Dragon's easy credit inflates bubble

Government spending and bank loans have resulted in sharp increases in fixed-asset investments (more than 30 per cent up on 2008). A big component is infrastructure spending, which accounts for more than 70 per cent of the Chinese Government's stimulus package. In the first half of 2009, investment accounted for more than 80 per cent of growth, about double the 43 per cent average contribution over the past 10 years.

Infrastructure investment is adding to production capacity in a world with sluggish demand and overcapacity in many industries. In the absence of sufficient domestic demand, the production may be directed into exports, increasing the global supply glut and creating deflationary pressures.

Progress on shifting the emphasis to domestic consumption has been disappointing. Government incentives, in the form of rebates for purchases of high-value durables such as cars, has increased consumption in the short run (up 15 per cent on 2008). But, over the past 25 years, Chinese consumption has declined from about 50 per cent to its current level of 37 per cent.

The current expansion in lending also risks creating a banking crisis in China from a rise in non-performing bank loans. The problem of bad debts from loose lending are not new. In the 1990s, similar credit expansion led to an increase in bad debts. The big state-owned Chinese banks had to be substantially recapitalised and restructured in a series of steps that ended only in 2004.

Chinese bank regulators are concerned that new lending is being used to finance real estate and stockmarket speculation rather than for productive purposes. They have moved to reduce speculative lending but it is likely that the central bank will resolutely maintain its moderately loose monetary policy because of uncertainties in the external and domestic environments.

The centralised control structure of the Chinese economy has allowed rapid action to be taken to avert the slowdown in growth. In July, Su Ning, vice-governor of the Chinese central bank, People's Bank of China, observed: ''The mind and action of all financial institutions should be as one with the Government's goal, and financial institutions should properly handle the relationship between supporting the economy's development and preventing financial risks.'' Even if execution is not in question, the appropriateness of the policy measures and the sustainability of the recovery are unclear.

There are also concerns that Chinese statistics are unreliable and frequently manipulated by officials to meet political and personal objectives. One unexplained and nagging discrepancy is the difference between reported growth figures and electricity consumption. It is difficult to reconcile falls in electricity consumption with continued robust economic growth.

Even China's state-controlled media have become increasingly sceptical about the accuracy of statistics. In recent polls, a high percentage of the population doubted official data.

International commentators have become concerned about the quality of the economic data. Commenting on the time taken by China's National Bureau of Statistics to compile growth data, Derek Scissors, from the Washington-based Heritage Foundation, wryly observed: ''Despite starkly limited resources and a dynamic, complex economy, the state statistical bureau again needed only 15 days to survey the economic progress of 1.3 billion people.''

The NBS recently launched a campaign - ''Statistical Feelings: We have walked together: Celebrating the 60th anniversary of the founding of New China'' - to increase confidence in its work. The campaign has already produced memorable slogans and poems. ''I'm proud to be a brick in the statistical building of the republic''; ''I can rearrange the stars in the sky because I have statistics.''

China's $2 trillion foreign currency reserves, a large proportion denominated in US dollars, may have limited value. They cannot be liquidated or mobilised without huge losses because of their sheer size. Increasingly strident Chinese rhetoric reflects rising concern about the security of these dollar investments as the US issues great amounts of debt, thereby reducing the value of Treasury bonds and the currency.

Chinese Premier Wen Jiabao has expressed concern: ''If anything goes wrong in the US financial sector, we are anxious about the safety and security of Chinese capital.'' In December 2008, Wang Qishan, a Chinese Vice-Premier, noted: ''We hope the US side will take the necessary measures to stabilise the economy and financial markets as well as guarantee the safety of China's assets and investments in the US.''

Yu Yindong, a former adviser to the Chinese central bank, castigated the US over its ''reckless policies''. He asked US Treasury Secretary Timothy Geithner to ''show us some arithmetic''. At the University of Beijing, Geithner obliged, indicating that the US intended to reduce its budget deficit to 3 per cent of GDP from its current level of 12 per cent, eliciting sceptical laughter from students.

China's position is similar to that of a bank or investor with poor-quality assets. China is trying to switch its reserves into real assets - commodities or resource producers, where foreign governments will allow.

In the meantime, China continues to buy more dollars and US Treasury bonds to preserve the value of existing holdings in a surreal logic. On the other side, the US continues to seek to preserve the status of the dollar as the sole reserve currency to enable the Treasury to finance America's budget and trade deficit.

Every lender knows Keynes' famous observation: ''If I owe you a pound, I have a problem; but if I owe you a million, the problem is yours.'' Almost 40 years ago, John Connally, then US Treasury secretary, accurately identified China's problem: ''It may be our currency, but it's your problem.''

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives.