Chinese Government Sidesteps Financial Crisis

Chinese stocks are still a long way off their October 2007 record highs, but if sentiment on the streets of Beijing or Chongqing is anything to go by, the one stock at a new all-time high is that of the Chinese government. The country's middle class now has incredible faith in its government's ability to pull off any plan it sets out to achieve.

Many people were obviously shaken by last fall's global financial crisis, and at the beginning of this year, there was widespread anxiety about employment and income prospects. However, the Chinese have been so impressed by their government's staggeringly large policy response and the traction those steps have gained in reviving investment that the dramatic events of 2008 now seem like a blip in the country's long march toward more prosperity.

It is popular in the capital city to contrast the Chinese economy's resilience with the bleaker outlook in Western countries. Cabdrivers, if only half in jest, talk about offering discounts to American and British passengers, while shopkeepers in the old town joke about how sorry they feel for foreign tourists not showing up at their door because the "poor" folks must be out of money.

The animal spirits of local Chinese consumers, on the other hand, are alive and kicking. Nowhere is this more evident than in the property market, where apartment prices in top-tier cities such as Beijing and Shanghai are back up to their 2007 highs. Even Hong Kong's latest property boom, which has seen both transaction volume and prices exceed the 2007 peak levels, is attributed to investors from mainland China. In Macau, gaming revenue touched new record highs in July, driven largely by Chinese money.

Not surprisingly, then, China is one of the first countries in the world where authorities are beginning to take action to rein in growth. Chinese policymakers are concerned that a significant chunk of the more than $1 trillion in new loans extended by the banking sector in the first half of 2009 (a figure that took the total amount of outstanding bank loans to a whopping 150 percent of GDP) has not made its way into the real economy. Anywhere between 10 and 20 percent of the lending is estimated to have gone into the local stock markets. As a result, banking regulators are now cooling lending, and the central bank is withdrawing some of the excess liquidity from the system.

The Chinese government is right to take the economy off steroids and reset policies for a more normal economic environment. China is too far along the development curve to maintain the near 10 percent economic growth rate of the past 30 years. The law of large numbers has to catch up with China just as it did with the other miracle economies, including Japan and South Korea during their industrialization phase. Furthermore, the country's past export boom will be hard to repeat given its already sizable share of the world market and the subdued economic outlook for its major buyers, such as the U.S.

If China were to keep growing at 10 percent, then the much-talked-about imbalances caused by overinvestment are bound to pose major risks for the economy over time. It's a common misconception that China needs to boost consumption to rebalance the economy. While it's true that Chinese consumption, currently less than 40 percent of GDP, is much lower than the 55 to 60 percent shown by Japan and other Asian countries when they were at a similar stage of development, it's not so much low consumption but overinvestment that is the problem. Since 1980, consumption in China has grown at a fairly healthy clip of 15 percent annually, and it's hard for consumption to grow at a faster pace. Instead, from 2002 to 2008, Chinese investment growth accelerated to an annual rate of more than 25 percent, up from its trend of 21 percent over the preceding two decades. That took investment as a share of GDP to more than 40 percent—a level that has been hard for other countries to sustain.

Now, following the government's huge stimulus package early this year, China's investment-to-GDP ratio has reached uncharted territory, at nearly 50 percent. The Asian giant needs to calm down this overinvestment drive, or risk a boom-bust cycle brought on by overleveraging. In this regard, China must increase the role of the bond market in channeling funds to the private sector and further liberalize capital markets to allow excess liquidity to flow abroad. While China's role in stabilizing the global economy with its extremely bold stimulus measures earlier in 2009 cannot be underappreciated, its focus at present must be on cooling its own growth. For the Chinese leadership to retain its reputation for brilliant stewardship of the economy, it will have to do at least as well as it has done over the past three decades. The government's stock is, after all, priced for perfection.