Yesterday once more

Fat Dragon is of course referring to the latest sturm and drang from the monetary authorities in Beijing about high-speed growth, and how they are determined to slow it down to a more sustainable level.

Those of us with short memories will remember we went through a similar monetary moral panic in 2004, when the government slammed on the brakes following an explosive expansion in investment, with year-on-year increases of over 40%.

Before the May Day break that year (an authentic communist holiday), the government delivered some "window guidance" to the banks, a polite way of saying they pulled them into a small room and yelled at them until they got the message, which was to slow down lending.

Things did indeed slow a little as a result. But Fat Dragon thinks it might be a little harder this time around. And he also suspects, as this column has suggested before, that the government doesn't want to slow too much anyway.

Don't trust Fat Dragon on this. Premier Wen Jiabao himself said a few months ago that the aim was to tap the brakes a little rather than slamming the vehicle to a halt.

There is a good reason for that. The single most important issue for Chinese leaders is the labor market – creating enough jobs to absorb new entrants and state enterprise cast-offs, which each year amounts to about 15-20 million people. Only high-speed growth can accomplish such a goal.

But the really interesting question for Fat Dragon is: how effective are the brakes anyway? Since 2004, China has executed a stunning reform of the big state banks, which have traditionally been responsible for about 60% of lending. Sure, the reform has not fixed the banks, but who would have thought three years ago that two of the large lenders could now be successfully listed overseas.

Bank reform has resulted in two conflicting impulses. On the one hand, they are under pressure to lend more to make sure they are earning profits for foreign shareholders. On the other, they should be operating more prudently, assessing credit more effectively and therefore lending less.

So far, it would seem, the first impulse is winning. China Construction Bank, for example, lent more in the first quarter of this year than for all of 2005.

The banks have always been considered the heart and soul of the Chinese economy and their lending practices the main driver of the investment that in turn powers business expansion. Investment is responsible for about 40% of China's GDP.

But this is only part of the picture. Banks only provide about 20-30% of investment funds. More than half, according to recent ground-breaking research by the World Bank, comes from retained profits, reinvested by both big state enterprises and private firms.

Their investments may not always be smart, but they are rational. If they left their money in the banks, for example, with low interest rates and an extra tax on the earnings from deposits, they would in fact be losing money.

Once you factor this into your equations about the Chinese economy, and few so far have, there are some important implications for the growth story.

For starters, high-speed growth is much more sustainable than many seem to realize. With retained earnings playing such a central role in the investment story, jawboning the banks to rein in lending will have a limited impact, unless accompanied by interest rate and currency policy refom.

Also important is another reform battle taking place outside of the day-to-day limelight, the need for state enterprises to pay dividends. It is no wonder the likes of China Mobile have so much spare cash: if they were forced to pay dividends to their main shareholder, the government, they would have less money to invest.

The big issue, however, is interest rates and the currency, and on that issue there is deadlock at present. So the economy will continue to grow fast for the moment, maybe too fast, no matter what Beijing says.