Chinese New Year but sobering times ahead

CHINA is a country that can do no wrong, or so it seems. Beijing, capital of the Asian giant, will host the Olympics in 2008. The Communist government, led by new president Hu Jintao, has just put one of its citizens into space; the economy is zipping along at outstanding rates as State-driven planning gives way to a more flexible and entrepreneurial system; and the tortuously crafted entry into the World Trade Organisation (WTO), sealed in 2001, has stimulated further heady expansion. China's ruling Party is, indeed, in charge of one extraordinary party.

This transformation has sparked glowing enthusiasm among the global business elite.

Lee Scott, head of US-based discount retailer Wal-Mart - the world's largest company - said this month that China is the only country with the potential to match his home market.

Other multinationals are investing about $1bn a week between them. The world's top investment banks are slugging it out for the honour and income that comes from winning the right to bring vast Chinese companies to global financial markets. China will soon be the world's largest economy, we are told.

But not everyone is convinced. Critics say the China story is compelling, but misguided optimism masks a more gritty and disturbing reality. They say the State that is winning international plaudits is weak; its buzzing economy is beset by thorny problems; and unacknowledged risks are much bigger than most in the business community are willing, or able, to admit.

'You have to see China the way it actually is, not the way you want it to be,' said Gordon Chang, commentator on all matters Chinese and high priest of those who say the reality in Beijing and the provinces is chillingly bleak and fiendishly complex.

Impact around the world

'WE ARE going to see disappointment because they are not going to democratise, they are going to prove an obstacle on North Korea, and eventually we are going to realise the state of non-compliance with WTO promises. It is going to cascade,' says Chang, who penned the unambiguously titled book The Coming Collapse of China.

Others are sceptical too, even if they cannot match Chang in the boldest reaches of his pessimism.

'China has a long way to go. It will grow enormously but it will not grow in a straight line,' said Justin Urquhart Stewart, a director at London's Seven Investment Management. 'There will be some nasty shakes and those reverberations will have a significant impact around the world.'

The roster of problems is sobering. Chang, a radical, claims that China's government has no future as its piecemeal efforts at reform are too slow to be effective, especially for its debt-laden banks.

Statistics are untrustworthy, the legal system is a mess, dissent is serious and rising, and the strictures of an authoritarian, one-party State are ultimately incompatible with a more open economy.

The pressure to open markets to foreign competition as mandated by the WTO will contribute to the failure of domestic companies and State banks, which face an onslaught from 2006.

'Within this decade, I think that it will [collapse],' said Chang. 'They have kept on deferring solving the real problems.'

Wall Street's titans, traditionally the most bullish constituency on China, have recently sounded more cautionary notes, too, although they are definitely not part of Chang's apocalyptic camp. Fred Hu, managing director at Goldman Sachs, has been telling clients that Chinese reform efforts have 'lost direction and momentum' because the fear that was inspired by the 1990s Asian financial crisis has faded.

It is worth noting that Hu is also tied to Tsinghua University, China's top education centre and grooming ground for its new elite.

It is as good a sounding-board as any for picking up on trends there. 'The broader banking sector...remains mired in perilous conditions,' added Hu.

Low quality expansion

STEPHEN Roach, Morgan Stanley's chief economist, recently said China was set for a marked slowdown but maintained that Beijing's mandarins were still up to the task of managing the move to a market economy.

He added: 'If history is any guide, the Western consensus will veer from one extreme to another in assessing China's economic prospects,' Roach wrote, suggesting a brutal readjustment in consensus expectations may be imminent. 'Fortunately, the Chinese have not fallen behind the curve - unfortunately, the rest of the world is misreading China once again.'

Author Chang is especially concerned about China's growth - among the sparkling statistics that make the boldest headlines. Last year's 9.1% was the fastest official rate in six years. But it is probable the breakneck expansion is of low quality, underpinned by government investment in fixed assets.

'Something is really wrong with the economy when you have all this foreign investment, you have all this supposed growth and you have still got to pump money into the economy to make it grow,' Chang argues.

Moreover, the funding splurge puts untold pressure on State finances. 'It is coming out of central government funds and it is going out a lot faster than it is coming in,' he said, putting the debt-to-GDP ratio as high as 180%.

Jun Ma, Deutsche Bank senior economist and one of the more sanguine on the country's future, said: 'Most of the things like bank restructuring, pension reform, unemployment are essentially fiscal issues - it boils down to how the government handles revenue and expenditure. In that regard, I am fully aware the authorities in every part of government have been working out plans to address these issues.'

The twin concerns remain, however, of whether effective action on all those fronts can come fast enough, and will what happen to people's skyhigh expectations in the meantime.

Urquhart Stewart warned: 'This undiluted optimism that people are getting carried away with needs some very severe tempering.'

Debt burden weighs on banks

FEW areas of China's economy elicit as much concern as its creaky banking system. Detractors and optimists say Beijing will struggle to clean up balance sheets, which have some 2.5 trillion yuan (£166bn) in bad loans.

China's fervent aim is to get its major lenders in shape for the arrival of international competitors in 2006, part of its World Trade Organisation commitments.

Officials at China's big-four State lenders - Bank of China (BoC), China Construction Bank (CCB), Industrial & Commercial Bank and Agricultural Bank of China - say that non-performing loans (NPLs) account for 21% of funds extended, down from 33% in 2000. Critics say the figures are understatements.

However large, the stack of stale loans stems from the process of turning financial institutions that used to issue loans by Communist Party diktat to inefficient State-owned enterprises into more orthodox lenders. It is a daunting transition, dubbed 'gai zhi' by locals.

This month, the government dipped into its bulging $400bn (£219bn) foreign exchange reserves and handed $45bn to BoC and CCB for recapitalisation. Both are being lined up for stock market listings.

'We are cautiously optimistic,' said Smith Barney analyst Yipang Huang. 'For us, the key test will be the NPLs in the next two years, when loan growth and GDP growth slow.'