SERIOUS MONEY: Chinese stocks may have surged, but the economy's growth path is simply not sustainable

THE FESTIVAL of San Fermín, or the Pamplona bull running as it is commonly known outside Spain, takes place each year in the second week of July. Six fighting bulls and two herds of bullocks are released from the Santo Domingo corral at 7am each morning, and the bull runners pray they will safely navigate the dash through the narrow streets to the bullring. The danger is considerable and there have been 15 fatalities and more than 200 serious injuries since 1911.

This year’s festival has been described as the bloodiest in decades and, as it drew to a close, wild bulls of a financial variety were unleashed on the world’s stock markets. Several indices posted the longest winning streak in years, if not on record. The Dow Jones industrial average breached 9,000 for the first time since January, while the Nasdaq composite index advanced for 12 consecutive days for the first time since 1992.

But the renewed enthusiasm for stocks on Wall Street pales in comparison to the manic activity in east Asia, where investors have re-embraced the global decoupling thesis that failed so miserably last year and sparked a more than 80 per cent surge in Chinese stock prices in the year to date.

The bears have been suitably gored but investors would be well-advised to consider the increasingly dangerous game being played by Chinese authorities.

China’s export-driven economy has remained remarkably resistant despite a collapse in European and US demand that saw Chinese exports drop by more than 20 per cent in the first six months of the year.

The economy staged a stronger-than-expected rebound in the second quarter, with year-on-year growth of almost 8 per cent, up almost 2 percentage points from the trough in the first three months of the year.

The Chinese growth of more than 7 per cent in the past six months in the face of weak external demand is no miracle, however, and is certainly not a cause for celebration, as the means by which it was achieved may prove costly in the long run.

Aggressive fiscal stimulus combined with turbocharged credit creation powered the domestic economy, which more than compensated for the sizable drop in exports. It seems certain the government will achieve its 8 per cent growth target for 2009.

The recovery in China’s fortunes is being driven almost entirely by investment and contributed more than 6 percentage points of its first-half growth rate of 7 per cent, with consumption adding fewer than 4 percentage points and net exports subtracting 3 percentage points.

While agriculture, transport, utilities, education and healthcare projects accounted for more than 40 per cent of the rise in capital spending, the 30 per cent rise in manufacturing investment runs contrary to the signal emanating from excess capacity and declining industrial profits.

The additional manufacturing capacity is sure to aggravate the weakness in corporate profits as external demand remains weak while the internal market is not large enough to absorb the incremental output. The consumption share of gross domestic product (GDP) continues to decline and is now the lowest among major developing economies.

A sustained rise in the consumption share is improbable in the short term given the upward trend in unemployment and, consequently, deflationary pressures may well persist.

The growth path is simply not sustainable in the medium term. It is clear the Chinese government will do whatever it takes to stimulate the economy in the short run but forcing banks to lend and state-owned enterprises to borrow and spend could have far-reaching consequences.

Credit creation in the first half of the year reached 7.4 trillion renminbi (€768 billion), three times the same period last year and exceeding the 2008 total by more than 50 per cent. New lending at an amount equivalent to roughly 25 per cent of GDP is excessive and, given that idle capacity is already at high levels, is virtually assured to lead to a surge in problem loans in the future.

Excessive credit creation has also contributed to irrational exuberance in China’s financial markets as the surge in liquidity adds fuel to the fire under real estate and stocks.

The lack of investment alternatives in the face of low interest rates has seen deposit growth lag the rise in lending, and the outsized first-day gains in new issues is evidence that liquidity is finding its way into the stock market. But fundamentals inevitably matter and asset prices may eventually return to earth with a loud thud.

The Chinese authorities have become increasingly myopic in their efforts to stimulate the economy. The current growth path is ill-advised and the inevitable jump in bad loans may pose a threat to the financial system and economic stability.

The wild bulls have responded enthusiastically to the better-than-expected growth but the long-term risks cannot be ignored.