Better in their words…

These are the folks Europeans hope will come to their rescue…

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By JOSEPH STERNBERG

Among the many myths surrounding China’s economy, the biggest relates to how Beijing averted a recession after the global financial crisis. The government was quick out of the gate with a stimulus program running to the trillions of dollars, and growth in gross domestic product (GDP) didn’t dip as deeply in China as it did elsewhere. China bulls say this shows the government is smart and worth emulating.

But dig a little deeper and the opposite turns out to be true. China’s stimulus took the form of a massive expansion of bank lending, rather than the kind of fiscal spending Westerners typically think of when they hear the word Keynesian. A glance at what has happened at the banks in the aftermath shows how Beijing has backed itself into a corner.

The stimulus opened a credit floodgate that so far has proven impossible to turn off. “There is a misconception that it was only limited to six months,” says Charlene Chu, an analyst at Fitch Ratings here and one of the few people outside the government who seems to understand what’s going on at China’s banks. “But in reality the credit boom lasted a full two years.” Fitch estimates that new financing for 2011 will hit 17.5 trillion-18 trillion yuan ($2.7 trillion-$2.8 trillion), equivalent to 37% or more of China’s GDP. Financing expanded by an amount equal to 42% of GDP in both 2009 and 2010.

As a proportion of the economy’s size, “that’s like having $6 trillion in new credit in one year in the U.S., but for two years running,” Ms. Chu points out. “In most countries, when banks encounter a difficult economic environment they pull back credit. They’ve learned over time that you do not want to increase your exposure in a worsening environment. Here, they like to do the exact opposite.”

Beijing essentially did what it has done all along—heavy investments in infrastructure and fixed assets—only more so. But the marginal returns on this strategy are rapidly diminishing. In 2006, one yuan in credit expansion yielded 0.76 yuan in GDP growth, according to Fitch. In 2007 and 2008, that one yuan of credit continued to create at least 0.70 yuan in growth. But in 2009, as the credit stimulus got under way in earnest, one yuan of new stimulus credit created a paltry 0.18 yuan in additional GDP. That has improved somewhat since then, but for 2011 one yuan of credit still is expected to create only 0.42 yuan in GDP.

Many economists expect some large portion of those loans to go bad. Beijing probably does have the resources to engineer a bailout of some kind. Less discussed but more important, however, is the question of what that means for China’s economy. A bailout will come at the cost of future economic reform and growth. (E.g. “No free lunch.”)

Consider the implications for rebalancing, or China’s crucial shift to domestic consumption from export-led growth. Chinese banks are heavily dependent on deposits for funding, as opposed to the interbank lending markets used by their Western peers. The last time Beijing faced a bank-solvency crisis, in the late 1990s, the authorities recapitalized the banks via what’s known as financial repression: Regulators set interest rates on household deposits below the rate of inflation, allowing banks to charge lower interest rates on loans while still gradually earning their way back into the black thanks to the guaranteed spread.

This amounts to a wealth transfer to the banks from households. Such a policy undermines the goal of encouraging those households to consume more. But Beijing may have little choice but to continue financial repression indefinitely given the large volume of nonperforming loans likely accumulating anew on bank balance sheets.

It gets worse. Sooner or later, China will have to fix its system for allocating capital. Introducing market interest rates would be the centerpiece, a way to shift capital away from inefficient state-owned enterprises and toward entrepreneurial, private-sector companies by pricing that capital in a way that encourages more productive uses.

That reform, though, is next to impossible now. Any increase in interest rates to the higher level more common for a developing country would risk pushing too many companies into default. Beijing can’t afford that at a time when the banks already are bloated with loans of dubious quality.

Then there’s monetary reform. Beijing has made waves with its talk about boosting the use of the yuan beyond China’s borders. This would eventually require lifting capital controls, which would facilitate a more efficient allocation of capital across China’s borders.

Easing capital controls is a nonstarter as long as the banks are under stress. The last round of bank bailouts, in the late 1990s, succeeded in large part because capital controls trapped depositors in the system. Controls remain strict, but it is somewhat easier now than it was then to take money out of the country. Already the banks are under strain as a result.

As the authorities have increased the required reserve ratio—the percentage of a bank’s assets it must keep on deposit at the central bank—banks that were once flush with cash suddenly find themselves in a squeeze. Banks are even trying to securitize risky loans on the sly (sound familiar?) to develop “wealth-management products” with which to attract depositors. So Beijing won’t risk any more capital flight by lifting exchange controls.

Ironically, then, China’s stimulus, hailed in some quarters of the West as Beijing’s greatest success, could become one of the most severe risks to face the Communist Party in a generation. Already inflation is re-emerging on the back of the credit expansion, with consumer-price rises above 6% in recent quarters. Inflation and regime change historically have gone hand-in-hand in China; the 1989 Tiananmen Square protests were preceded by a bout of inflation.

Meanwhile, the stimulus is denting Beijing’s ability to undertake reforms it will have to pull off to keep the economy growing. This is dangerous for a regime whose legitimacy rests solely on its ability to deliver rapid growth.

China’s 9.1% growth rate for the July-September period may compare favorably to the situation in the U.S. and Europe right now, but don’t read too much into it. Beijing has only delayed a moment of reckoning. It has not avoided one.

Mr. Sternberg is an editorial page writer at The Wall Street Journal Asia.

Joseph Sternberg: The Phony Success of China’s Stimulus – WSJ.com.