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Is China's economic boom the next bubble to burst?

The prospectus for China Green Holdings Ltd. looks a little like a seed catalog. Color photographs show the corn, cabbage, pickled plums and other vegetables that the company exports, mostly to Japan. There is even a helpful list of the growing times for broccoli, cauliflower and sweet peas; it is tucked between tables showing that the company earned $14.1-million on sales of $31.2-million in its past fiscal year.

Though China Green's business literally involves small potatoes _ cubed and shipped in plastic bags _ its initial public offering in Hong Kong was anything but. Retail investors bid to buy more than 1,600 times as many shares as were available for sale, making it the most oversubscribed IPO ever in Hong Kong. The stock jumped 58 percent on Jan. 13, its first day of trading.

Japan had its bubble in the late 1980s, when the Imperial Palace grounds in Tokyo became worth more than all the land in California. Thailand and Indonesia had their bubbles in the mid 1990s, when speculators and multinationals poured money into what seemed like a Southeast Asian miracle. The United States had its Internet and telecommunications bubble in the late 1990s, when stock prices looked as if they could rise indefinitely and unemployment kept hitting new lows.

Each of those bubbles ended badly, with millions of families losing their savings and many losing their jobs.

As 2004 begins, China's economy looks as invincible as the Japanese, Southeast Asian and U.S. economies of those earlier times. But recent excesses, from a frenzy of factory construction to speculative inflows of cash to soaring growth in bank loans, suggest that China, too, may be in a bubble now, especially on the investment side of the economy.

Bubbles can last years before they pop, but they seldom deflate painlessly when they do. Nobody knows how the pain of a sharp economic slowdown would affect China, a country undergoing huge social changes, such as the migration of peasants to the cities. The Communist Party rests its legitimacy on delivering consistent annual increases in prosperity.

The Chinese government is showing concern. In the past few weeks, the central bank has tried to dissuade banks from reckless lending while the government has bailed out two of the largest ones, to prepare them for possible hard times as well as planned stock sales. The State Council, China's cabinet, has warned that it will discourage further construction of factories in industries such as aluminum and steel, whose capacity has grown swiftly in the past three years.

Because China is so important to the global economy and to global political stability, the possibility of economic trouble is starting to draw serious attention among economists and China specialists.

Huge billboards in Guangdong Province commemorate Deng Xiaoping's decision a quarter-century ago to allow capitalism to gain a foothold in a few cities here in southeastern China. Practically ever since, China's astounding economic growth has provoked warnings that the boom may not be sustainable. Year after year, China has proved the worriers wrong, although there have been a few missteps along the way, most notably when inflation surged temporarily and foreign exchange reserves withered in the early 1990s.

But even by Chinese standards, things have been moving at a blistering pace of late. Official statistics, which the government tends to smooth so as not to indicate big booms or busts, show that the economy expanded 8.5 percent last year, even though growth came to a virtual halt during the second quarter because of an outbreak of SARS. According to independent economists, however, the Chinese economy actually expanded at an annual pace of 11 to 13 percent through the second half of last year.

Strains are already showing. Blackouts have become a problem in a majority of China's provinces, as new air conditioners and refrigerators compete with new factories for electricity. Chinese steelmakers are building so many mills that shipping executives say all the world's ports combined will not have the capacity to load enough iron ore for them. Auto sales soared 75 percent last year, as prices in a market protected from imports until 2001 drifted down toward global levels. Still, automakers are planning huge factory expansions in the hope that such growth will continue.

Most economists specializing in China predict that sometime this year, growth will have to slow, at least for the investment side of the economy _ the building of new factories, for example. That could prove painful. The U.S. economy suffered severe weakness on the investment side in 2001 and 2002, when the market for telecommunications equipment became glutted. The upshot was tens of thousands of lost jobs in that industry, not to mention steep drops in the stock portfolios of millions of Americans.

But consumer spending is now strengthening in China, while household savings rates are high. China, like the United States, is likely to rely on consumers to prevent any coming slowdown from becoming too severe. "We look for a hard landing in investment, a soft landing in overall economic growth and no landing in consumption," said Tao Dong, an economist in Hong Kong with Credit Suisse First Boston.

The risks to China, and indirectly to the world, fall into four broad areas. Those categories follow, starting with the most likely, a cyclical bust in the investment sector, and ending with what appears the least likely but also the most serious: political turmoil or some other loss of social stability.

Business cycle risk

A quarter-century ago, Dongguan, in the Pearl River delta region of southern China, was an impoverished farming village where residents struggled to survive on limited rice rations. Today, its 14,000 foreign-controlled factories make it the world's largest single site for the production of microwave ovens, and it is a huge producer of everything from computer cables to furniture and computer displays. The roads are jammed with freight trucks carrying boxes of components to assembly lines and the finished goods to ports in Hong Kong and Shenzhen.

Other domestic and foreign businesses have noticed the low wages and cheap factory space here and in many other Chinese cities. In fact, so many factories have been built that in industry after industry, from washing machines to cell phones, production capacity far exceeds domestic demand. Exports have not entirely absorbed the difference, so prices have plunged.

Many business executives and economists complain that factories are often built with little attention to whether similar plants are being constructed elsewhere or to how low prices will fall if all of them start churning out the same products at the same time.

Executives of multinational corporations in even the most crowded industries see China as such an important market that they have little choice but to continue investing, in the pursuit of ever-greater slices of the market.

China also has some advantages that, at least in the short term, may forestall a plunge in investment. One is a banking sector that is willing to lend heavily to even the most indebted companies, provided that they have political connections. But in postponing the final reckoning in the current business cycle, China may be making an eventual bust even worse.

Protectionism risk

China Green exports three-quarters of its fresh vegetables, and the prospectus for its IPO warns that it relies heavily on sales to several Japanese companies. If there were a prospectus for China's economy, it would need to warn of a high dependence on sales to America.

China exported $125-billion worth of goods to the United States in the first 10 months of last year and imported just $22-billion. The resulting trade surplus equaled an extraordinary 9 percent of China's economic output during this period.

To avoid a full-scale trade war, Beijing has followed Japan's example in sending official buying missions to the United States. Shopping for everything from soybeans to communications equipment, they have agreed in the past two months to buy $11-billion worth of goods, by Beijing's calculations. Some of these deals might have happened anyway, such as the one to import General Motors auto parts for assembly into finished cars here.

So far, U.S. trade restrictions have covered a tiny percentage of Chinese shipments to the United States. But any significant broadening could slow the Chinese economy in a hurry, and with it the economies of many Asian neighbors that increasingly send components to China for final assembly and reshipment to the United States.

Financial risk

Lists of potential causes of a Chinese economic derailment tend to start, and sometime end, with a banking crisis. By plying borrowers with ever more loans, following lending criteria that credit ratings agencies contend are laced with corruption and political influence, Chinese banks have wound up with extremely high proportions _ as much as 45 percent _ of nonperforming loans.

The banks rapidly stepped up their pace of fresh loans last year. Exporters, foreign investors and speculators were depositing large sums of dollars. The central bank then exchanged the dollars for China's currency, known as the yuan or renminbi, at a fixed exchange rate, so as to keep the holders of those dollars from bidding up the yuan's value. The banks lent heavily from their expanding deposits, with loans rising 21.4 percent last year.

Most Chinese savers have few alternatives to the state-owned banks as places to park their cash, and the banks appear to have informal but total government guarantees of deposits. As a result, they have not experienced significant losses of depositors, although that could change as ever more businesses engage in trade deals that can be used to transfer money to safer banks overseas if hard times return to China. Lately, concern has gone beyond the stability of the banks to the economic effects of all the extra money sloshing through the banking system.

Chinese officials have said they would try to sterilize the effects of their purchases of dollars by selling bonds to the public for yuan that the central bank then cancels or destroys. If the central bank actually sold extra bonds as fast as it bought dollars for yuan, it could theoretically leave domestic banks with no more cash on hand than they had before, and prevent the risks of faster loan growth, a rising money supply and, eventually, inflation.

The central bank has been able to soak up little if any of the billions of extra yuan it has been pumping into the economy lately to buy up dollars, said Liang Hong, a Goldman Sachs economist. At the same time, flows of "hot money" _ short-term investments being moved into China from overseas through a variety of channels despite China's capital controls _ appear to have accelerated.

"I'm really worried about their losing control of the money supply," Liang said.

Political risk

To the West, the hallmark of the past quarter-century in China has been rapid economic growth. But for hundreds of millions of Chinese, it has meant something else: a respite from the wars and the domestic strife that had dogged the country for more than a century, from the Taiping Rebellion of the 1850s to the Cultural Revolution in the late 1960s and early 1970s.

In the years immediately after the Tiananmen Square killings in 1989, China became relatively placid, perhaps in part from fear. But that calm seems to be fading now.

President Hu Jintao has gingerly tried to restrict some police powers _ like the ability to detain people without proper identity documents _ and is seeking slightly greater openness in Chinese society. Human rights groups report a growing number of protests in China, mainly workers and retirees seeking unpaid salaries and benefits. At the same time, many on the mainland are acutely aware of the huge marches organized over the past seven months by democracy activists in Hong Kong, now an autonomous region of China.

Whether any of these forces become significant enough to rattle China's stability is anybody's guess. Peaceful change toward a more democratic system may still be possible, especially if it is fairly gradual.

But if the economy slows sharply, political instability could follow. And that would be a serious problem not just for China but also for the world.

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