Cracks appear in China's economic model

As the United States and Europe struggle with debt crises, China's economy appears in robust health, but analysts say its growth model is too dependent on investment and cannot be sustained. Sitting on foreign exchange reserves worth nearly $3.2 trillion and with breakneck growth of 9.5 percent in the second quarter, the world's second largest economy appears to have breezed through the global financial crisis. "Clearly China is becoming a larger percentage of the world economy and its growth rate is higher than the developed world," said Fraser Howie, co-author of "Red Capitalism: the Fragile Financial Foundation of China's Extraordinary Rise". "It is becoming stronger as a result of that but I would argue that much of that strength is misleading," he told AFP. When the global economic crisis hit its huge export industry in 2008-9, China unleashed a torrent of credit to finance new highways, high-speed railways and real-estate projects, in a bid to stimulate domestic demand. Now, experts warn China's growth has become too reliant on investment. "If you look at infrastructure projects, it is very clear that the banks have looked at them as risk-free lending because they're guaranteed by the government," said Patrick Chovanec, associate professor at Beijing's Tsinghua University. "It does create growth but it also creates big problems down the road in terms of bad debt." China's state auditor said last month that local governments held a massive 10.7 trillion yuan ($1.65 trillion) in debt at the end of 2010, warning there was a risk some might default. Several days later, global ratings agency Moody's said authorities may have understated that debt burden by as much as $541.6 billion, adding the proportion of bad loans could be higher than previously forecast. "The problem is not really what took place in 2009 and (China's) initial response to the global financial crisis, the problem is that in 2010 and continuing on into this year, it became the new normal," said Chovanec. "It became the new growth model, but it is not a sustainable growth model," he added. Spooked by inflation, which hit a three-year high of 6.4 percent in June, China has been trying to stem the flood of credit by hiking interest rates, amid fears rising prices could cause social unrest. It has also increased the amount of money banks must set aside several times. But Michael Pettis, professor at Peking University's Guanghua School of Management, believes that "China's growth has become so unbalanced that it is going to be extremely difficult for it to change to a new growth model". The government has stipulated in its new five-year economic blueprint that it wants consumption to play a bigger role in growth, by increasing people's purchasing power and further developing services and social security. But month after month, economic indicators show that investment and exports still continue to rise faster than consumption. "It will prove very difficult for China to grow without maintaining high levels of investment, but these high levels will guarantee an unsustainable increase in debt," Pettis said. The government does have powerful levers in its possession to adjust the direction of its economy. For instance, it controls the majority of large companies in the country. As such, state-owned enterprises (SOEs) have better access to credit. But for many economists, this is a poor allocation of resources as the more competitive private sector is the main source of employment in China. "We know that the SOEs are a lot more powerful than they used to be," said Richard McGregor, author of "The Party: The Secret World of China's Communist Rulers." "The state has become momentarily stronger, but I'm not sure that's a lasting phenomenon." Analysts doubt that China, faced with a new debt crisis in the developed world, will be able to implement the same measures it did in the 2008 international financial crisis. "Can China do the same again this time? Well, yes, it could -- more cheap money flooding the system to build unproductive things," said Howie. "But ultimately that is a waste of resources and the model will eventually fail."