CHINA'S ECONOMY HAS set so many records that it is easy to become blasé about stratospheric growth rates and unprecedented investment levels. After all, are not such abnormalities an inevitable by-product of the world's fastest-growing economy?
Rather as with the much-trumpeted new economy that supposedly explained the internet valuation excesses in the US, economic reality, it seems, is often set to one side so that we can marvel at China's economic miracle.
As China euphoria among foreign investors gathered pace over the past two years, so structural imbalances have emerged as everyone tried to board the China growth train before it left for good. So high has the level of domestic and foreign investment in China become, for example, that it accounted for much of the recent growth in GDP.
"Last year was the most imbalanced period of growth in [recent] Chinese history," says Desmond Supple, managing director and chief strategist for Barclays Capital. "We saw GDP growth of 9.1% but investment 70% by investment is not healthy. "The level of investment is unsustainable," Tim Condon, managing director and chief economist Asia for ING Bank, says. "On the face of it, if it keeps up, the entire economy will only be made up of investment. They'll be saving everything."
The problem is not just one of too much investment, says Supple. "What has happened in the past two and a half years," he says, "is an investment bubble fuelled by a credit bubble. So the government has had to step down harder on the brake than it would have liked to."
In fact, over-investment and loose lending are just two problems facing the Chinese economy as it attempts to complete its great capitalistic leap forward. To be more accurate, these problems are really symptoms of a much more fundamental problem: China's refusal to open its capital account and float its exchange rate.
Its government refuses to do this essentially because it is fearful of a capital flight that would put enormous pressure on the financial system, most notably
contributed 6.5 percentage points of that figure. We've never had that kind of fixed asset investment growth before."
An economy accounted for more than the big state banks, which are creaking under the weight of non-performing loans and are technically already insolvent.
It could also create a run on the renminbi and would be likely to trigger inflation, something of which the Chinese authorities are especially fearful.
So instead China is in a race against time to restructure its bust banks, and sell them off to what it is hoped will be still eager investors. There is a cost in the meantime.
"The fundamental problem is that there's too much liquidity in the system," says Frank Gong, head of research and chief economist for China at JPMorgan. "Total deposits of households and corporations are 200% of GDP. Banks have to pay interest on the deposits. They have to find a way of making money to pay interest on the deposits and the only real way [for banks] to make money in China is to lend money."
Vicious cycle of loose credit
So with pressure to lend and so much liquidity trapped in the system, interest rates remain low and credit loose. Bank loans inevitably end up funding unproductive investment projects that should not be undertaken. That means more NPLs, exacerbating the very problem the government is so desperate to fix.
"Normal trend bank lending growth is 12% to 13%," says Jonathan Anderson, regional economist at UBS, "and we've been seeing 25% at the peak. What that means in hard numbers is $150 billion of new NPLs. It's an enormous number on top of the $500 billion already in the system."
Despite the enormous numbers, no-one is predicting the imminent bankruptcy of China's state banks. UBS's Anderson calculates that NPL ratios are actually likely to decrease.
"Remember there's $2 trillion of credit in the system," he says. "In two years' time it will be $2.5 trillion of loans. Fast forward when this all goes bad, in 2005/06, and you'll have $700 billion of NPLs versus a $2.5 trillion loan book. It's around 30%: actually lower than 2001. So even with the bad lending, NPLs will have gone down not up."
According to Anderson's numbers, after additional capital injections from the government, NPLs will settle at around 20% to 25% of loans.
"Is that going to send the banking system under?" asks Anderson. "The answer is no – they've been living with these ratios for a decade. They're 100% state guaranteed, lending deposit spreads are big and with a closed capital account there's nowhere for the money to go, so you have large savings."
That might sound fine. In reality, though, all it will do is to buy the government more time to fix the banks. Nobody believes that the government can get away with keeping the capital account shut for ever.
"Without more capital account flexibility, it's very hard for them to solve the problem," says Gong. "They need to let companies and people invest overseas. Why not use the money more efficiently by making more investments and investing overseas rather than investing domestically and generating more NPLs? They can't convert fully at least for the next two to three years until they have restructured the banks."
So the problem comes full circle back to the banks. Meanwhile, China's fixed exchange rate plays its own part in complicating matters.
Since the renminbi is rigidly pegged to the US dollar, the government has effectively surrendered its interest rate policy to the Federal Reserve, leaving it even less scope to manage its economy.
Behind that decision is China's bet on the familiar east Asian economic model that relies on selling manufactured goods to US consumers.
The predictable result has been a rapid build-up of US dollar reserves and the effective import of yet more liquidity as the People's Bank of China issues new renminbi in exchange for US dollars earned by exporters.