The Red Dragon is massively overlending to sustain an unsustainable growth rate, which means a crisis is looming in its future, writes editor-at-large Howard R. Gold.

For several years, China’s economy has achieved one milestone after another: world’s largest automotive market, biggest energy consumer, No. 1 exporter, and leading manufacturer.

It has catapulted past Japan to become number two in gross domestic product. Some say it’s a matter of time before it leapfrogs the US to become the world’s largest economy.

All of that was powered by China’s phenomenal GDP growth—10% annually for the last three decades, unmatched in recent history.

But now, China may be on the verge of a big slowdown, as its leaders and lenders squeeze the liquidity out of a system that has produced one asset bubble after another in the last few years. Inevitably, that will spill over into China’s stock markets, making them less hospitable for investors than in years past.

There are signs of big changes ahead from the highest levels of the Chinese government. In a March 5 speech to the National People’s Congress in Beijing, Premier Wen Jiabao laid out what’s ahead in the government’s next five-year plan.

Wen said the government’s two top priorities were:

  • Maintaining price stability
  • Increasing consumption

The second, of course, has been the biggest concern of the US and other developed countries, which have run huge trade deficits with China and have urged Beijing also to let its currency, the renminbi, rise.

It’s a huge change. In previous five-year plans, economic growth was routinely the top priority, said Michael Pettis, a China expert at the Carnegie Endowment for International Peace who teaches finance at Peking University.

End of an Era
Significantly, the leaders also trimmed their growth targets to 7% annual GDP increases, from 7.5% in the last plan.

Of course, China effortlessly racked up double-digit growth and then some, year after year. But in an interview, Pettis said those days could be coming to an end.

“I think there’s a growing concern in the more sophisticated economic circles that something is going to change,” he told me. “Some people say the 7% [target] will be optimistic.”

In fact, Wen himself told reporters in March: “It will not be easy for us to achieve 7% GDP growth with quality and efficiency.”

Why? Because China has been performing way above the norm for years. The country has been in an investment-led boom since Deng Xiaoping unleashed free-market forces in the late 1970s.

“Certainly countries have grown rapidly in the past, but such growth has generally abated in time; 30 years is a very long run,” wrote David Beim, a former investment banker and now a professor at the Columbia Business School.

In an important new paper, “The Future of Chinese Growth,” Beim argued that China’s hypergrowth cannot continue.

Japan, he said, also racked up double-digit percentage growth rates from the mid-1950s to the mid-1970s, then growth tapered off and reached the 5%-7% range by the mid-1980s. Pretty strong, but not spectacular. Korea followed a similar path.

But Japan’s growth was artificially pumped up by banks’ “massively overlending,” which led to the great stock and real-estate bubble of the late 1980s, when the Nikkei Composite index nearly hit 40,000. This week, more than 20 years later, the Nikkei traded below 10,000.

China, too, is using massive over-lending to keep the growth engine going.

“There is ample reason to believe that China’s growth is being artificially sustained by financial excesses,” wrote Beim. “Its response to the…recession of 2008-2010 has been overlending by the Chinese banks, leading to substantial inflation of wages, equity values, and real-estate prices much as happened in Japan. The longer this continues, the more painful the comedown is likely to be.”

Next: Overinvestment and Bad Loans


Beim and Pettis agree that China’s huge growth has been powered by capital investment—the huge Olympic stadia, high-speed rail, spiffy air terminals and highways, and glittering ultramodern subways (and see-through office towers) we saw in Beijing, Shanghai, and Guangzhou last year.

Gross fixed capital formation, Beim reported, grew from 29% of GDP in 1980 to 42% in 2010—and “most of the investment is made by state-owned banks lending to state-owned companies,” a recipe for inefficiency and corruption.

Meanwhile, as the government cleaned up the books of Chinese banks early in the last decade, magically making hundreds of billions of dollars of bad loans “disappear,” consumer spending dropped from 46% of GDP in 2000 to 36% now, Pettis told me.

“The way you clean up banking in every case is you basically transfer wealth from the household sector,” he said. Think of Ireland. Or the Troubled Asset Relief Program (TARP) here.

Pettis is worried about the next wave of bad loans, which financed the recent huge wave of expansion—and haven’t been written down yet. Who’s going to pay for it? The emerging Chinese middle class? Migrant workers? Peasants?

Or will China have to dig into its massive foreign-currency reserves to bail out its banks?

It all makes the government’s second priority—boosting consumption—that much more difficult. Wen and the new generation of leaders—Li Keqiang and Xi Jinping, who will succeed him and president Hu Jintao, respectively, next year—“understand you can’t grow consumption while you continue pumping up investment,” Pettis told me.

That’s a problem when they’re also trying to boost capital spending in Chongqing and other cities in the interior, which are trying to catch up with the booming east coast.

For capital investment-oriented economies, “it’s very hard to know when to stop, so in every case the country has gone too far and they ended up with a very difficult adjustment,” Pettis told me.

Meanwhile, inflation is running close to 5%, and China is more vulnerable to rises in food and energy costs than we are. Also, rapidly rising wages are making China less competitive with low-cost competitors like Indonesia and Vietnam.

“Inflation is like a tiger. Once set free, it will be very difficult to bring it back into its cage,” Mr. Wen said in his March press conference.

Pettis, however, is more concerned about asset price inflation—real estate, to be sure, but also art, stamps, and rare Bordeaux wines, all of which are changing hands at record prices.

“That typically accompanies periods of excess liquidity,” he said.

But as the government drains liquidity from the system (and our own Federal Reserve winds down its “quantitative easing” program), we are likely to see some of these bubbles pop. Look for a big cooldown in mainland and Hong Kong real-estate prices. Collectible markets will take a hit, too.

Under those circumstances—and with slowing economic growth on the horizon—I’m expecting very little from Chinese stocks in the years ahead. Nonetheless, there are ways investors can make money from a China that grows “only" in the mid to high single digits, and I’ll write about them next week.

But, as Beim put it, “In the meantime, it seems more than likely that the golden age of Chinese super-growth is nearing an end.”

That, like China’s recent rise, may shake the world.

Howard R. Gold is editor at large for and a columnist for MarketWatch. You can read more commentary and watch his videos on and follow him on Twitter @howardrgold.

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