China praise won't avert debt crisis day of reckoning

If only America's leaders were more Chinese. That's the provocative suggestion made in a paper published by the Federal Reserve Bank of St Louis, and it's sure to elicit a smile among Communist Party bigwigs.

Before this goes to Beijing's head, let's consider how silly this insinuation by economists Yi Wen and Jing Wu really is - and how China is a much bigger worry for the world economy than the US is.

Was the United States response to the 2008 financial crisis state of the art? Far from it. Should lawmakers have granted US President Barack Obama his wish of a bigger fiscal stimulus package? Absolutely. As Obama said at the time, and economists such as Paul Krugman have argued since, US$787 billion was insufficient to revitalise a US$16 trillion economy in free fall. That, as Wen and Wu point out, meant rescue efforts in the US and Europe too were "almost purely monetary".

But the idea that China acted in economically rational ways that merit study and replication is just too much. What Wen and Wu gloss over when they laud China for implementing policies "no other nations dared to adopt" is that Asia's biggest economy is merely delaying a debt crisis that will be much bigger and more spectacular than it had to be. The "bold and powerful" stimulus efforts the economists cite were largely driven by the state-owned enterprises that China should have been reining in since 2008. Those stimulus efforts also saw China's shadow-banking system explode in size and influence, threatening the country's economic outlook.

This month's National People's Congress meeting can be distilled down to one number: 7.5 per cent. That's China's growth target for this year, and all the chatter at the meeting - talk of reform, increased income, urbanisation, currency flexibility - can be traced back to meeting it. Given the global economy's lacklustre state and China's poor start this year in investment growth (the weakest since 2001), the only way to hit that number will be even more stimulus.

Premier Li Keqiang's news conference last week was telling in itself. He hit all the right notes about creating a more diverse and services-oriented economy, reducing pollution, and clamping down on debt. The trouble is, Li offered zero specifics about how to do any of that. Even more important, Li didn't mention two things: the fate of the Shanghai free-trade zone and the method by which China can somehow retool the economy while also growing at a rate of 7.5 per cent.

In September, with great fanfare, China designated 28.5 square kilometres of land as an economic laboratory in which authorities would allow the yuan to trade more freely, offer greater interest-rate flexibility and place fewer limits on foreign money flows. Li's failure to mention the Shanghai zone suggests that growth is trumping experimentation.

The growth-target riddle gets us back to the St Louis Fed research paper. Looking back to 2008 and 2009, Wen and Wu argue that the "crucial lesson learned from China" is the importance of "credible fiscal policies" as opposed to "half-hearted" ones. China, they argue, "may be lucky to have had a large enough SOE sector available at the onset of the financial crisis to help defend its economy from a crushing slowdown". What's more, they say, "for a massive developing country with more than 1.3 billion mouths to feed in the middle of an uphill great transition, China cannot afford a Japanese-style 'lost decade'."

What if China's crisis response to 2008 and the stimulus ramp-up taking place this year actually ensure a lost decade? China's state finances have become more opaque since 2008, not more open. Local government borrowing became more prolific, not more productive. The shadow-banking industry went from fringe status to mainstream. Ghost towns grew more numerous.

As former Fitch Ratings analyst Charlene Chu told London's The Daily Telegraph last month, China's banking sector has extended US$14 trillion to US$15 trillion in just the past five years. That explosive growth is the price China will pay for the "credible fiscal policies" Wen and Wu applaud. And that's the credit bubble that analysts know about - never mind the true figures.

Every industrialising nation has its reckoning, and China will, too. Sure, its US$3.8 trillion of currency reserves may come in handy. The crucial lesson learned from China is that how growth is generated matters just as much as, if not more than, its increase. The US might not have got everything right in the past five years, but it isn't setting itself up for a huge debt crisis in the near future. Odds are, China is.

Bloomberg