Is China's growth real?

By Weijian Shan

China's economy is a great paradox.

On one hand, it has been the fastest growing economy in the world rising at an average annual rate of 8.6% since 1980, outperforming any other country at any time in history for such a sustained period of time. On the other, Hong Kong's Hang Seng China Enterprises Index has fallen by 1/3 since it first began in 1993.

In no other country at any time in the world history one would lose money investing in a portfolio of the best companies a country has to offer if that economy grows anywhere near the pace of China. In fact, that kind of growth usually turns everyone, even the dumbest dart throwers, into a smart investor in the stock market.

Even more inexplicable is the fact that the fastest growing economy has been and remains probably the most inefficient major economy in the world, as measured by the average bad loan ratio in its banking system.

At the micro-level, if a firm makes chronic losses, it is likely to suffer from productive inefficiency. At the macro-economy level, if resources continue to flow to such producers, allocative inefficiency arises from such misallocation. Both types of inefficiencies are captured in the form of bad loans in a country's banking system, to the extent bank lending represents the bulk of resource allocation in an economy. This measure is particularly applicable for China as 97.8% of the total financing for companies was bank loans for the first half of this year.

Foreign analysts estimate that the bad loan ratio of Chinese banks is about 50%, or about twice the official estimate. That is arguably the highest of all major economies in the world. Even by official estimates, the Chinese banking system makes the largely insolvent Japanese banks look vastly over-capitalized.

It defies conventional wisdom in the extreme that the economy with the highest growth rate is also the most inefficient.

In this sense, China's growth is as beyond belief as a polio patient winning Olympic gold medal in heavy-class weightlifting. No one in the history of mankind has ever accomplished such a feat, except in the movie Forrest Gump, who, exhibiting no signs of post-polio syndrome, still pales in comparison as he plays only the easier stuff like football and Ping Pong.

This paradox gives rise to such opposing views on the future of China's economy as reflected in book titles ranging from `China's Century' to `the Coming Collapse of China.' Unable to reconcile such seemingly sharp contradictions and yet unwilling to accept either of the extreme views, many China observers have questioned the truthfulness of China's published statistics. Pundits point to numerous data inconsistencies, such as the large gap between the aggregate of provincial numbers and those released by the central government and the significant mismatch between economic growth and energy consumption.

It seems, however, that the Chinese data have largely stood the test of international scrutiny. The debate was put to rest last year by Andy Xie of Morgan Stanley, who convincingly shows that the increase of China's economic size of 5.5 times in real terms in the past 20 years is supported by verifiable data, such as the even faster growth in household savings and the more rapid growth in China's exports which are corroborated by import statistics of its trading partners.

If China's growth is real, what then is the secret of China's growth which seems to turn accepted logics of economics on its head?

Once upon a time, there was another economy whose rapid growth seemed at odds with mainstream economic theories as its inefficiencies were also well-known. That was Stalin's Soviet Union, which grew to become the second largest economy in the world, only after the US.

But it literally collapsed after the breakup of the USSR with its gross domestic products, or GDP, falling almost 50% in early 1990s to less than 10% of Japan. Today, Russian economy is only about 1/3 of China's in size. Had the Soviet growth been real?

A friend of mine used to visit Russia often after Gorbachev's perestroika. He always noticed a big sign hanging in front of the TV screen in his hotel room. Paying no attention, he would remove the sign before turning on the TV to watch it. One day, by chance, he read in an English paper that the biggest cause of fire in Moscow was televisions. Puzzled and somewhat alarmed, he took a Russian friend to check out the sign. It read: `Please keep a safe distance while watching as this TV set may explode at any time!'

Now the Soviets bought exploding televisions because they did not have any better choice. Imagine Soviet factories churning out increasing number of exploding televisions year after year. That was real production and real growth. In fact, thousands of Soviet factories produced increasing quantities of all kinds of shoddy products. They also exported many of their products including such large items as automobiles and aircraft to Eastern European countries and China. The Soviet economy was real and so was its growth.

But when foreign goods invaded after the Soviet break-up, the demand for Russian made products dropped precipitously. Why would a Russian consumer still wish to buy an exploding television if he could buy a cheaper Sony? Without demand, much of the productive assets became worthless overnight. The economic power of the former Soviet Union just evaporated like a puff of smoke as its doors opened.

In retrospect, the Soviet economy itself was simultaneously real and unreal. It was real when closed but turned unreal when foreign competition came in.

Closing doors, however, was a necessary but not sufficient condition to achieve high growth of an inefficient economy. North Korea is as closed as it gets, but it starves its people. The Soviet Union had the advantage of a high savings rate which was another necessary condition.

Paul Krugman caused a controversy in 1994 with his observation that the growth of Singapore economy could be explained by increases in measured inputs, particularly the supply of educated labor and capital, but not by productivity increases. The difference from the Soviet model is that Singapore `has already been fairly efficient.'

China enjoys the similar favorable condition of a high household savings rate, at more than 40%, one of the highest in the world. But unlike the former Soviet Union, China has become a relatively open economy with foreign products ubiquitous throughout the country. Products `made in China' are also found in every department store in the west. Trade now represents more than 40% of China's GDP, a ratio larger than that for Japan. One of the necessary conditions for the Soviet growth, autarky, does not apply to China.

One part of China's economy, however, remains closed. That is capital control. Chinese citizens can buy foreign products and services, but they cannot convert their money into foreign currencies for the purpose of investing abroad. Does that make any difference?

This question may be best answered through a simple model. Consider an economy with only three players: a firm, a bank and a worker. It is an open economy which exports all it produces and imports all it consumes. Its currency is freely convertible under the current account, or the account of trade and services, but its citizens are not permitted to invest their capital abroad.

In the first period, the firm invests $10 in production facilities, which it borrows from the bank. It receives an order for 100 units of some widgets and is paid in advance for $90, or 90 cents each. The firm pays the worker $1 for each hour worked and it takes the worker an hour to make a widget. So labor costs the firm $100 for the entire job. The firm organizes production and makes delivery to order. Not counting capital expenditure, it makes a loss of $10 in this period.

The worker saves $40 of his $100 earnings and spends the rest on imported stuff.

The bank begins with $10 in equity and $10 in assets consisting of the loan to the firm. But by accepting the $40 savings deposit from the worker, its balance sheet shows assets and liabilities of $50 each at the end of the first period with $40 in cash.

In the second period, the firm receives a larger order, for 200 units of widgets. It increases production capacity with a capital expenditure of $15, $5 more than required to meet the current demand, as it wishes to build more capacity for the future. But the price has fallen so it will be paid 85 cents for each unit produced or $170 in total. It only needs to pay $190 for labor, because there is productivity gain so that it now takes only 0.95 of an hour to make a widget. The firm needs $205 to organize production, requiring financing for the difference of $35. The bank lends the firm $35 and ends up with a period-end balance sheet of $126 including $76 deposit by the worker as he continues to save 40% of his earnings.

Notice that this is an inefficient economy: the firm loses $10 in the first period and $20 in the second, or $30 cumulative loss over two periods, not counting capital expenditure. Yet, the firm can count on the bank to continue to provide lending. This inefficient economy has achieved remarkable growth: At the end of the second period, production capacity is up 150%, GDP 100%, personal income 90%, bank assets 152%, and savings 90%. Personal wealth has reached $116. There is a productivity gain of 5%. In addition, external trade rises sharply and it enjoys a healthy trade surplus which swells its exchange reserves. More complexity can be added to the model without changing the basic results. Allowing the bank to pay and charge interests will simply mean that the firm makes bigger losses, the bank makes bigger loans and labor accumulates his savings a bit faster. Creating a government which collects taxes and spends its revenue on either investing in the firm directly or through injecting capital into the bank makes no difference to economic growth except that part of the personal savings of our worker cum taxpayer becomes `public wealth.' The government will even be able to run a budget deficit and inject more money into the economy than it receives from taxation, further boosting growth. Now substitute the firm, the bank and the worker for unprofitable state-owned firms, state-owned banks and the labor-force, you are staring at an economy a lot like China's.

The moral of this story is that it is plausible for an inefficient economy to achieve real growth. There are two necessary conditions. The first is high savings rate, which is a natural condition. The second is capital control, which is an artificial condition. Suppose our worker for some reason stops saving, the growth will stop when the bank runs out of excess cash to loan to the firm. The growth will also stop if savings are allowed to flow out of the country in search of better returns associated with more efficient economies.

Removal of capital control will thus create a `financial crisis.' The bank cannot hope to collect its loans from the firm to pay back the depositor because the firm has only made losses. Without another source of capital, the bankruptcy of each of the bank and the firm will bring down the other. To keep itself going, this country will have to go, well, perhaps to International Monetary Fund, or IMF, for help.

This, essentially, was what happened to Korea in 1997-98. After two decades of non-stop economic growth driven, to a large extent, by relentless and unprofitable capacity expansion fueled by cheap lending of Korean banks, it seemed that the Korea's success was real enough and fail-proof. Korea removed capital control in mid-1990s. The failure of Korean banks to further lend and to collect their loans in the wake of capital flight bankrupted many among them as well as their chaebol customers. IMF came to the rescue with a condition that Korea restructures its banks. Eventually, Korea spent $130 billion, or more than 1/3 of its GDP, to clean up its banking system alone. To this day, the Koreans call the debacle `IMF Crisis,' as if IMF was to blame for it.

For Korea, the wealth destruction, in terms of write-offs of bad loans, equity lost in bankruptcies and capital injected for bailouts, wiped off years of economic growth. What had been real growth came unraveling and its citizens ultimately paid the costs.

In general, an inefficient economy produces lower average returns on capital in real terms than a more efficient one if capital is not allowed to flow freely. This can be seen in persistent price differentials in the stock prices of the Chinese companies whose shares are simultaneously traded in the Chinese and overseas markets. For example, the price for domestically listed Jiangsu Expressway is almost 3 times as expensive as the same stock traded on Hong Kong Stock Exchange. The average price differential of all dual-listed Chinese companies is about 2 to 1. In other words, the average return on capital in China for the same risks is about half of that outside of China.

China is probably unique in the world today by possessing both of the necessary conditions for an inefficient economy to achieve fast growth. But these conditions also make China's growth simultaneously real and unreal.

It is real because with capital control, the high savings rate of China translates into high investment rate, through banks, propelling relentless capacity expansion, particularly by the state-owned sector. Such investments produce rapid and verifiable growth in asset formation, personal income, savings and exports, along with and proportional to the increase in the size of the economy, although, critically, Chinese firms need not to be profitable.

It is also unreal. The misallocation causes great waste in scarce resources. For example, the Chinese state-owned sector only contributes to less than 30% of China's industrial output but accounts for more than half of the country's fixed asset investments. The price for such inefficient growth is paid in the accumulation of bad loans in Chinese banks. Standard & Poor's, an international credit rating agency, estimates that it will cost some $518 billion, or more than 40% of China's GDP, to clean up China's banking system. These costs plus the equity write-off of those companies which will go bankrupt without continued funding from banks translate into years of negative growth. China's growth therefore can be regarded as borrowed at very high costs which will need to be paid sooner or later.

In fact, the concept of `borrowed growth' explains almost all observed Chinese data inconsistencies except man-made ones. For example, if one builds a new factory but leaves it idle, GDP goes up but energy consumption does not.

Suppose China lifts capital control and allows RMB to become freely convertible. It will likely trigger a capital outflow. That will endanger state-owned banks as well as those highly leveraged but unprofitable state-owned companies. Even if the government bails them out, banks will no longer be able to finance unprofitable firms. Not only will the wings of China's growth be clipped, it will not fly again until both banks and firms are made truly competitive on their own.

Can capital control sustain China's `borrowed growth?' The answer is no because the other necessary condition, high savings rate, will likely decline as the population ages in about ten years time, if not sooner, for two reasons.

First, Chinese baby boomers, born after the Korean War in 1950-60s, will begin to retire. The much tighter birth control policy after the baby-boomer years ensures that the ratio of the number of workers supporting pensioners will drop off a cliff then. As China's pension system is substantially under-funded, the aging of the population will mean less saving but more withdrawals.

Second, the Chinese are culturally much more frugal than, say, the Americans, due to historical uncertainty and volatility of their livelihood. But this culture is changing. The younger generation consumes more, saves less and has even learned to consume on borrowed money. No country can sustain household savings rate of more than 40% and China will not be an exception.

Capital control is, ultimately, very costly as it distorts efficient resource allocation. The cost of cleaning up the banking system will have to be borne by citizens sooner or later. The longer such distortion is allowed to continue, the more costly it will be in the future.

Furthermore, China has joined the World Trade Organization or WTO. Under the WTO framework, China has committed itself to letting foreign banks in to conduct local currency business without restrictions beginning from 2007, or in just about three years. Foreign banks are unlikely to fund inefficient producers. Unless China's own banks adopt sound banking practices, it will become difficult for them to compete for deposit money. Therefore, the game will be over for inefficient producers.

Finally, China has committed itself to the full convertibility of the RMB without which many of China's economic ambitions will not be realized. For example, Shanghai has long aspired to be an international financial center. But it will not be such until China allows free flow of capital across borders, a prerequisite for any international financial center.

If so, does it mean that the Chinese economy will eventually collapse, when the payback time inevitably comes for the `borrowed growth?' Yes, if China's economic policies continue to favor, protect and subsidize inefficient firms through its already weak banking system. It will just be a matter of time.

There are reasons to be cautiously optimistic, though. To be sure, the Chinese economy is not well, contrary to popular perception, and it requires urgent treatment including major surgeries. However, anyone who considers the Chinese economy to be terminally ill might as well call it a walking dead, since he would have certified it dead 25 years ago when it was in infinitely worse shape. It is anything but. It has changed almost beyond recognition in the intervening years. It used to be a closed, Soviet style command economy not even quite capable of producing exploding televisions, but it now competes with Sony in America. The Chinese economy is more viable and dynamic today than at any time in its history. After all, China is full of surprises, as we all know.

In the past two decades, the successive Chinese leaderships have not just thrown stimulus measures at the economy to maintain growth; they have also pushed for reforms. As a result, the Chinese economy is far more efficient, especially on the production side if not as much on the side of resource allocation, than when reforms first began in 1978. As recently as 1991, a US manufacturing worker was 40 times more productive than his Chinese counterpart. By 2000, that gap was narrowed to only 10 times. Chinese labor productivity has increased by 4 folds in the past decade. Whereas it was a centrally planned economy dominated by the state-owned sector, it is basically a market economy, although still troubled by legacies of the past.

By comparison, China's achievement in `structural reforms' puts Japan to shame. By absolute amount, Japanese banks have more bad loans than anyone else in the world. On top of it, Japan's domestic savings have fallen by 23% per year for the past five years alone, to a household savings rate of only 3%. Capital outflow has made Japan the largest creditor country in the world by far. Without the ability to retain capital, all the massive stimuli have failed to return Japan to the path of growth. Koizumi won the election by promising structural reforms, which, as even a school child in Japan knows, is the only way out for the economy. Yet, Japan's continued failure to take tough actions has frustrated the world and its own revival.

True reforms are painful. The benefit is for the future but the pain, especially using taxpayers' money to clean up banks, is immediate. This is not exactly the kind of risk-reward profile politicians look for, except in public speeches. A leadership must have the vision and, more crucially, the resolve to pursue it in the face of guaranteed political opposition. In this regard, China has proven to be more determined and decisive than, say, Japan. The question only is whether it has the will and wherewithal to go all the way.

It does seem that the Chinese reforms have picked up pace, with the decision by the top leadership at the last-year's Communist Party congress to privatize the vast majority of state-owned firms, to shut down the hopeless ones and to clean up banks. It remains to be seen if China will succeed in all of these.

Reform of the banking sector is the most fundamental of all reforms. Without sound banking practice, banks will continue to create bad loans and breed inefficient corporate customers, state-owned or private. A weak banking sector produces inefficiencies in private economies as well, as evidenced by other Asian economies. It come as no surprise that most of China's private companies are poorly run, in addition to being subscale and speculative. In fact, more than 70% of all bank loans made to small and mid-size companies eventually become bad. Most of bank scandals in China involve unscrupulous private entrepreneurs. As a result, banks are reluctant to lend to private firms as they tighten credit approvals. Lending on the basis of credit quality is the ultimate way to improve corporate efficiency as companies will be forced to focus on cash-flow in order to access bank capital.

Realizing that the WTO clock is ticking, Chinese policy makers have turned their attention to cleaning up banks. A number of important measures have been taken. A large amount of non-performing loans have been transferred to several government financed asset management companies, which have successfully sold first batches to foreign buyers of distressed debts. Banks are ordered to have their books audited by international auditors and to reveal as well as to reduce bad loan numbers.

However, much, much more needs to be done. All Chinese banks are woefully under-capitalized and to recapitalize them will stretch government finances. While it is possible for banks to reduce bad loan ratios by quickly growing its loan book, or the denominator of the ratio, the challenge is how to prevent new loans from turning bad as they near maturity. To do so, banks must build a credit culture to lend on the basis of cash-flow as opposed to collaterals, relationships or policy guidance. This is a lot harder to do than adopting risk control procedures of best international banks, as it requires training and proper incentive systems. But all will fail if the government continues to interfere in lending and personnel decisions because of perceived political and policy necessities. There is so far no sign that the government is prepared to relinquish those powers.

Chinese banks have been poorly regulated. Not only there exists the incestuous relationship between banks and firms under state ownership, owners of a few joint stock banks habitually borrow more loans from their banks than the capital they put in. Some of these loans sour as well. Such conflict of interests creates moral hazard and puts banks at risk. Many private businesses clamor loudly for the right to set up more private banks. But without proper regulation prohibiting self-dealing, private banks are in danger of becoming private coffers of their owners, which is the reason why America's Bank Holding Company Act prohibits non-financial companies from owning banks and vice versa.

The good news is that banking regulation is expected to tighten and substantially improve, with the establishment of the new banking regulatory commission. Both the central banker, Zhou Xiaochuan, and the top banking regulator, Liu Mingkang, are tough-minded banker-turned-regulators of impeccable integrity with intimate knowledge of international best practices in banking and regulation. They are world-class regulators to get the job done.

The challenge to Chinese banks is to find good credits to lend to. There has been an explosive growth in retail lending. Although there are more bad credits than good ones among domestic firms, China is blessed with a large `foreign funded' sector which operates side by side with the inefficient state-owned ones and have already transformed China into a dual economy. China has brought in $400-$500 billion cumulative foreign direct investment in the past 10 years, more than the rest of Asia combined. Foreign firms are responsible for 65% of China's three-fold increase in exports in ten years. Most foreign funded firms are well run and competitive, and would make good credits.

But most of them will tell you that China is a very tough market. In the two decades before 1997 Asia crisis, well-capitalized American and European firms had gone through a process of downsizing and `core-competence' building to have improved their competitive edge. Ironically, it was precisely during this period of time they collectively lost significant market share to highly-leveraged and over-diversified Korean chaebol and Japanese keretsu whose competitiveness was largely derived from access to cheap financing by their home banks. Similarly in China, bad banking practices will continue to breed incompetence and inefficiency, which crowd out good credits, at the expense of both the banks and the economy. To date, few foreign firms compete successfully in China's domestic market and most only manufacture in China for exports.

There are however signs that this distortion is in the process of being corrected. As the pressure to reduce bad loans intensifies and regulation tightens, Chinese banks have begun to favor foreign firms, which report a surge in lending by Chinese banks to them in the first half of this year. The leveling of the playing field in bank lending will go a long way to address the distortion in resource allocation in the economy. In conclusion, if the Chinese economy looks surreal, it is. In a way, China is like a world champion on performance-enhancing steroids, financed by banks wasting household savings. This, at the expense of long-term health, cannot last. Only by freeing itself from bad habits will China really be able to grow healthy and compete like everyone else without the aid of the crutches of capital control. The process to get there is not without pain, to be sure. But the sooner it does it, the better it is for its future, as the heavy costs of a `borrowed growth' compound by the day. Weijian Shan is a partner of Newbridge Capital, a private equity firm.
- posted by JaneAthos @ 5/07/2004 02:43:00 PM 0 comments

 
Borrowing Growth From Chinese Banks -- Will They Be Repaid?

China's growth model is not sustainable, Newbridge's Weijian Shan tells 1600 delegates at CSFB conference.

It was a luncheon speech that must have put some of the delegates at CSFB's Asian Investment Conference off their food. Newbridge Capital's co-managing partner, Weijian Shan delivered an incisive and brilliant speech (without notes) on China's current growth model and why it must change, or else fail.

Here we reprint the speech in full:

I am talking today about a subject that has caught the imagination of almost every investor in the world, and that is China. China has produced the most spectacular growth in the past 25 years - in fact, no country in the world has ever been able to grow as fast for such a sustained period in world history.

In the past 25 years the average growth rate - in real terms - was about 9% per annum. The question is, in this fast growing economy, how much return would you have made from investing in arguably the best Chinese companies?

These companies first came to Hong Kong to list in 1993, and if you invested in the Chinese enterprises index then you would, 10 years later - have lost about one third of your capital. Indeed, throughout that period you were underwater more than not. If you had held till today - that is if your investors had not fired you by now - the return would be 24%. During the same period of time the US economy grew about 3% per annum and if you had invested in the Dow Jones you would have made a return of about 188%. The Hang Seng index would have given you a return of 84.7%.

So what is going on? Why has the fast economic growth rate not translated into a high return for investors?

I recently read a report talking about bad loans. It said that Japan was number one in absolute terms. But in terms of the bad loan ratio, China was the worst. S&P estimates about 45-50% of Chinese loans are bad. What does that mean? I believe NPLs are a very good measure of the inefficiency in the economic system. It captures both types of inefficiency: productive and allocative.

There you have a paradox. China is the most inefficient economy producing the fastest growth rate the world has ever seen. How can this be? How can an inefficient economy continue to grow like this?

History shows there are examples of economies which are inefficient and are still able to produce rapid economic growth rates. The Soviet Union produced very rapid economic growth in the 1950s and 1960s. Was Soviet growth real? After its collapse, the Russian economy shrank very rapidly, until it was only 10% of the size of Japan. I would argue, however, that the Soviet economic growth rate was real. There was a real economy.

If you had visited Moscow before the fall of communism you might have been interested to discover that the principal cause of fires in the city was exploding television sets. In Moscow hotels the television would have a sign covering the screen which said "Please keep a safe distance from the television because it may explode at any time".

Why were they making exploding televisions? It turned out that there were TV producers who were only producing exploding televisions. Obviously there was demand, and year after year the factories just turned out more exploding televisions. There was real supply and real demand. Everything was real until after 1990, when Sony came in. Why would you then buy an exploding television? All those manufacturers producing shoddy products became worthless overnight. That's why the Soviet economy shrank. But it was there.

Yet why did it grow for such a long period of time? There were two necessary conditions for such an inefficient economy to grow so rapidly. One was a high savings rate, much of which was forced. The other was a closed economy. Without competition, consumers have to buy whatever is available.

Of course, I am not suggesting that China is a closed economy. In fact, trade now represents about 60% of Chinese GDP, which is far greater than that of the US or Japan. So China now depends more on international trade than America or Japan. China is an open economy as far as the trade account is concerned.

So what are the necessary conditions for allowing the Chinese economy to grow at such a rapid pace? The first condition is a high savings rate - which at 42% is among the very highest in the world. Such savings are translated into investment, which pushes the economy forward. The second condition is capital controls.

If you look at data that shows the price differentials of those Chinese companies that are listed both in Hong Kong and Shanghai, you note that the price in China is twice as much - for the same stock! That means the return on capital in China is about half that in Hong Kong. A rational investor would bring money to Hong Kong to buy the stocks there. It follows that without capital controls money will flow out of China. With capital controls, the banks are able to channel all this capital into investments - which in turn is responsible for economic growth.

Now, the question is: what is the catch? The catch is that if the economic system is inefficient, much of the investment may be wasted or become NPLs in the banking system. And therefore you will find that the cost of Chinese growth is the NPLs in the banking system, which the country has to pay for sooner or later.

That's why I call Chinese growth, borrowed growth. Chinese economic growth is not demand-driven but supply-pulled. It is driven by capacity expansion which is financed by bank loans which came from the high savings rate. Last year the money supply went up 20%. Local currency loans went up 21%. Foreign currency loans went up 27%. Fixed asset investment, or capital formation, went up 27%. And all this investment produced economic growth of 9.1%, with industrial output up 17%.

That's just the average. The growth is much more spectacular by sectors. If you look at personal computer production, it grew by 83.2%, sedan car sales by 80.7% and air-conditioning units by 47.4%. The growth in such areas is truly explosive.

This is all driven by large amounts of investment in these industries. I would argue that most of the impetus for the money supply increase came from outside China, due to the inflow of foreign capital. The central bank is obligated to buy dollars or whatever currency and convert them into the local currency. So every dollar that comes into China translates into an increase in the money supply of Rmb8.3.

The increase in fixed asset investment last year was 27%. I saw data for the first two months of 2004, that it was up 53%. That is hot.

What does that imply for an investor? There is a debate as to whether the Chinese economy is overheating. Usually overheating is accompanied by inflation. But last year the CPI rate was 1.2%. In January it rose to 3.2%, but then in February it came down to 2.1%. So it seems that inflation is not a serious threat.

But China is an economy of such diversity. The average doesn't really tell you anything. My analogy is that if a person has one foot in a fire and one foot in ice, before you know it he is dead, but his average body temperature looks normal.

That's what you see in China today. I call it bi-flation. There is both inflation and deflation in the market. If you look at the prices of raw materials and intermediate goods they all went up in price substantially last year. We're talking about 30%.

At the same time, investment has created so much overcapacity in the system that prices for finished products have become depressed. Therefore you see the price for durable goods come down 4.6%, for telecoms equipment and electronics 6.5% and for cars 10%. And the trend is continuing.

What does this do to your business? On the one hand the price for all your materials goes up 30%, on the other hand the price for your finished products have come down 10%. Your margin is severely squeezed.

And you have borrowed from banks to make all this investment. Now, without the cashflow, you are becoming more dependent on banks, just as your ability to service those debts has diminished. This increases the risk of adding to the stock of NPLs in the system.

NPLs are thus the cost of economic growth in China. And also, by bidding up commodity prices, China is paying a higher price for its raw materials from abroad, while Chinese companies are selling their products at a lower price worldwide. So China buys dear, and sells cheap. Thus China's terms of trade have significantly worsened in the past year or two. That means China is really subsidising the rest of the world.

You may be asking me what is Newbridge doing in a country like this? I do believe there are places that can make money, where overcapacity and over-competition will not harm your profits. If you are careful enough there are still a lot of good investment opportunities.

For example, between 1949 and 1996 it took China 47 years to reach a production capacity of 100 million tonnes of steel from 50,000 tonnes in 1949. The next 100 million tonnes were added in six years, and by the end of the year China will reach 300 million tonnes.

That's very rapid growth. Why would you invest in the steel industry in China? But look at Baosteel - it supplies 60% of China's steel plates for cars. With that kind of technology and market share, you know that company cannot be easily imitated.

Another example is milk. The consumption of milk has been growing at more than 100% for the past three years. The supply of milk has increased so much that the margins have become very thin. But to my knowledge there is only one company making the paper cartons for milk. This particular company is doing extremely well.

There are 47 mobile handset makers in China. They don't make money. But China Mobile does.

So there are pockets of opportunity in China for foreign investors. But you need to be careful.

The question is: can the current pace of economic growth in China be sustained, given all the problems? I don't think that this type of growth is sustainable, if nothing is done, particularly in regard to the banking sector.

In 2007, China will have to open the banking sector to foreign banks. By that time, depositors will have a choice. The foreign bank is not likely to loan their money without regard to cashflows. Regardless of the savings rate a lot of money will be diverted away from all these capacity expansion projects. And therefore this type of growth cannot be sustained.

And in five or six years China has said it will make the capital account convertible. Then you will see an outflow. You will not be able to capture all of the capital for capacity expansion purposes.

In the longer term, the Chinese population will age precipitously and in the next 10 years money will be withdrawn from the banking system by those retiring. That's because the social pension system is underfunded. Therefore sooner or later, this type of growth will not be sustained.

Fortunately the Chinese leaders have the wisdom to tackle the problems. I was pleased to hear Wen Jiaobao say that this year China faces a bigger challenge than SARS, when he talked about the need to readdress macro-economic policies.

The government has taken measures to clean up the banking system. That will put Chinese growth on a much sounder footing and is welcome news for investors.

- posted by JaneAthos @ 5/07/2004 11:32:00 AM 0 comments