1.29.2007

China’s Economy: A Ticking Time Bomb

Rising from a backwards rural society, China is well on its way to surpassing Germany as the world’s third largest economy, behind Japan and the United States. Due to the introduction of commercialism and capitalism, large amounts of foreign currency have found its way into China’s economy, quickly boosting her annual growth rate. In fact, 2006 marked China’s fastest growth rate in a decade (since 1995), at an almost unheard of 10.7%.

Everybody seems very happy. This growth is well ahead of China’s own expectations. And her neighbors, such as Japan and South Korea, have seen their own economies jump forward as part of a “halo effect.” But all is not good news. Despite how it appears on the surface, it is possible to grow too fast, and now there are significant problems rooted underneath this progressive growth. In fact, China’s current state of high growth shows similar strain to that of Japan’s infamous bubble in the 1980s, right before it burst and caused incredible damage to the country. China, is in fact, a gigantic “ticking time bomb” and when it goes off, it won’t be contained to just China -- most other countries will suffer as well.

In the beginning, the world was in awe of China’s economic shift from a communist to a capitalist country. It was quite the obsession: individuals, companies and even countries poured hundreds of billions of dollars in to China’s economy in hopes that the current trend of economic growth would continue and they would be amply rewarded. Where did that money go? Much of it went into real estate, building houses and factories, anticipating future productivity.

Although there are many reasons as to why the economy will overheat (including issues in the areas of economic growth, foreign investment, trade, finance, banking, state ownership, unemployment, income distribution and social factors), Japan’s economic collapse was specifically related to its banking system. And in an eerie deja vu, China’s banking system appears to also be assuming the same role as hub for imminent economic collapse. China has a corrupt and practically a bankrupt banking system. Standard and Poor’s estimated in June 2002 that China’s non-performing loans exceed 50% of its total bank loans, thus counting for 43% of its GDP. The standard manageable rate for non-performing loans in other parts of the world is a mere 5%.

It’s a real mess. China’s banks have dished out money for years to companies without profits and consumers without income, therefore, never receiving repayment for the loans. The banks operate under great political pressure to lend money to failing companies owned either by the government or by any government-connected entities or individuals. For example, in China, you do not refuse a loan to a business owned by the People’s Army, no matter how poor its finances may be. The banks have always been under pressure from the government to increase lending to keep the Chinese economy expanding; now, with the economy in hypergrowth, the pressure is most intense. Incredible sums are being loaned out.

So far, it’s been working because new loans bring in money to cover bad loans. But like a giant Ponzi Scheme, that only works as long as fresh money is flowing. The problem is, many think the flow could stop very abruptly, giving the Chinese banking system (and government) little time to react. At some point, speculative investments in real estate and other assets will start selling to lock in financial gains. If there are no buyers to absorb the selling, then good investments will turn bad, and investors will default on their loans. It’ll be bad loans on top of bad loans, well beyond the government’s ability to bail out the system (remember, Japan’s banking system collapsed, and it was the second largest economy during that point in time). That will cause an economic collapse.

Charles Calomiris, a finance professor at New York’s Columbia University, remarks that “bad loans are not some little problem a good regulator can take care of; they are part of the whole way the system functions. Looking into the crystal ball, there will be a crisis in the financial sector in China in 2009-2010.” My guess? That crisis will occur sooner. Fueled by multiple bad loans, the dwindling banking system is stifling China’s future growth and emergence as a world power. Gordon Chang, author of “The Coming Collapse of China,” warned that the current state of the banking system would “almost certainly lead to a collapse of the economy.”

Now that China manufactures products for most companies around the world, even the mildest recession would have a great impact on the global economy. So what should China do? Besides cleaning up their “messy” politics, China needs to focus on reforming the banking system by curbing investment spending and bank lending until the issues are resolved. In other words, “hit the brakes.”

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