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Henny Sender is chief correspondent, international finance, for the Financial Times



Years ago, when Industrial & Commercial Bank of China was getting ready to list, it went through its own spring cleaning of its balance sheet. It established Huarong Asset Management, a platform to take all its bad debts, while the Ministry of Finance recapitalized the bank itself.

Today, Huarong has re-invented itself as a nonbank financial institution. Its Hong Kong affiliate today is busy making loans to those who can't borrow in China directly from ICBC itself, albeit at much higher rates -- as much as 20 per cent per year, thanks to introductions from the big Chinese bank.

Many of Huarong's borrowers are second-tier property developers who can't get credit at home as China tries to slow a rise in property prices which threaten its social stability. Usually, these borrowers are able to get the money back across the border into China.

So the platform which was originally created to deal with ICBC's problem loans may well now be creating the next round of problem loans instead.

Such concerns are one reason that bank shares are down 10 per cent this month and trading is at all time lows in terms of price-to-book value, according to GaveKal Dragonomics, a research company specializing in the Chinese economy.

Analysts disagree on the extent to which Chinese regulators have succeeded in putting a stop to the breakneck lending of the past two years. But fears linger that China will careen from the overheated pace of investment of the last two years to the opposite extreme in which companies can't get any credit. That outcome would have dire consequences for the macro economy.

But lack of credit is not yet the problem. Credit is still flowing in China, though at a slower pace and with a higher cost, thanks to non-banks in Hong Kong such as Huarong. Bank credit in Hong Kong stands at 240 per cent of gross domestic product, according to data from JPMorgan, mostly reflecting the arrival of Chinese borrowers circumventing restrictions at home. (In mainland China itself the figure is 120 per cent.)

The current problem is just how much money is going to the high end property market, precisely because China depends so heavily on the property market for its economic growth - and how little is going to more productive small and medium enterprises.

A big part of the Chinese miracle has to do with the fact that over this past decade China's economic expansion was driven by quality growth that came from making things that the rest of the world wanted to buy at a price that no other country could match. That was because Chinese labour was both cheap and productive and because China offered unique economies of scale. Even now, with rising inflation in wages, China still has the advantage of those economies of scale.

By contrast, most of the rest of Asia's growth came the easy way - by putting up endless apartment towers that swell GDP but not in a sustainable way, and so paving the way for the Asian financial crisis. Yet mainland China has now become too dependent on the easy economic growth which comes from putting up concrete blocks which are then traded like sardines. Beijing today looks much more like Bangkok in 1997 than it looks like it did itself back then.

At the same time, the government has become much less effective in its attempts to bully the economy to move in the direction it desires.

In the mid 1990s - the last time China faced rising prices and inflationary pressures - Zhu Rongji, the then-premier, could use administrative measures far more effectively than is possible today because the economy is much more complex today than it was 15 years ago.

Today, all the choices involve difficult trade-offs: Local governments need revenue from land sales since that is their main source of income and have a vested interest in keeping prices high. The interest on bank deposits is still negative, leading investors to put their money into property because they don't trust the stock market and there isn't much else in which they can invest, as long as capital controls remain in place.

There is a need for more housing. But it wont be met by the luxury flats that can now be seen in third and fourth tier cities where there isn't the sort of rising income that could support that kind of high-end market.

Today, it is hard to know what the cost of all this actually will actually be.

In the official sector, where ICBC itself dwells, rates are low and the cost of capital is, if anything, too cheap. Foreign investors are beginning to look elsewhere for opportunities since asset prices are so inflated, reflecting the fact that credit is still available. (In India, by contrast, bank credit as a percentage of GDP is a mere 52 per cent.) Meanwhile, outside the official sector, where Huarong sits, the cost of capital is much higher.

But China won't always be awash with cash. It needs to spend more wisely today while capital is still abundant.

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