By Malcolm Thomas
Interinvest Review & Outlook

        Over the last decade, China has developed from a marginal player on the global economic scene to a major force, coming of age with accession to the World Trade Organization in 2001. Such a frantic pace of transformation has inevitably created substantial social and economic stresses in the country, but will the boom outlive the 2008 Olympics in Beijing?

        China's growth in recent years has been nothing short of spectacular. From a marginal player on the global economic scene only a decade ago, the country's extraordinary development has made it a major force. Although China still accounts for less than 5 percent of world GDP, recent revisions and annual growth over 9 percent now show it to be the fourth biggest, overtaking the UK and France. In fact, China, has contributed 28 percent of world GDP growth over the past 15 years.
        However, in many ways, the country's true economic "coming of age" occurred with accession to the World Trade Organization in 2001. It was then that China's development begun to broaden visibly, reflecting a return of international confidence following the disturbing events of the late 1980's. Foreign investment accelerated dramatically, reflecting China's attractions as an ultra-low costs producer in a fast-growing but relatively stable political environment, and its share of global trade mushroomed to almost 7 percent from around 3 percent as exports exploded - rising 300 percent in six years. But more importantly, in its de facto transition to capitalism, China's ascendancy has been characterized by a massive investment boom that has produced a corporate revolution and transfigured major cities. While appearing a rural society on strict population count, a twenty-year migration of workers from the countryside - accelerating in the past five - has meant that 40 percent, or some 520 million people, now live in urban zones, double the early 1980's tally. The physical impact of this change and the development of infrastructure to support it have gone hand in hand with moves to rapidly modernize the economy. Since capital, especially in the post-WTO accession era, has been ample and relatively cheap, and potential returns alluring, investment from both domestic and foreign sources has been correspondingly fast and furious. Fixed asset investment has grown at annual rates of over 20 percent for four years now, helped by foreign direct inflows accounting to $315b since 2000. While the government has tried to encourage consumer spending (including raising wages and, lately tax incentives) savings rates remain extremely high and investment continues to account for around 45 percent of GDP. Companies have raced to expand capacity to meet ever-higher demand, focusing on a spectrum of products including basic industries, vehicles and technology. There have also been moves to reduce China's heavy dependency on raw materials. In many cases, the dash for growth was not met quickly enough by commensurate energy and infrastructure; widespread power shortages in 2004 triggered plans to double electricity generation in some areas, with the government deciding to invest $75b over five years.
        Examples of the boom are not only in massive new complexes in Shanghai/Pudong and projects such as Port developments and the Three Gorges Dam (one of the biggest hydropower structures in the world, to be completed this May at a cost of $22b). They are also embodied in huge construction projects like those near Zhengzhou (creating a new $25b city) and the unprecedented development of Beijing ahead of the 2008 Olympics. Some $160b of projects are presently underway in the nation's capital, adding the equivalent of three Manhattans to the skyline, with $99b worth started between January and September last year. Apart from Olympic ventures, developments include apartments, shops, offices, subways, railways, ring roads and an airport terminal larger than all those at London's Heathrow combined. The 4.9 million square foot Golden Resources Mall, twice the size of the largest US mall, has already been completed. In all, a total of 1 billion square feet of new offices, shops and apartments will come onto the Beijing market by 2008.
        The consequences of such development are being felt far beyond China. The country is now the world's third largest importer and presently consumes some 40 percent of global cement production, 31 percent of all coal, 30 percent of iron core, 27 percent of steel, 25 percent of aluminum and 7 percent of crude oil. Exports to China account for as much as 32 percent of Japan's export growth, 36 percent of South Korea's, 68 percent of Taiwan's and further a field, 21 percent of the US' and 28 percent of Germany's. Should China even sneeze, the world could catch more than just a head cold. And sneeze it might...
        While the process of transforming China into a modern economy is moving ahead, the frantic pace has placed substantial strains on the system. Numerous problems have emerged, many of which threaten to destabilize the economy. On the social front, disparities in income have widened alarmingly even in cities, with statistics showing the bottom 20 percent of urban residents earn under 3 percent of the country's total urban income, or just 4.6 percent of that earned by the wealthiest 20 percent. The gap between rural and city dwellers is even more vivid, highlighting deepening inequality. In addition, environmental damage is widespread and pollution rampant: China has 20 of the world's most polluted cities, due in part to ever-increasing numbers of vehicles, many of which lag European pollution standards by a decade. In Beijing, some 2.5 million cars now throng the streets (increasing at a rate of 1000 per day); a recent US Embassy report says the amount of particulate matter in the air is equal to that of Atlanta, Los Angeles, Washington, and New York combined. Fully 70 percent of the country's rivers are contaminated by toxins and an estimated 300 million people are drinking water that makes them ill. In a country where water is scarce, recent disastrous chemical spills have resulted in acute shortages in many communities. Health risks are on the rise, with incidences of avian flu (H5N1) increasing. To add to these challenges, unemployment has actually worsened in recent years despite stellar economic growth, reflecting the restructuring of state companies and the changing labor-intensiveness of the private sector. The economy's "leap" forward amidst new technology and intense competition has left it less capable of absorbing new entrants while rural migration shows no sign of let-up. Of an expected 25 million in entrants this year alone, the government itself estimates the economy will only be able to create 11 million jobs, leaving more than 14 million workers "surplus." Unofficial figures suggest the total number of unemployed or "underemployed" could even be into nine figures. Small wonder that crime rates are climbing rapidly and social unrest growing; in 2004, 74,000 protests involving some 3.76 million people were officially recorded, and many more than that occurred last year. These factors on their own would explain why the leadership, fearful of having its central authority compromised, is beginning to rethink strategy.
        But the economic challenges may run even deeper. Although outwardly embracing the rapidity of development, there has also been a growing fear that the momentum of change is spinning out of control. As keen interpreters of the various manias and crashes that have pockmarked the capitalist landscape since Adam Smith, the leadership will have noted that most western booms did actually end in tears. This is not to say that the forces behind the booms were illusion - the internet, for instance, is definitely here to stay, and so, we would hazard, is the Chinese economic revolution. But lengthy periods of correction have regularly occurred to facilitate the next phase...and the social issues confronting China suggest a long consolidation is probably not advisable. The fact is that its banking system is still in a fragile state having amassed a mountain of bad loans, largely from state companies, over the past 15 years - estimated as high as $1 trillion (or 45 percent of GDP). Although the government has made substantial progress in reducing these, spending some $432b funding write-offs since 1998 as it prepares for foreign competition and more deregulation, an untoward setback could seriously compromise confidence. The risks come from several directions, but are largely a function of the prolonged investment boom. This has led to a significant increase in production capacity in many industries, with symptoms of over-supply beginning to show. Earlier fears of inflation have been replaced by deflationary concerns as heightened competition has forced down some prices and squeezed profit margins, while pushing companies into exporting excess supply. Steel capacity is already 120 million tons greater than demand but an extra 70 million tons is still under construction, while more than 25 percent of aluminum capacity is idle and vehicle output capacity is 2 million more than needed. Further over-investment could push prices down more, leading to production cutbacks and widespread bankruptcies and worsening the unemployment situation. It could also further aggravate trade tensions as companies ramp up exports in the face of deficient domestic demand; already China's slow response to complaints over lack of exchange rate flexibility has increased the risk of it soon being branded a "currency manipulator" by the US Treasury. And although domestic consumption is improving, the pace remains gradual and unlikely to compensate quickly enough for the effects of excess capacity.
        This explains why the leadership moved in 2004 and again last year to dampen over-heating in an attempt to head off the risk of a sudden upset. Credit to "extended" areas was forcibly curtailed, notably to industries like steel, cement and aluminum. Real estate came under special scrutiny, particularly in Shanghai where speculation had become widespread (real estate absorbed 75 percent of new local bank loans in 2004). Interest rates, down payments and capital gains taxes were raised. Since June, Shanghai house prices have fallen almost 12 percent and the number of home loans in default has jumped 56 percent. But this trend has not yet been emulated all across the country; in Beijing for instance, prices continue to rise "ahead" of the introduction of massive new supply. And in the corporate sector much of manufacturing and property development is now being done by the private sector, effectively outside central control. Last month, the country's banking regulator warned banks to monitor lending even more closely to prevent bad loans from escalating. While so far there have been no major cracks, note that foreign direct investment flows, the leading indicator of the boom, failed to accelerate in 2005 for the first time in five years, and many measures of activity, like purchasing managers' and business sentiment surveys, have slowed of late. Exports are also likely to be affected by the slowdown in US demand anticipated later this year, with another probable revaluation in the Yuan to assuage G7 pressures adding to the equation.
        So although we are uncertain whether the boom will quickly reverse or "wait" for a year or two, a slowdown in growth looks pretty inevitable. But the Olympic gold may well turn out to be a bust.
        Editor's Note: Malcolm Thomas is a contributor to Interinvest Review & Outlook, P.O. Box 51462, Boston, MA 02205, 1 year, 12 issues, $125. Interinvest is a global money management firm.