There is a lot that may not look right with the Chinese economy. Yet the faith that the Chinese government and foreign economists place in Chinese regulations, restrictions and policies remains absolute

Laws are supposed to solve problems. A government perceives some sort of economic or social problem. Then in step the technocrats, the bureaucrats, or the executive, and implements a solution, a regulation, or a policy. There is one problem, unintended consequences. Certain people may not believe that a government decision works for them, so they find a way around it. An excellent example is inflation in China. It is out of control.

In China the government's economic policies have a great deal of street cred. After all, didn't China use its control over the banking system to avoid a major recession that crippled the West? Haven't they successfully engineered constant, rapid, often double-digit growth? According to the Financial Times, economists think that China can do it again. "Most economists expect inflation to peak this month and begin to ease in the second half of the year as Beijing's tightening policies take effect." Many economists also expected the central bank's rate increase in July to be its last for the year. In June, Chinese premier Wen Jiabao encouraged these views by declaring victory over inflation. Mr Wen wrote that "China has made capping price rises the priority of macro-economic regulation and introduced a host of targeted policies. These have worked."  

It seems that 'most economists' have a lot of patience as well as almost religious belief in China's ability to control its economy. Sadly, the Chinese government first started 'tightening' in February of 2010. As part of its tightening programme it has raised reserve ratio requirements four times in 2011 and interest rates five times since October 2010. But it hasn't stopped inflation.

Consumer price inflation has been rising since the middle of 20l0. It reached a 34-month high of 5.5 % and then topped that in June, when it rose to 6.4%. This is the highest inflation rate since June 2008, when CPI hit 7.1 %. The only thing that stopped inflation then was a global meltdown. Even the headline number might be too low. Food prices rose 14.4 % from a year earlier in June, exacerbated by a 57 % increase in the price of pork.

Like prices, growth shows no sign of slowing. The Chinese economy did dip to a 9.5% growth in the most recent quarter, but industrial production has increased 15.1% since May. Retail sales in June are up 17.7% and real estate is still booming despite efforts to control it. Housing sales in June rose 31 % from May and China's largest developer, Vanke Co, reported that sales had increased 79 % this year.

To slow this torrid growth in prices, the Chinese have resorted to restrictions and controls rather than the market. They required sellers of pork, rice, noodles, cooking oil and other staples to ask permission before raising their prices. They even fined the international consumer goods firm Unilever, for announcing planned price rises.

The problem with these mandates is that they don't work. The Chinese, like Wall Street banks, are past masters at getting around regulations. According to the People's Bank of China, of the 14.27 trillion yuan of new credit extended in 2010, about 41.5 % came from other non-bank channels. Just published figures reveal that local government debt had soared to $1.7 trillion, or about 27 % of the nation's gross domestic product. To get around restrictions on lending, local governments created 6,576 local government investment vehicles, which are not included on the state-owned banks' balance sheets along with other off-balance sheet dodges like entrusted loans.

So despite the tightening efforts, China's banks succeeded in extending 633.9 billion yuan ($98 billion) of loans last month, which represents an increase of 14.9 % from May. The money supply is also out of control. M2 growth rate rose to a three-month high of 15.9 % in June, accelerating from 15.1 % from May, which according to a local economist was "unexplainable". A Credit Suisse report states that Chinese credit growth has reached a critical level, which in other countries has signaled a sudden downturn.

One thing that the Chinese could do to tame inflation would be to subject the yuan to market forces, but they have no intention of doing so. Instead they have to print yuan to buy all the foreign exchange streaming into the country. As its foreign reserves rise to unsustainable levels, so does its rate of inflation.

The off-balance sheet lending spree has created another mountain of bad loans that may be as high as $400 billion. A Fitch ratings gauge suggests that China faces a 60% risk of a banking crisis by mid-2013.

And yet the faith that the Chinese government and foreign economists place in Chinese regulations, restrictions and policies remains absolute. China simply cannot have either a hard landing or hyper inflation and that's the law.
 
(The writer is president of Emerging Market Strategies and can be contacted at [email protected]  or [email protected].)