China's Exit Strategy

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This is a revised version including corrections of data by one of the sources quoted.

WHILE PUNDITS PONDER when or if the Federal Reserve will deftly execute its so-called exit strategy from unprecedented monetary stimulus, the withdrawal has begun on the other side of the globe.

China's stock market plunged 5% Wednesday after two major state-controlled banks said it will put the brakes on its rapid lending. Prices of economically sensitive commodities such as copper and crude oil followed suit, casting a pall on the U.S. stock market.

The Shanghai bourse has been on a tear that's put the U.S. market's rally to shame, soaring 90% prior to Wednesday's selloff on the stunningly huge fiscal and monetary measures Beijing took to counter the global collapse last year in the wake of the world credit crisis.

But the boom, which has extended to real estate as well as equities, has raised concerns of a new bubble and inevitable bust among Chinese officials. Indeed, there are hints the fiscal and monetary measures may have more successfully stimulated asset prices than the real economy.

Beijing enacted a fiscal package late last year equal to $600 billion, or 20% of China's of gross domestic product, proportionately four times the U.S. stimulus program. Meanwhile, Chinese bank lending exploded by over $1 trillion in the first half -- half again the total for all of 2008! Standard & Poor's, evidently having learned the perils of a credit bubble, recently warned the rapid loan growth could lead to a sharp deterioration in banks' assets if there were prolonged economic slowdown in future years.

According to domestic media reports, China Construction Bank and Industrial and Commercial Bank of China, the nation's two-largest state-owned banks, had put a ceiling on their 2009 lending targets. That should sharply slow the breakneck growth in credit.As is well-known, Beijing's priority is to preserve economic growth to provide employment and thus maintain political stability. Its financial system is structured to provide widely available credit to promote those aims.

Even before the latest reported curbs, China was already attempting to rein in bank loans. According to the authoritative Stratfor global intelligence service, Beijing was forcing banks to purchase $14.6 billion of bonds to sop up excess liquidity, one of the few blunt instruments it has to effect policy.

"Large pools of citizens' savings are forcibly harnessed by state-controlled banks and used as the reserves base necessary to provide ample and cheap credit throughout the system. Credit is then directed to specific sectors and businesses according to Beijing's political considerations and demands," according to a report from Stratfor.

Not all of that credit is being used wisely. Companies on the verge of collapse are using the loans to stay alive while "speculators are taking advantage of the cheap interest rates to gamble in the stock market and real estate, giving rise to new bubbles in those sectors. These practices do not bode well for future returns on the masses of new loans," Stratfor adds.

Lacking the policy tools of the Fed or the European Central Bank, the Chinese monetary authorities have to resort to relatively crude methods to start and stop lending.

After having gone full throttle, Beijing is now pulling back. And as with everything concerning China, the effects ripple around the globe.

Writing in Wednesday's Financial Times, Stephen Roach, chairman of Morgan Stanley Asia, estimates that China alone accounted for 2 percentage points of real, annualized global economic growth in the second quarter. With contractions slowing elsewhere, China by itself may have lifted the global economy into positive growth for the first time since last summer, the veteran economist figures. But, adds Roach, the growth has come at a high price.

As is often the case, Chinese economic data can be, to put it politely, inscrutable.

Vitaliy Katsenelson, writing in his blog, dissects the Chinese GDP numbers and finds some puzzling contradictions -- mainly that the export-dependent economy grew while exports dropped sharply.

By his quick calculations, while Chinese exports fell about 20% in the second quarter, the economy still expanded 8%. Assuming imports fell in tandem with exports, that would imply the domestic economy (excluding net exports) grew at a robust 11% annual rate, he reckons.

One explanation is that the government's numbers are bogus. "It has the incentive to interrogate economic data until it confesses to the party line numbers," he writes.

For instance, while GDP numbers show growth while electricity output is declining -- an unlikely combination for an economy based on producing goods. Or if the numbers are real, the quality of the growth is poor, the result of force-feeding credit to the system.

Giving the data the benefit of the doubt, the growth in China induced by fiscal and monetary steroids still has accounted for the lion's share of the negligible global expansion this year while Europe, Japan and the U.S. have been mired in deep recession.

The question now is how will the world economy perform now that China no longer is juiced? The selloffs in Shanghai and commodity markets hold a clue.