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China's blistering 10%-plus growth in the first quarter and its undervalued currency stir up plenty of resentment in the West. The rap is that Beijing is obsessed with high-speed expansion and massive trade surpluses regardless of what the rest of the world thinks.
But what if the real issue is that Chinese President Hu Jintao's government actually does want to cool down its white-hot economy, export far less, and even let the yuan trade more freely against the dollar and other major currencies? But it can't, because the government doesn't really have control over its own banks, local governments, and exporting industries.
That's not as absurd as it sounds. While Westerners generally believe Beijing can control any aspect of Chinese society -- as it did in the past -- the supreme irony about China today is that its leaders can no longer wrestle down its $2 trillion economy. It's far too complex and plugged into global capital flows that are beyond Beijing's control. And because of that, China is showing signs of overheating.
UNCONTROLLED GROWTH. Property bubbles are well underway in Shanghai and Beijing, and loan growth is off the charts. The money supply is exploding, and so is spending on new plants and infrastructure, even as sectors such as autos and steel are facing capacity gluts.
Regional governments are ignoring Beijing's entreaties to cool it, and instead continue to plow money into questionable public-works projects. Fixed investment in public infrastructure, plants, and equipment -- heavily influenced by regional economic planners -- shot up 27% year-on-year in the first quarter, despite an 18% growth target set by Hu's government. China's Vice-Finance Minister Li Yong conceded as much at an Asian Development Bank conference in India in early May. "We have to control investment among local governments," he told reporters.
So what's the problem? The last thing Hu's top economic planners or People's Bank of China governor Zhou Xiaochuan want see is a nasty bust. Social instability terrifies this crowd, and China is home to a massive number of underemployed workers barely making ends meet. Chinese manufacturers aren't thrilled, of course, by talk of a dramatic appreciation of the yuan.
STILL DEVELOPING. At the same time, any modest move to use a stronger currency to slow things down meets fierce resistance from China's sprawling and inefficient agricultural sector, which is a huge employer and politically vital to the Communist Party.
Yes, China is home to glimmering skyscrapers and emerging high-tech and manufacturing companies. But at heart, the mainland is a developing nation, heavily dependent on agriculture. And a big increase in foreign food imports -- made more competitive by a sizable appreciation in the yuan -- would hit this sector hard. "To the Chinese government, the agricultural industry and small farm villages are the biggest political issue," says former Japanese financial diplomat Eisuke Sakakibara, who met with officials from the People's Bank of China in December.
Nor does China have a truly independent central bank that has the authority to oppose the leadership on economic policy or really crack down on reckless lending by banks. Political meddling by local party officials when it comes to loans is a huge problem on the mainland. If you are a loan officer at a major bank, it's hard to say no to the local power elite.
INDUSTRY GLUTS. Add it all up, and you get studied inaction while the economy continues to roar along at unsustainable levels. Fresh data out on May 15 confirm the government is having a tough time turning off the cash spigot. Money supply clocked 18.9% growth in April compared to a year ago -- well above the 16% target set by the government in January. And the excess cash swirling around is feeding ultra-loose bank lending. Loan growth ballooned 70% during the first quarter vs. the same period in 2005.
That generous lending is creating industrial gluts, which makes China even more reliant on exports. The Chinese auto industry can produce about 8 million cars annually, but sells just 5.5 million or so at home. Increasingly, those excess nameplates are heading overseas, with car exports having almost doubled in the first quarter. The steel, aluminum, and coal industries face similar gluts. Last year, China's global trade surplus tripled to $101.9 billion, and in April, exports shot up 23.9% vs. April, 2005.
China is now the third largest trading nation. In recent years, it has been a voracious consumer of industrial commodities such as copper, iron ore, and steel to fuel its rapid industrialization. Though it represents about 5% of the world's economic output, this hungry dragon devours about 20% of global aluminum, about 30% of steel, iron ore, and coal, and 45% of cement produced each year, figures Morgan Stanley (MS
) economist Steven Roach.
BIGGER STORY. Even a modest slowdown in Chinese grow would cut short the recent boom in commodity prices. And that would hurt stock markets and economies from Brazil to Australia. However, a repeat of the boom-and-bust cycle China experienced in the early 1990s, when runaway growth and inflation forced Premier Zhu Rongji to take draconian measures to cool things down, would also affect big trading partners such as South Korea, Japan, and even the U.S.
All this explains why the whole melodrama over China's exchange rate is really beside the point. The yuan is just one dimension of a far bigger problem for Chinese monetary authorities who don't have effective tools to manage the economy. Many inside the Chinese government would actually love to see a modest appreciation of the currency.
It's a big headache to keep the yuan in its tight trading range against the dollar when so much money is rushing in from exports and foreign direct investment. The central bank has to buy foreign currency from Chinese exporters and banks, then must try to mop up some of the extra yuan by selling treasury notes to the banks.
TIME TO MOVE. That system has more or less worked in recent years, but now it seems to be breaking down. Money supply is growing about twice as fast as the overall economy. That is why there is growing speculation that Chinese authorities will let the yuan appreciate about 5% this year. On May 15, the Chinese currency breached the 8-to-the-dollar mark for the first time in 12 years.
A move now makes great sense for China's own national interest and economic management. And if it comes, U.S. hectoring will have mattered very little. "A strengthening currency helps bring the trade surplus down, which in turns lets the PBC manage domestic liquidity," UBS (UBS
) economist Jonathan Anderson noted in a May 15 research note.
China will also need to ride roughshod over its banks to rein in lending and possibly follow up its modest interest rate hike in April with more of the same. Wish Beijing luck, for if China experiences a crash landing and not a soft one, the ramifications will be felt far and wide in the world economy.