The recipe for stagflation requires permitting excessive growth of the money supply with excessive regulation of markets. Both of which exist in China. This is the second part of the article on the slowing Chinese GDP

China’s GDP (gross domestic product) numbers last week confirmed suspicions that China’s economy is slowing. But not to worry, the central bankers of the world will ride to the rescue. Every investor has been conditioned better than one of Pavlov’s dogs to expect that any indication of a slowing economy will bring in another acronym for printing money. Investors will react with a risk rally that will temporarily mask the real problems. The rallies last until the next set of figures again confirming a basic paradox. For wads of additional stimulus to actually promote growth it has to actually go somewhere productive. It hasn’t. In the US the money has simply gotten stuck on corporate balance sheets and encouraged additional profligate government spending. In Europe it has had a similar effect. Banks used the money to buy government bonds, delaying the need for painful adjustments.

The monetary manipulation in developed countries has many harmful side effects, especially to underfunded pension funds to say nothing of pensioners, but at least they have been achieved in market economies. In China flooding the market with more cheap money has an even larger perverse effect, because of the nature of the system.

An example of the problems with the Chinese political economy is how they choose their leaders. The Chinese Communist party uses as system known as paoguan. It means to “run around for titles”. In essence at promotion time members of the party make tribute-paying visits to higher-level officials. In China this process is in high gear. The change of leadership means that offices in 31 provinces and province-level municipalities, 361 cities, 2,811 counties and 34,171 townships will be reshuffled among 80 million members of the party.  Many of these offices have vast discretionary power and their decisions can be very lucrative.

A selection process based on paoguan also creates a perverse allocation. Government officials are not chosen by either merit or their appeal to public interest, but by their abilities to manipulate a corrupt system. Patronage and pay off become more important than the actual ability to do the job.

The same problems exist with the Chinese stimulus. With state-owned banks, loans are directed by the state and the state is run by a system of patronage. This guarantees that any stimulus package that the Chinese produce will to go to the wrong place. The unprecedented amounts of stimulus money in the form of massive bank loans went to inefficient state-owned business and local governments. Neither have any intention of paying the money back.

Of course the good news is that state-owned banks have a monopoly. They can generate large profits even with mounting loan losses by paying lower interest rates to captive depositors. This means slower growth, but the financial system remain solvent. Until now.

The Chinese are well aware that the distortions have slowed growth. To change that, they are attempting to gradually reform parts of the system. One such reform is an experiment in the ever entrepreneurial city of Wenzhou.

Since small and medium sized businesses, the more efficient parts of the economy, were excluded from the state banking, a shadow banking system grew to cater to the need. The Wenzhou experiment extends legitimacy to the system. But there is a catch to reform. If the Chinese legitimize private banks, then the state-owned banks no longer have a monopoly and must compete for depositors. Depositors like their western counterparts will shop for yield. This will deprive the state-owned banks of much needed cheap financing to help prop up their balance sheets.

In addition to the Wenzhou reform, the Chinese government has also widened the trading ban for the yuan and raised the cap on foreign investment in the country’s securities market. Although these reforms seem encouraging, both loosen the grip of China’s government on its economy which could potentially lead to sudden drastic moves.

Still despite minor reform, the state retains a tight rein on the economy. It is also reflating. State-owned banks lent up to 2 trillion yuan in the first two months of 2012. This is almost twice what was lent in the last quarter or 2011 and two thirds of the entire lending for 2008. Not only does the patronage system distort this lending, the continuing government restrictions on real estate developers have made the problem worse. It has to be remembered that the recipe for stagflation requires permitting excessive growth of the money supply with excessive regulation of markets. Both of which exist in China.

The vaunted Chinese policy makers are faced with a paradox. Reforms aimed at strengthening the economy could weaken it. Unlike western economies, China’s economy is still growing quickly. To revitalize their economy the Chinese are resorting to more bank loans which will simply increase inflation and bad loans without rekindling growth.

You may also want to read: China’s slowing GDP

(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages. Mr Gamble can be contacted at william@emergingmarketstrategies.com or w.gamble@alrroya.com).