Dilemmas of interest

It was from an essay written in 1994 and published in an obscure academic foreign affairs journal. The last time China's economy faced a crisis it was hardly noticed by the rest of the world and only then in a narrow Asian context.

This time around, the overheating or bubble or whatever you want to call it (Premier Wen Jiabao and the People's Bank of China have used both terms) is bringing sleepless nights to many more than just the economic tsars in Beijing. From the trading floors of global commodity exchanges to the multinational boardrooms, everyone wants to know what will happen next in the economy the UN Trade and Development Organization named as this year's most attractive investment destination.

So what exactly is the problem facing the people who hold the purse strings? The problem is growth – too much of it, too fast, paid for with too much cheap money.

Inflation is at a seven year high and still climbing; transport, water and electricity infrastructure is being pushed to its limits and beyond; spending on fixed asset investment – housing, factories and other property – grew an unsustainable 43% in Q1 2004 versus the same period in 2003, and banks keep lending indiscriminately even though many new loans are as likely to go bad as the old ones did. The government knows it has to do something to slow things down if the country is to avoid a "hard landing". But it is walking an economic tightrope. China needs high growth just to stand still, and if austerity measures go too far, they could contribute to realizing the hard landing they are meant to forestall.

The application of austerity measures could push more marginal companies, particularly state enterprises, into effective bankruptcy, creating a whole new generation of bad loans. Many of the bad debts the banks currently hold resulted from the belt-tightening campaign of the mid-1990s when draconian measures were taken to cool the economy and reign in rampant inflation.

"We should reduce the speed but not have a sudden slowing," Chinese Premier Wen Jiabao said. "The most important thing is that we have to control the two valves: one is credit; the other is land." So far, the government has raised the amount of money that banks must hold in reserve three times since last August. It has repeatedly signaled to banks that they should grant fewer new loans, and has introduced regulations to slow industries identified as the worst overheating offenders – cement, property, aluminum, steel and automobiles.

At one point commodity prices tumbled on world markets when China's Banking Regulatory Commission was reported to have outright forbade banks from lending in the run up to the May public holiday. Denials followed but many economists saw it as an indication of high-level debate raging in the government.

Since the middle of last year the government has been pointing to various macroeconomic figures as indications of success. But as each month goes by, even official statistics have shown that more needs to be done. The GDP growth rate, admittedly skewed by last year's SARS scare, was expected to hit a year-on-year 11.4% in the second quarter following a 9.8% jump in the first quarter.

The question that many Western economic observers have been asking is why the government hasn't raised interest rates to slow the flow of cheap money. The current one-year interest rate, which has not gone up since 1995, is 5.31% in an economy growing at an official rate of about 10%. The government seems to view a rate hike as a last resort, saying it will raise rates only if inflation reaches 5%. It may already be there. The official consumer price index (CPI) figure for May was 4.4% but Andy Xie, Morgan Stanley's China economist, has said he believes first quarter inflation was probably closer to 7 or 8%.

The government's reluctance to touch interest rates stems partly from the fact that no one can be sure of the impact it might have. A large disparity between China's interest rates and the rest of the world's could lure more hot money into the country, placing pressure on China's RMB to appreciate and requiring the government to inject more money to relieve that pressure. State-owned enterprises still receive the lion's share of loans and their profit margins would be hurt by higher borrowing costs. Higher rates could also depress consumer spending, exacerbating problems of oversupply while having little immediate effect on the problems facing China's infrastructure.

Despite these potential negatives, the government is running out of options. With inflation creeping up and no change to official interest rates, there has actually been a fall in real interest rates over the last two quarters which further fuels the investment boom.

The administrative measures the government has so far been relying on are much less effective than they were during the last "landing" in the mid-1990s, mainly because of the rapid decentralization of the former command economy. Regional and provincial governments now have a much greater say over their own economic policies and there is even a proverb about Beijing's inability to control the provinces: "The mightiest dragon cannot crush a local snake." With pressure mounting, many experts expect an initial interest rate rise of about 50 basis points (bringing the one-year rate to around 5.8%) within the next few months.

French bank BNP Paribas recently came out with a report that downplayed the effect a slowdown on the mainland would have on the rest of the world, saying that its role in the global market had been greatly exaggerated.

There is probably some truth to that as China still only makes up about 4% of the world economy. But that is double what it was 10 years ago and the country has contributed an estimated quarter to a third of the growth in world trade in recent years. Without the growth machine of China humming along, the rest of Asia, and to a lesser extent the world, would definitely feel the pinch.

It is safe to say that nobody envies the central government their job at the moment, but it is worth remembering that the technocrats in Beijing this time round are much more capable and experienced than their counterparts a decade ago. Compared with the mid-1990s bubble, inflation is still in its early stages and many industries are not overheating yet.

The most likely scenario is still that the government will keep things under control and the economy will settle down, perhaps after a short hiccup, to a modest (by China's incredible standards) 7% GDP growth rate that allows enough jobs to be created and everyone to just get on with the business of getting richer.