stratfor
Infosearch:
José Cadenas
Bureau Chief
USA
Research Dept.
La Nueva Cuba
June 21, 2006

China announced Wednesday that industrial production increased in May more rapidly than at any time in the past two years. Output rose 17.9 percent compared to May 2005. The numbers exceeded expectations. Exports in May rose by 25.1 percent while domestic retail sales grew by 14.2 percent. In other words, the Chinese government's campaign to slow China's overheating economy isn't working. On the contrary, the economy is accelerating.

That's why the People's Bank of China (PBoC), China's central bank, issued a statement Wednesday saying that banks should be concerned about the potential risks associated with the rapid increase in lending, following a meeting between PBoC officials and representatives of China's banks. China's M2 -- the broad measure of China's money supply -- grew at 19.1 percent year-on-year, outstripping government targets. More important is the fact that Chinese banks, which are provided annual targets for the amount they should make in loans, have already loaned over two-thirds of that amount -- with more than half a year to go -- and it appears that the rate of lending is accelerating.

Put very simply, the Chinese economy is out of control. One would think that the faster the growth, the better the economy; but at a certain point -- and in this case -- that isn't so, which is why the PBoC is trying to get control of the situation. The problem is the massive overhang of debt, and in particular, troubled loans. Looked at from the standpoint of Chinese corporations, servicing this debt is a tremendous burden. Looked at from the standpoint of Chinese banks, the loans threaten the banks' viability if they become nonperforming.

The solution of Chinese companies is to sell more product to generate cash to pay off the loans. It is difficult to sell into the Chinese economy because of high savings rates, driven by government policies and economic insecurity. The Chinese government needs a high savings rate to help stabilize the banks; dramatically increasing domestic consumption would undermine the savings rate, threatening the banking system just as surely as defaulting loans would. The solution for these companies, therefore, is to increase exports. In a world already saturated with Chinese exports, the only way to increase cash flow is to cut already low prices. That increases cash flow but does nothing for profitability. In other words, companies already saddled by debt burdens cut into (or below) profit margins to service the debt.

The banks, meantime, do not want to write off nonperforming loans. The trick is to keep them performing -- at least to some extent -- since the definition of a "troubled" loan is both more elastic and less devastating to a bank's balance sheet. To do this, the banks arrange to lend more money to troubled enterprises. This allows some repayment of old debts, but simply puts off the day of reckoning on all sides (and increases the magnitude of reckoning when it arrives). Thus, bank lending accelerates at a breakneck pace -- not going into market-driven opportunities, but maintaining essentially failed enterprises for a while longer. Production surges at lower prices and the entire process moves faster and faster.

The problem is that any slowdown in economic growth decreases cash flow from imports, cuts into debt payments, and increases nonperforming loans until the entire edifice starts to collapse on itself. This is what happened to Japan in slow motion in the 1990s, and to Southeast Asia with dizzying speed in 1997.

The Chinese government knows it needs to slow down growth to avoid hitting a brick wall. It also knows that slowing down the economy can threaten the entire banking system. It is therefore engaged in setting restrained economic targets and expansionary economic policies simultaneously. It is caught between a rock and a hard place. At a certain point, Chinese companies will no longer be able to grow their exports rapidly. In the case of China, it is the speed bump that is the brick wall. Slowing down is dangerous and speeding up disastrous.

At this moment, therefore, the Chinese economy, incredibly, is speeding up. Virtually every economic indicator we see -- with allowances given for uncertainties in Chinese statistical methodology, to put it politely -- is surging out of control. It has been clear to the Chinese government for a while that this is coming, and it is now clear to the Western media that China is in trouble. Business Week, which has normally written breathlessly enthusiastic articles on the Chinese miracle, ran one this week entitled "China: Big Economy, Bigger Peril?"

Indeed.