The words "overheated", "sizzling" and “red hot” have been used so many times recently to describe China's economy that you would think economists have developed a peculiar new penchant for TV cooking shows. These harsh warnings about future economic gloom in the country of 9% growth rates started as whispers in academic journals, were then pushed to newsprint by the media and are now being bellowed by politicians in the form of global conference agendas and altered foreign policies. For a while Chinese authorities played deaf, relying on the unprecedented wealth pouring into their country as the decidedly universal solution to all future problems. Now, awakened by the realization that the gluttonous inflow could not only have an end but a devastating backwash of recession and job loss, they're starting to sweat.

Determined to retreat before it's too late, the controllers of the state-run economy are trying desperately to cool things down before the market forces attack. Trouble is, the Chinese can't seem to figure out how to smother the economy’s flames.

To better understand this dilemma, we first need to answer the question, “What does it mean for an economy to overheat?”.

The meaning of this term can certainly vary depending on the context, but in general an economy that is overheating is growing so fast that its production capacity is being maxed out and spurring a risk of inflation. In China's case, overheating also has significant meaning within the banking industry. The country has long been plagued by mismanagement of risk. Banks lend money to borrowers who are insolvent at interest rates that are way too low to compensate for the risk of nonpayment. This is due in part to the lack of quality information that would allow let lenders to differentiate among borrowers of better and worse standing. More problematic, however, is the cushion the lenders think that they have when making loans. For so long banks were state owned and loans were implicitly backed by the government. As it was widely known that the government would be very averse to bank failures, loans were made with more ease and less consequences.

Today, even though the banking sector has progressed in the direction of the market economy with the loosening of state controls and the entrance of foreign competitors, it still has a long way to go. Basic education on how to manage risk is still lacking and practices of corruption and misinformed decision making still need reform. A combination of recent capital injections made by the government and the Chinese populations’ extraordinary savings rate have made the banks awash in liquidity, which is encouraging them to be even more careless with their investments.

It is everyone's fear that one too many bad loans will be signed and investors who have been fueling the dramatic growth will soon peer into the hollow shell of their worth and flee. Memories of the 1997-98 Asian financial crisis are far too prominent in investors’ minds for them not to be cautious about China.

So given the risk of inflation and financial meltdown, what is the solution?

One scenario is just to let things roll without interfering. This would entail letting the banks overextend themselves to the point of failure and producers push themselves to the point of widespread inflation, and then hoping that market forces would make the corrections necessary for growth to start occurring at a more sustainable pace thereafter. Of course the “correction” period would result in a high loss of jobs as construction projects stall due to loss of funding and factories tighten shifts. Not to mention the problem of having nowhere to put the 10.3 million newcomers to the Chinese workforce who are added each year from population growth alone.

Understandably, the Chinese authorities view this solution as political suicide. Given that the country’s economy is still centrally managed, the government is taking advantage of the tools it has to try to directly control the growth itself. The problem is that the country is using the wrong tools.

Take the coal industry as an example. China is beautifully rich in this resource, with its reserves surpassed only by the United States and Russia. Eyeing regulation of coal production as a way to put a stop to growth, Chinese authorities have required that mines be formally authorized and obtain approval prior to operating. However, the industry is boldly disobeying these orders and thousands of unauthorized coal mines are popping up all over the country. Coal mine operators view the profit opportunities too great to pass up. In the Mongolian province, which is very rich in coal, illegal coal mines have helped its economy grow by roughly 20% each of the past two years. In addition, rolling blackouts due to power shortages in 2003 and 2004 encouraged local authorities to build plants illegally to keep their economies from faltering.

Even the government’s own previous mandates are working against them now. In recent years the Chinese government placed controls on energy prices to (guess what) encourage growth. These low prices are so deeply embedded into China's systems that its economy virtually depends on inefficiencies and waste of resources to keep functioning.

China's landmass is too large and the coal mines too numerous for the state authorities to monitor everything. And it certainly doesn't help that over 4,500 government officials were identified as owning illegal stakes in coal mines last year.

Another area that the authorities have tried to regulate is the auto sector. Production of passenger cars has increased dramatically within China, and the country is now the world's largest vehicle market by unit sales after the United States. This was driven in part by years of government promotion when the industry was seen as a critical driver of growth and industrialization. Local governments are still trying to offer deals and incentives for plants to be built in their provinces. Meanwhile, the national authorities think that the cutthroat price competition that is occurring in the industry will soon discourage the entrance of large manufacturers that will be able to compete in the long term with the technological superiority and brand awareness of the US, Japanese and European manufacturers. In response to this fear, new pronouncements released this week require that a company must either achieve capacity utilization of 80% or produce a certain quota of vehicles before it can build a new plant.

It is obvious that the beast has gotten too big for China to control through these types of measures. Once again China is repeating the symptoms of the disease that is a state-run economy: The government accumulates incomplete information, makes sweeping decisions based on an inevitable mix of personal incentives and national interests and then forces all minorities to submit to a majority solution. This process, by choking off the variety and diversity of voluntary exchanges made possible in a free market prevents effective decision making and real-time responses to supply and demand.

Instead of releasing more ad hoc legislation aimed at industries where the government authorities have lost control, perhaps they should focus on more simplistic endeavors best suited to politicians. Interest rates should be raised, and the yuan should be allowed to float. These two monetary policy tools are unbiased across industries, can be easily monitored from a central authority, and can have almost an immediate impact.

The Chinese are fumbling around with kettles and cauldrons while the whole world around them is screaming to use Tupperware and Teflon. Perhaps they’ll start to listen soon, but hopefully it won’t first require getting burned.

Posted by Michelle Smith on January 1, 2007 07:26 PM