Bursting China’s Bubble

Bureaucrats, whether in business or government, in the United States or abroad, are prone to wait for the crisis they didn’t directly cause rather than take painful steps with which they are known to be associated. Thus it is with China.

China’s $100 billion trade surplus with the United States is causing a massive inflow of money into the Chinese banking system. The need to employ that money is resulting in increasingly questionable loans at a time when the banks are supposed to be cleaning up their huge bad debts to state-owned enterprises.

Chinese banks issued more new loans in the first seven months of this year than in all of last year. Standard & Poors estimates that nearly half of all Chinese bank loans have ended in default. The oversupply of production capacity caused by loose lending raises the trade surplus even more, and adds to the financial excesses from capital inflows. All of this could come crashing down. Whether it does, when, and how hard will depend on what is done next.

While important additional steps can be taken to influence credit, the main solution, as the Chinese know but avoid acting on, is to let the Chinese currency strengthen. That would reduce the trade surplus and the capital inflows. It also would cause slower growth and higher interest rates. Letting the renminbi adjust even partially could unleash speculative attacks in currency markets designed to compel further adjustments and even force the currency to float. Extreme outcomes would themselves be highly disruptive and have political as well as economic consequences in China. However, the economy remains sufficiently controlled so gradual adjustments can occur and unacceptably disruptive outcomes most likely could be avoided.

Rather than adjust the currency even partially, Chinese leaders are allowing the financial vulnerability from capital inflows to become increasingly severe. They are rejecting pleas from the United States that are growing stronger, such as the September 1, 2003, consultations with U.S. Treasury Secretary John Snow.

Imbalances that arise from inaction may build to such heights that they eventually lead to turmoil that can’t be controlled. In the meantime, manufacturing jobs hang in the balance, with great political consequences in the United States and other nations as well.