China Blows Up?
By Staff News & Analysis - June 01, 2010

Beijing in a sweat as China's economy overheats … China is struggling to contain the threat of an overheating economy in the face of rising house prices, inflationary wage increases and a continuing surge in money supply, the head of the country's second-largest bank has warned. Guo Shuqing, chairman of China Construction Bank, said that the latest figures for China's M1 money supply – a key predictor of inflation – had raised concerns that the country's vast stimulus and bank-lending was running too hot. "I saw the figures for last month and M1 is still very high, increasing 31 percent from last year, which is one per cent higher than last month," he said in an interview with The Daily Telegraph. "We are seeing a lot of money coming to China which is creating a current and capital account surpluses." China's regulators have introduced a raft of measures in recent weeks in an attempt to cool down the economy, forcing banks to raise the capital adequacy ratios and hitting second home-buyers with regulation designed to drive speculators out of the property market. – UK Telegraph

Dominant Social Theme: More concerns to conquer.

Free-Market Analysis: When we first predicted the overheating of the Chinese economy early last year, we could hardly find a word about it. Nonetheless, it was clear to us that no economy grows at 10-percent per quarter normally – year-in and year-out – without some very strong monetary stimulation. Now the mainstream press, not to mention the Chinese authorities (and of course the market itself), has caught up – and with considerable energy. The reality of the surging economy has investors spooked and even the Communist Chinese government expressing concern. Here's an excerpt from another recent article on the subject carried on-line by the AFP newswire:

China's Wen maintains 'sense of crisis' over economy … Chinese Premier Wen Jiabao (above left) warned Monday that the world must stay alert to the risk of relapsing into economic crisis as Europe's debt woes drag on, and not withdraw stimulus measures prematurely. During a visit to Tokyo where he met Japanese counterpart Yukio Hatoyama, Wen said the global economy is recovering but remains fragile and faces various risks that require international cooperation. "Some people argue that the global economy has already recovered and that we can now take stimulus exit measures but I think that judgment is too early," Wen said in a speech to business leaders in Tokyo. "We need to prepare for (future) difficulty. The debt crisis in some European countries may impede Europe's economic recovery and bring change to European markets," he said. "China will make sure it maintains a sense of crisis," he added. …

Wen added that "individual countries need to cooperate and increase their support to the economy through policy. There is no room for slacking." China's exports in April were up 30.5 percent from the same month a year earlier, according to state media, as shipments help drive economic growth that registered a blistering rate of 11.9 percent in the first quarter. However, rampant inflation and soaring property prices at home have fuelled fears the world's third biggest economy may overheat and derail, putting pressure on Beijing to hike interest rates and let its currency rise. On the domestic front, Wen added that it was "very important to control inflation," in China and maintain the yuan "at a reasonable level" despite international pressure on Beijing to alter its exchange rate policy. "We have to take a certain stimulus policy so that the economy will keep on growing steadily at a relatively high rate," he said.

We know that Western leaders (along with the Chinese) are trying to project a rosy picture. The dominant social theme is supposed to be that the world will struggle through these tough economic times (and without complaining about the killing that Western banks are to make). But we can surely see in this excerpt the economic complexities that China is facing.

Wen states that China must maintain a "sense or crisis" and warns that Europe's debt woes could become increasingly problematic for world prosperity. For this reason, he suggests that there is no room to slack off when it comes to increased economic support – printing more money in other words. Finally he states his fears that China may be overheating, but that the stimulus – printing more money – will continue in China so that the economy "will keep on growing steadily at a relatively high rate." Just listening to Wen, one could get whiplash. Wen knows that China is overheated but he doesn't have an option. The balance must be kept just right – not too much inflation and steady growth.

Our feeling in all this is that the Chinese people, even more than the Europeans, are at the end of their collective rope. Every time we read a quote from Wen, or other top officials, we get the same feeling. The Chinese are worried that employment will drop off. They are worried that Chinese government corruption will finally prove the proverbial last straw. They are worried that inflation will climb and erode the small material progress of the average Chinese family. Mostly they are worried about a vague but ominous, pending economic collapse that will spell the end to the hopes and dreams of a billion Chinese.

Once it is clear that the party has failed yet again, once the economy begins to sputter and the fragile prosperity is put at risk, we cannot imagine how the apparatchiks of the Communist party will survive. They have been in power too long. They have been arrogant, contemptuous, murderous and finally shown themselves (in their desperation to cling to power) to be entirely without principles, even Communist ones. "Whatever works," they have told the Chinese people, "so long as we stay here and you remain there." But if by chance it doesn't work, the contract is fractured and the conversation is kaput. It's been 60 years. No more chances.

And where does Europe stand as regards all this? China is Europe's main chance; and we think the US regards China much the same way. If China goes down, Europe's prospects just got a whole lot bleaker, and they are pretty bleak right now. As for the US, we see the same mechanism at work. China is the only large economy showing significant growth. It buys both American and European bonds and helps facilitate the deficit-based growth of both powers. Yes, China's steady growth has been a miracle for years and years. But could it ever come to an end? Here's a little more from the Telegraph article we excerpted at the beginning of this analysis.

China has moved quickly to apply the brakes after first quarter figures showed the economy expanding at 11.6 percent year-on-year, driving down sentiments on the country's benchmark Shanghai index, which has fallen 27 per cent this year. However, while loan growth is slowing from 2009, huge amounts of fresh loans continues to pour into the Chinese economy with the total outstanding loans still growing at a rate of 18 percent this year. After issuing 10 trillion yuan (£1 trillion) of new loans in 2009, Chinese banks are targeted to inject another 7.5 trillion yuan this year, a reduction but still nearly twice the 4.6 trillion yuan of the loans disbursed in 2008.

Mr. Guo warned that the continuing splurge in lending also raises the risk of a sharp rise in non-performing loans among smaller Chinese banks that have funded local government infrastructure projects, often of dubious viability. "I think that small banks last year newly issued loans grew even fast, some even doubled their liability and assets," Mr. Guo said. "At the moment the banks seem healthy but I think that small banks, because we don't know the structure of their assets, maybe have got more risk exposures because they are growing too fast and their risk management is not as good as big banks. "And secondly because they are very small and their loans are going to a more concentrated number of customers, that also could definitely cause a problem."

It doesn't sound exceptionally hopeful, but the reality we humbly submit is even worse than such factual perspectives convey. China, as we have written in the past, is a kind of a Potemkin Village of an economy. Stocks travel up or down depending on whether the government favors them. The country's larger banking system may seem competitive but it's not. There's considerable evidence it's run from the top down, as, likely, are many of China's other large industrial complexes.

The part of the economy that is market-based is the "people's economy" – the economy where vendors are free, finally, to compete with each other in the pricing of their wares and to build businesses, in some cases fairly large ones, and to speculate on real-estate, commodities, etc. But the real power resides in China's biggest financial and industrial instrumentalities, and these remain firmly in the hands of the Communist party – though this control has been disguised for purposes of Western investments and to show a more market-oriented face to the world.

Additionally, in the country's larger industrial enterprises, frustration with the system as it is, is building. There are still many in the country – the agricultural poor – that have not realized the benefits of the current Chinese industrial "miracle." And the Chinese system of industry still remains in many cases built on the competitive advantage of third-world wages. Wages in fact can be as little as US$100 per month. With prices going up, and real-estate prices continuing to jump around the country, wage-push is starting to be an issue, we believe. Here is an excerpt from an article in the Financial Times that does not – curiously – mention Chinese price inflation but does delineate the new militancy of the Chinese worker:

Chinese workers swap angst for anger … The workers' defiance was written in red ink. "If you are Chinese you will definitely not sign – one for all and all for one," a striking Honda employee wrote over a form urging his colleagues to renounce more industrial action. Suicidal angst is giving way to worker solidarity in southern China, as a factory strike that has halted the Japanese carmaker's nationwide operations enters its second week. Most worryingly for the Chinese government, the industrial unrest at Honda and other big employers in Guangdong province is raising questions about the nature of work itself on 21st century factory floors. Alienated Chinese workers are signalling that they are determined to fight back.

At least a third of the transmission plant's employees are interns, reflecting a wider use of students and temporary employees across China's manufacturing sector as demand for labour outstrips supply. This, in turn, has increased the bargaining power of workers across southern China. "The previous availability of labour in China meant you could de-automate industrial processes and turn cheap workers into machines," said Arthur Kroeber, managing director at the Dragonomics consultancy in Beijing. "If workers didn't like it, they knew there were 10 other guys waiting to take their job. Now, there's no one waiting to take their job."

The Chinese economy reminds us a lot of South American economies – and some Western economies more and more – where large institutions are in the hands of the ruling elite and everyone else competes for the leftovers. What is even more ironic from our point of view is that the Chinese leaders are treated by the mainstream Western media with the same breathless coverage as European and American leaders. Unlike the Russians, the Chinese Communists have mastered the art of lying expressionlessly, which is of the utmost importance if one wants to help run a mercantilist, fiat-money economy these days.

We don't know when the "third shoe" will drop. The American and European economies are not in good shape, and Europe's position is actually deteriorating. US political and industrial leaders are proclaiming that the US economy is bouncing back, but we think these pronouncements have an element of wishful thinking. The expanding European sovereign-debt crisis is bound to be a significant drag on any larger Western recovery.

After Thoughts

All this puts a great deal of weight on the Chinese to maintain a feverish pace of growth – one that nonetheless does not ignite price inflation and subsequent social unrest. The leadership seems to have pulled it off so far, but the line between success and failure seems to grow finer every day, even as the stakes themselves grow higher. Having the current fate of Western economies resting on the shoulders of Communist leaders is certainly ironic. It could end in tears.