Boom!

Boom!

International economists are asking more and more frequently: Is the China boom a bubble getting ready to burst? Can its economy keep running at the double-digit growth that is restructuring the patterns of world manufacturing, world trade and world supply chains?

Certainly there are dangers lurking that could puncture the bubble. The state-owned Chinese banking sector, already burdened by a huge number of non-performing loans, could touch off a bust. Protectionism, which has already seen the U.S. impose quotas on certain Chinese textile imports, could feed on itself as it fails to stem the tide of manufacturing jobs moving to China. Protests against local corruption could lead to a political crisis. And inflation in China, which surged by 3 percent at the end of 2003, could force the Central Bank to clamp down on credit, which has helped feed the domestic economic boom.

But according to some economists, such factors are unlikely to derail China's rapid expansion. To the contrary, they argue, China is in the early stages of a long-term economic transformation comparable to the U.S. after the Civil War, Europe after World War II and Japan in the mid-1960s.

"We're on the verge of one of the greatest global economic booms of all time," said Edward Yardeni, chief investment strategist of the Prudential Group. "This could be the big one, driven by the tag team of the U.S. and China."

Economists point to three factors that are likely to sustain China's boom at least through 2008, and probably for years after that:

-- The Chinese government's determination to spur economic development in the country's agricultural interior in order to slow migration to the coast.

-- The 2008 Olympics, which the Chinese government is going all out to prepare the entire country for, not just Beijing, the host city.

-- The growth of a Chinese middle class as large as the entire U.S. population, with Western-style consumer habits that are beginning to account for a large part of China's internal growth.

Yardeni discounted concerns that China will be forced to cool the boom before it turns into a bust. He said China must grow rapidly enough to absorb the 20 million immigrants per year migrating to urban centers from rural China. "China has to build the equivalent of one Houston every month, month-after-month to accommodate this migration," Yardeni said in a speech at the annual joint shipping conference of the Hellenic-American and Norwegian-American chambers of commerce in New York earlier this month.

Yardeni said China will continue to push its economy fast so it can absorb this growth up through the 2008 Olympics. "They are preparing the country to impress the world with their achievements," he said. "They have to find jobs and housing for all the masses of people moving into cities to prevent the proliferation of shanty towns, disease and social and political instability."

China's coastal cities cannot continue to absorb the migration - the largest in human history - so the government is encouraging economic development in the largely agricultural interior, where 80 percent of China's 1.25 billion people still live. Beijing must build modern communications and transportation infrastructure to attract foreign direct investment in and around its five major interior cities, Chongqing, Chengdu, Wuhan, Kunming and Zhengzhou.

To accomplish this, China must import large amounts of capital goods, including factory machinery, construction equipment and telecommunications gear. China has to build its telecommunications system from scratch because it has virtually no legacy communications sector, which means everything has to be imported. This will mean the kind of containerized imports that could gradually move the import trade slightly more into balance with the booming export trade and boost freight rates on that leg, said Koay Peng Yen, president of APL Greater China in Shanghai.

"This can't be done overnight," Koay said in a telephone interview. Containerized imports are growing at 10 percent a year now, he said, but much of that trade is in raw materials and other low-value goods. As China begins to spur growth and development in its rural interior over the next 10 years, imports should grow by 15 percent a year, he said.

Chinese companies are also starting to import higher-value goods that are not being manufactured domestically. "Not all parts and components are being made in China," Koay noted. Concern about theft of intellectual property is leading some companies to withhold manufacturing technology from China and to supply high-value goods instead from plants in Thailand or Singapore.

Also spurring China's economy is its growing consumer sector. There are various, sometimes conflicting estimates of the size of the middle class and how fast it is growing. Koay thinks the middle class accounts for about 4.5 percent of the population, or 58.5 million people. But Yuelin T. Yang, group director of direct investments at IMC Pan Asia Alliance Pte., estimates it will account for 300 million people by 2007, when it will be larger than the entire U.S. population.

"There is a pent-up demand for brand-name consumer goods, and my own experience is that you still can't find a broad array," Koay said. "A lot of our customers are excited by the outlook for imports of higher-value goods."

Foreign automakers are setting up plants in China, a development that will spur imports of parts and components. General Motors began producing cars in China at the end of 1997, when "everyone thought they were crazy to do this," Robert Kapp, president of the U.S.-China Business Council, said in an interview. "Now GM is laughing up its sleeve."

Indeed, the demand for GM cars in China is so strong that one of GM's three joint ventures in China only had an inventory of 4,000 vehicles, or six days worth of sales, at the end of last year, compared with a norm of 60 to 80 days in most of its markets. "We are doing everything we can to keep up with demand," said Toni Simonetti, a GM executive who recently accompanied John Devine, GM's chief financial officer, on a tour of its Chinese plants. GM sold 386,710 vehicles in China last year, an increase of 46 percent over 2002. "We didn't predict this kind of growth," Simonetti said in an interview.

But this does not necessarily mean it will import the parts and components it needs to make them. When GM began producing its vehicles in joint ventures with Chinese companies in 1997, it was using 50 percent local content. That content will rise to 70 percent in the next year.

The fastest growth was in the four Buick lines GM produces in China, where sales jumped 82 percent last year. Sales are constrained because "the Chinese don't have a good credit infrastructure," Simonetti said. GM China has received a license to start financing the vehicles it sells in China and expects to finance up to 70 percent of all sales, up from 20 percent currently.

GM is seeing "robust growth at the high end of the market," Simonetti said. "The development of the middle class is incredible," she said. "It takes your breath away; we expect double-digit growth to continue for years to come." So explosive is the growth that GM has obtained licenses to import Cadillacs to test the Chinese market for the CTX sedan and the SRX S.U.V. If the two luxury models sell well, GM will consider producing them locally.

Growth in Chinese spending on brand-name consumer goods is being driven by the rapid creation of wealth, especially in the urban areas along China's coast. This is where most of the factories are located that have become a manufacturing platform for the global economy.

So what could go wrong with this rosy picture? Barring the kind of catastrophe that no one can predict, there are three dangers threatening the Chinese boom: inflation, protectionism and a banking crisis.

On the inflation side, consumer prices are heating up, rising 3 percent in November and December after years of a 1 percent growth rate. The price of real estate along the coast is growing even faster.

Anthony Whitworth, president of Navios Corp., a bulk carrier based in Norwalk, Conn., said he believes carriers in the China trade "will get hit by inflation sooner than anyone expects." But to the question of whether the China Boom is a bubble, he answered, "Hogwash!" That's because "China is where Japan was in the mid-'60s, with export growth and domestic investment firing on all cylinders." He said the Chinese habit of frugality is waning as they become more consumer-oriented.

If, as widely expected, the Chinese government decides to revalue the yuan by allowing it to float in a higher range against the dollar, or against a basket of currencies, this will dampen import prices for both commodities and raw materials, which are surging, and consumer goods. But it won't do much to lessen the competitive prices of China's exports; most economists don't expect the yuan to go up by more than 5 percent.

As for protectionism, the need to stem the loss of U.S. manufacturing jobs is becoming a major presidential campaign issue. President Bush chimed in last year when he imposed quotas on certain textile imports from China, as the U.S. was allowed to do under China's World Trade Organization accession agreement. With China accounting for close to 20 percent of all U.S. textile and apparel imports in 2003, the highest share ever for any country, and up 50 percent over its market share in 2002, political pressures are likely to fuel further efforts to curb imports in textiles, an industry employing about 1 million Americans.

China's largely state-owned banking sector faces a threat because approximately 20 to 40 percent of its outstanding loans are non-performing, largely as a result of lending to other state-owned companies that are neither competitive nor profitable. The country's four largest banks, which hold 60 percent of Chinese banking assets, have a total of $242 billion in non-performing loans. These banks are technically insolvent, said Peter Yip, chief executive for China business of HSBC in Shanghai, who spoke at the shipping conference.

The government is addressing this problem, and with foreign exchange reserves of $403.3 billion, second only to Japan among the world's nations, it has adequate resources to deal with the bad loans. In addition, the government has deregulated foreign ownership of banks and will open its capital markets to foreign banks by December 2006. As a result, China will have to conform to international credit levels by 2007, Yip said.

With nine out of every 10 foreign companies that are already investing in China making plans to expand, the dangers that could burst the Chinese bubble look manageable. But it's still a Communist country, isn't it? Navios Corp.'s Whitworth doesn't see that as a problem: "The Chinese are Communists in the same way the French are Catholics."