Conventional wisdom would suggest China's economy is heading for a painful landing. But the government will go to great lengths to avoid that—which creates a different set of problems.

Is China’s economy headed for a hard landing in 2011 or 2012?

I don’t think so. I’d go so far as to say, not a chance.

That answer, and most definitely its certainty, will surprise you if you think the question is about economics. After all, growth in China’s manufacturing sector seems to be slowing, but with no discernable effect on inflation.

Investment in assets such as factories and real estate is exactly what we’d expect in a bubble. And the latest interest-rate increase by the People’s Bank, to 6.56%, is a tiny adjustment that won’t nip the problem in the bud.

We’ve seen this movie before, and it ends with the central bank having to crack down hard after waiting too long to take meaningful action.

But this isn’t a question about economics. It’s about politics. If anybody thinks that Beijing’s leaders are going to let anything like inflation targets, asset bubbles, or bad loans spoil the 90th anniversary celebration of the founding of the Chinese Communist Party, or the coronation of a new generation of leaders in 2012, they’re confusing China with a free-market economy.

China’s government will do whatever it takes to prevent a hard landing this year or next. That said, China’s economy has the numbers of an overheated engine ready to blow all its gaskets:

  • Inflation is continuing to go up despite three interest-rate increases from the People’s Bank of China in 2011. Economists project that inflation hit 6.2% in June, up from 5.5% in May.
  • Fixed asset investment—that’s money going into real estate, commercial space, and factories—climbed by 25.8% in the first five months of 2011 from the same period in 2010. That’s a disappointing increase from the 23.8% rate of growth in 2010, and a clear sign that the economy is still putting excess cash to work in assets that won’t pay off. For example, even though China’s steel industry earned a net profit of just 2.91% in the first five months of 2011, plans are to expand production by 25% over the next five years.
  • Money supply (as measured by M2) slowed its growth to 15.1% year-over-year in May, from 16.6% in April. But the gap between growth in the money supply and in the economy is still inflationary.
  • Bank lending is down. New loans fell to 552 billion yuan ($85.4 billion) in May, from 740 billion yuan in April. But evidence suggests bank loans are falling because lending has shifted to non-bank lenders. And if you include loans made by local-government lending platforms, China has the kind of growing bad-loan problem that precedes a hard landing. Moody’s recently estimated that if you include all local government lending, China’s banks could be looking at 8% to 12% of loans going bad.

Anecdotally, there are more ways that China looks like an overheating economy headed for a quick dip in ice-cold water.

NEXT: High-Speed Trains to Where?

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High-Speed Trains to Where?
Take the boom that’s occurring around railroad stations on China’s new high-speed train lines.

For example, in Qufu—the birthplace of Confucius—the town government built a bus terminal near its station on the just-opened Beijing-to-Shanghai line, and then connected it to downtown with the new Confucius Avenue.

The bus station and Confucius Avenue cost the town 755 million yuan, or about 70% of the city’s 2010 revenue. Nearby, the Shangri-La Asia chain is building the city’s first luxury hotel, with 491 rooms. Qufu will be the smallest city in China to host a Shangri-La hotel.

Qufu isn’t alone in investing to exploit the potential of the new high-speed rail system:

  • Xuzhou, a city near the midpoint of the line, is developing a 5.2-square-kilometer (nearly 1,300-acre) business district near its train station, which will include offices and a four-star hotel.
  • Bengbu, in Anhui province, is developing a satellite town around its train station, with government offices and a residential complex.

It reminds me of one of the first stories I covered during the US technology boom of the 1980s. The first venture capitalist I talked to said that the disk-drive company he had funded “only needed 10% of the market.”

So did the second venture capitalist and the third and the fourth. By the time I got to the 20th disk-drive company that needed just 10% of the market, I knew this investing boom wasn’t going to end well.

And it didn’t. Atasi went bankrupt. Cogito Systems went bankrupt. Data Storage International, ditto. Integral Peripherals. JT Storage. Ministor Peripherals. Tulin. Microscience International.

During the product’s history, about 200 companies made disk drives. Today the industry is down to just three major players.

It’s unlikely—extremely unlikely—that all the Chinese cities and towns that have invested so much in projects linked to the high-speed rail system will recoup their investments. It’s also unlikely that the additional 25% capacity planned for the steel industry will be profitable. Or that all the loans made by China’s local-government lending platforms will be repaid.

But don’t expect the Chinese economy to be left littered with the smoldering hulks of the crashed and burned. This system doesn’t work like that.

Business as Usual in China
Companies that run out of cash—after having never made a profit—will either get new loans (if they provide enough jobs) or get discreetly merged into another company.

Cities that can’t meet their budgets (because they spent too much on projects that aren’t producing enough to cover their debt service) will balance their books by selling land to developers.

Developers that can’t meet interest payments to their banks will get their loans extended by banks that choose to pretend the loans are still good.

Chinese banks and financial platforms with so many bad loans on their books that they need new capital will get recapitalized by the Beijing government—at the same time their bad loans vanish from their books, sold to new financial entities funded by the government or by the same banks that sold them the original loans.

How do I know this will happen? Because it is what China has done before. China’s experience with the Asian currency crisis of 1997 is a template for the way it could handle the next bad-loan avalanche.

NEXT: Roll the Videotape

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Roll the Videotape
China escaped the first stage of that crisis, which took down countries like Thailand and Indonesia, because the country’s tightly controlled financial markets had kept out overseas hot money.

China’s export economy was built on domestic bank loans. In the 1990s, these loans were all that kept the doors open at some of China’s biggest state-owned companies.

In its review of the crisis, the Congressional Research Service estimated that about 75% of China’s 100,000 largest state-owned companies needed bank loans to continue in business.

That became a problem when, as a result of the crisis, China’s exports fell in 1999. Suddenly China’s banks were sitting on billions of bad loans.

So the government buried the bad debt. Beijing created special-purpose asset-management companies that bought the bad debt—$287 billion of it—from China’s big banks. In most cases they paid book value, too.

How did these special-purpose companies pay for their generosity? With bonds that they issued to the banks in exchange for the loans.

The bonds were backed by a promise that the asset companies would redeem the bonds in cash after they sold off those bad loans. And, until those bonds matured in ten years, the special-purpose companies would pay interest to the banks.

Like magic, the bad loans were not only off the books at the big banks, but they’d been transformed into streams of income.

What happened in 2009, when the ten-year bonds matured and the special-purpose asset companies couldn’t pay off on them? (The bad loans were so bad that recovery in the first five years averaged around 20 cents on the dollar.)

In many cases, the asset-management companies secured strategic investors and then went public. Who would partner with a company whose major asset was bad debt?

How about the same big banks that sold their bad loans to the asset management company ten years earlier? Problem solved.

I expect that when the renminbi finally hits the fan, China’s financial regulators will engineer a scheme something like this. No loans will go bad. No banks will face bankruptcy. And the problem will just disappear.

Of course, this kind of financial engineering can’t solve critical real-life problems, such as rising inflation. If you go to the market on Tuesday and the melons cost 10% more than they did on Monday, the melons really do cost 10% more.

But China clearly intends to do as much as it can to manage the reaction to that pesky reality.

Fudging the Inflation Fight
For its international audience, China will show the inflation-fighting flag with moves such as the July 6 increase in benchmark interest rates. These measures aren’t particularly tough if you compare China’s three 25-basis-point rate hikes with the more frequent and larger interest-rate increases in Brazil, India, and Chile.

But so far, the hikes have been enough to convince the overseas financial markets that China is serious about fighting inflation.

The government will also fudge, as much as it can, the country’s inflation target. China has already raised the official target to 4% this year. And now officials are starting to talk about 5% as a “realistic” target.

For its domestic audience, China will take steps to decrease the pain of inflation. Local governments will open bargain stores selling produce at below-market prices. Local and provincial governments will raise the minimum wage so that lower-paid workers will have more money in their pockets to pay those higher prices.

Also, the national government has promised in its most recent five-year plan to raise the minimum wage an average of 13% a year during the term of the plan. Beijing will also build 36 million low-cost housing units, according to the plan, and increase spending on health care, pensions, and other services.

If worse comes to worst, the government will call on security forces to keep the economic peace.

I think all of this—the financial engineering, the effort to ameliorate the effects of inflation, the threat of force—will work to prevent a hard landing this year or next. These measures might even work over the longer term to keep China’s economy from paying the price of a hard landing for its current excesses.

But avoiding a hard landing, in my opinion, isn’t the biggest challenge facing China. The bigger task is avoiding what development economists have labeled “the middle-income trap.”

In my next column I’ll explain what that means for China—and for investors.

Full disclosure: I don’t own shares of any of the companies mentioned in this column in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this column. For a full list of the stocks in the fund as of the end of March, see the fund’s portfolio here.