In a train wreck, there comes the moment when it's no longer possible to avert disaster. Pull the brakes as hard as you can, the momentum of the train is so great that disaster is unavoidable.I fear that China's economy passed that point of no return in the second quarter of 2006. Today, I'm going to tell you why I think China's economy is headed for a train wreck. Not tomorrow, but in the reasonably near future. I'd say 2009. If you've been following the debate in the U.S. about the likelihood that cheap money here has produced a bubble in housing prices, you're already familiar with the basic scenario for a train wreck in China. Cheap money makes it easy to borrow to buy assets. That produces an asset bubble -- in the U.S., first in stocks and then in real estate. As the asset bubble grows, borrowers get in over their heads as their judgment is overwhelmed by the excitement of rising prices. And lenders under the influence of similar emotions make loans to unqualified borrowers. When the asset bubble starts to deflate, overextended borrowers default on their loans, putting pressure on lenders, who respond by tightening their lending standards, reducing the amount of money available to all borrowers. That sends the economy into a slowdown or worse.
Borrowing to GrowChina adds a few wrinkles of its own to that scenario. Since the Chinese economy is still very bad at allocating capital, corporate borrowing to build new plants itself becomes part of the asset bubble. I'll start my sketch of China's coming train wreck with the problems in that sector. In the second quarter, China's gross domestic product grew by an extraordinary 11.3%. That's a significant acceleration from 9.9% growth in 2005, 10.1% growth in 2004 and 10% growth in 2003.
- First, by adding new, modern capacity, smaller and less-efficient producers can avoid the government regulations that would force them to shut.
- Second, local officials have big incentives to keep mills open, even if they're losing money: Officials are judged on metrics such as local job growth, and they often have a financial stake in local companies.
- Third, money is cheap in China. How cheap? The People's Bank of China recently raised its benchmark one-year rate to just under 6%. But with inflation at the wholesale level running at about 2.4%, that leaves the real cost of a one-year loan at about 3.5%.