China's challenges

This is what an economic slowdown looks like in Beijing.

The Chinese economy grew 9.5 percent in the second quarter compared to 9.7 percent in the first three months of the year, according to government figures.

China's factory output shot up 14.3 percent. Retail sales soared 16.8 percent in the first half of the year compared to 2010.

To be sure, the current growth rate is the slowest expansion of the Chinese economy in almost two years, but it still was higher than analysts had expected.

Staggering growth itself, however, is not the key risk but rather an indicator of other and more severe problems Beijing is facing, argue experts.

Twin problems

"I think the two major challenges are bad debt and inflation," says Patrick Chovanec, an associate professor at Qinghua University's School of Economics and Management in Beijing.

Barbara Krug, director of the research center on China's economy at Erasmus University Rotterdam, agrees and notes that those risks are more worrisome than the much-mentioned real estate bubble.

Krug is particularly concerned about what is called debt overload in China, essentially an overinvestment by municipalities and counties in infrastructure projects ranging from railways and airports to new city halls.

Since local governments are in control of local banks they have access to easy money without fretting about whether they will be able to pay it back, said Krug.

"Therefore an increasing number of banks in China are overburdened with bad loans. And that will burst one day of course."

As the Financial Times reported earlier this month, according to the ratings agency Moody's, Beijing "may have understated the debt load of local governments by Rmb 3,500 billion or $541 billion (380 billion euros), a hole in public finances that is likely to inflict damage on banks."

Wasted investments

What's more, adds Chovanec, with an almost unlimited flow of money it's clear that a lot of it is wasted on superfluous projects:

"If it's going into good things that generate a return that's one thing, but if it's going into empty buildings or redundant infrastructure or things that won't generate a return than even though it's generating high GDP growth it will end up being a curse rather than a blessing in the long run."

The second major risk for Beijing is inflation. Despite repeated interest-rate hikes and other measures the inflation rate reached a three-year high in June with 6.4 percent.

"Inflation for historical reasons is a very sensitive point in China and it is in the collective memory certainly of the political leadership," says Krug who adds that the central bank and the government have worked very hard to solve the problem for the past six months, but so far have failed to do so.

Artificial growth

And while the spokesperson for China's statistics office this week downplayed the danger for a so-called hard landing of the country's economy saying the risk for a severe slowdown was small, Patrick Chovanec is not so sure.

"What China has is growth on steroids," he says. "It looks like growth and it looks like a strong economy, but resources and energy are not being channeled to the most productive parts of the economy."

Chovanec believes that the central government can indeed soften and manage the economic downturn that he believes is inevitable, he is simply not convinced that they they will because of the political and economic risks involved.

"They can kick the can down the road," he says and push back the inevitable, but ultimately that will only make things harder in the long run.

"China will have a correction, China needs a correction," predicts Chovanec.

His colleague Krug is more optimistic that China can avoid a hard landing, pointing out that the leadership has shown over the past decades that it can manage inflation and reign in regional binge-spending.

But don't expect drastic measures coming out Beijing anytime soon, advises Krug.

"The year before a leadership change everything will be postponed until the new rules of the game are clear."

Author: Michael Knigge
Editor: Rob Mudge