China, Largest Command Economy, Isn't Responding to Commands July 31 (Bloomberg) -- China's leaders are finding that the world's largest command economy no longer responds to their commands.
Growth is hurtling along at the fastest pace in a decade, defying official efforts to curb investment in unneeded factories and real-estate projects. The government's immediate concerns are that overheated growth will saddle China with excess capacity, create more asset bubbles, and increase friction with the U.S. and other trading partners.
``China's unbalanced growth model has now gone to excess and seems in danger of veering out of control,'' says Stephen Roach, chief global economist at Morgan Stanley in New York. ``The longer China's economic boom runs, the tougher it will be to avoid a more treacherous endgame.''
That might include defaults on bank loans, and eventually deflation and a collapse of asset values. Such a hard landing would risk breeding social unrest within China while drying up export markets for neighbors such as South Korea and Taiwan.
Risks of a bust are increasing, says Robert Subbaraman, senior economist for Asia at Lehman Brothers Holdings Inc. in Hong Kong. ``We have raised our likelihood on the Chinese economy slowing sharply to a one-in-three chance,'' he said in a July 28 interview.
Deng's Reforms
Investment and exports have catapulted China's economy to the world's fourth largest in the 28 years since former leader Deng Xiaoping's free-market reforms. In the most recent quarter, gross domestic product grew 11.3 percent over the year earlier, the fastest pace since 1994, when the economy was one-fourth its current size. Industrial output surged at a record 19.5 percent rate in June, according to Morgan Stanley.
China has tried a variety of tactics to rein in the economy. Under pressure from the U.S., officials a year ago loosened the yuan's peg to the dollar, and the Chinese currency has since appreciated about 3.8 percent. The People's Bank of China has raised both interest rates and reserve requirements for banks, and last month ordered regional branches to halt ``blind expansion and building of redundant, low value-added industries.''
``China has been talking about trying to slow this breakneck pace, but it simply hasn't worked,'' says Don Straszheim, vice chairman of Roth Capital Partners LLC in Newport Beach, California.
In Beijing, an airport terminal under construction will be bigger than all five terminals at London's Heathrow Airport combined. The capital will also add an estimated 1 billion square feet of high-end property by 2008, according to Jack Rodman, a partner at Ernst & Young in Beijing.
Expensive Space
``I keep wondering where all the demand is going to come from for all this expensive office space,'' says Rodman.
Home construction in China, rising 20 percent year over year, threatens massive oversupply within two years, Morgan Stanley says. The lending spree and inflows of foreign money have helped push the Shanghai Stock Exchange Composite Index up 45 percent this year.
Some say the government will eventually get a handle on the situation. Standard & Poor's, which on July 27 upgraded Chinese government debt, said that ``current measures are only the first steps,'' and that it expects ``ongoing efforts to moderate growth to more sustainable levels.''
Still, growth will barely slow in the current quarter from the first half's 10.9 percent rate, according to the National Development and Reform Commission in Beijing. And official efforts to boost consumer demand have also been slow to take hold. China has one of the world's lowest ratios of household spending to gross domestic product, at 38 percent, says Nicholas Lardy, senior fellow at the Institute for International Economics in Washington.
Overflowing
In the banking system, measures taken so far to curb lending ``are like taking a spoonful of water from an overflowing swimming pool,'' says Tao Dong, chief Asia economist at Credit Suisse Group in Hong Kong.
Outstanding yuan-denominated loans on June 30 stood at 21.5 trillion yuan ($2.7 trillion), 15.2 percent higher than a year earlier. New yuan lending in the first half totaled 2.18 trillion yuan, approaching the central bank's full-year target of 2.5 trillion yuan.
China's banks carry more than 1.3 trillion yuan ($163 billion) of non-performing loans, exceeding 8 percent of those on their books, according to Moody's Investors Services. Moody's rates the financial strength of Chinese banks E+, on par with Pakistan's and Ukraine's.
`Backward'
Chinese banks are ``backward in terms of their risk management and pricing of loans,'' says May Yan, vice president at Moody's in Hong Kong. ``It's going to take years for these banks to learn how to price risk, and they're going to get burned along the way.''
Nor are foreign lenders exempt. International banks are offering China Eastern Airlines Corp. and China Southern Airlines Co. Ltd., which have credit ratings that suggest a high risk of default, loans at rates 260 basis points below those offered to AMR's American Airlines Corp., the world's biggest carrier.
To slow inflows of foreign capital, China's government is drafting regulations to make it harder for overseas investors to buy Chinese assets. China has attracted more than $248 billion in foreign direct investment since 2001.
Many of China's overheating problems result from the fact that the Chinese economy is still ``in transition from a command economy to a market economy,'' says Lardy. ``A lot of the controls they've had in the past have weakened, but they don't have the market controls in place yet.''
Ignoring Quotas
For example, local governments routinely disregard land- supply quotas set by the central government; more than 60 percent of land transactions in 15 major cities since September 2004 were illegal, according to the Ministry of Land. That makes it harder for the central government to head off a real-estate bust.
For China's leaders, one of the biggest risks from an abrupt slowdown is the threat of unrest among laid-off urban workers and millions of farmers who are flooding cities in search of jobs.
Neighbors and trading partners are also vulnerable. Exports account for 40 percent of South Korea's economy, Asia's third- largest, and China is that nation's largest market.
``Korea will be one of the hardest hit if China slows,'' says Oh Suktae, an economist at Citibank Korea Inc. in Seoul. ``It's a big risk for not just Korea, but Asia-wide and for the rest of the world.''
About 40 percent of Taiwan's exports go to China; Australia is similarly dependent on Chinese markets. ``Taking out Australia's second- or third-biggest buyer would cut overall export prices and volumes,'' says Shane Oliver, head of investment strategy at AMP Capital Investors in Sydney. ``It's our biggest source of growth.''
Straszheim observes that ``we used to say if America sneezes, Europe catches a cold; China is now in that situation.''
``There is a day of reckoning coming at some point,'' he says.
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