Efforts to cool the economy may undo crucial reforms

Faced with rising consumer prices and signs of runaway growth, the Chinese Communist Party in November issued a strongly worded statement vowing to stem inflation and slow investment. At the time market players paid scant attention to it. But as the State Council's increasingly stringent policies show no signs of letting up even in the face of global financial turmoil, players in China's property and equity markets are at last waking up to the harsher reality. In recent weeks both housing and stock prices have started to retreat from their irrationally exuberant highs. Chinese policymakers, however, should be careful of what they wish for. Falling asset prices could bring back an old problem that many thought had been conquered: bad debts in the banking system. Meanwhile, inflation is reviving throwback elements of state economic planning.

Deflating housing prices was not an explicit goal of the party's November statement. But Chinese leaders were clearly worried about the froth in the market. For five years housing prices enjoyed average annual growth of more than 5% nationally, according to Liu Shiyu, a deputy governor of China's central bank. In 2007 the pace picked up even more, with prices rising 10% year on year through October. There were other unwelcome trends. For example, in December Mr Liu revealed that nearly 80% of new housing investment in the first ten months of 2007 went into units bigger than 90 sq metres. These flats are well beyond the means of most ordinary Chinese households. So why were developers building them? The obvious answer was that they were focusing on "investment grade" luxury housing targeted at speculators.

To cool the property market, the government began tightening on all fronts. It raised both interest rates and banks' reserve requirements. It also stiffened administrative controls. In December the China Banking Regulatory Commission (CBRC) declared that the large state-owned banks' lending in 2008 could not exceed the total amount they lent in 2007. In fact, in the case of Bank of China, it was told to extend Rmb20bn (US$2.8bn) less in loans than it did in 2007. For borrowers, authorities imposed higher down-payment requirements. At the same time, the central government and local governments of major cities rolled out aggressive plans to provide various grades of subsidised housing at below average market prices. A new regulation also required property developers to pay fully for leased land before obtaining the deed. The central government sent roving inspection teams to make sure local officials were implementing its myriad decrees.

These measures are having a noticeable impact. National Development and Reform Commission (NDRC) figures on housing prices in December revealed tepid month-on-month growth for much of the country and a decline in formerly hot markets such as Guangzhou, Shenzhen and Wenzhou. As the number of transactions has dwindled, prices in the key markets of Shanghai and Beijing have also stagnated. Investors are now holding their breath to see if these two bellwether cities will witness drops in property prices.

Victims of their own success

Chinese policymakers are, in a way, victims of their own success. During the past few years China has enjoyed record current-account surpluses, which have allowed the central government to use ballooning foreign-exchange reserves to recapitalise sickly state-owned banks. Flush with cash, the banks have fuelled spectacular rallies in both property and stocks, which have sent even the prices of their own newly listed shares into the stratosphere.

In heated competition with each other to lend money, banks have flouted both basic risk-management practices and government regulations. They looked the other way when borrowers did not have all the paperwork. Since September buyers have had to make a 40% down payment for a second mortgage. But most banks interpreted the rule as applying only to individuals, and not to households. Thus, a large number of borrowers simply had their spouses or children take out mortgages and kept speculating in the property market. In other instances, CBRC officials discovered that local bank branches accepted false documentation showing proper down payments where none existed. Such lax lending has led to a Rmb1trn increase in housing loans in the first ten months of 2007, or nearly one-third of all new bank loans made during that period. Bank regulators have publicly raised alarm about these highly leveraged mortgages, which look uncomfortably like their sub-prime counterparts in the US.

On the stockmarket front, the CBRC has long-standing regulations forbidding the purchase of shares with bank loans. In reality, though, it is all but impossible to enforce how the money is spent once it leaves bank vaults. And in the great Chinese bull market of 2007, it did not really matter anyway because most people were making a killing on stocks and promptly repaying their loans. Indeed, Chinese banks were indulging their own speculative urges by investing in junk US mortgage-backed securities.

As the sub-prime crisis deepens in the US, the Chinese euphoria is beginning to evaporate. Bank of China, one of the country's largest commercial banks, recently admitted that it would need to write off a substantial amount of its investment in US sub-prime mortgages. Although the evidence is far from conclusive, a senior CBRC official admitted at a meeting in mid-January that non-performing loans (NPLs) were showing initial signs of reversing their decline of recent years.

Should China's housing and share prices follow a sustained downward trajectory, a serious NPL problem would no doubt rear its ugly head again. To be sure, China does not seem in danger of plunging into a bank-liquidity crisis. Unlike many developing countries that have suffered such financial emergencies in the past, China has more than enough bank reserves and foreign exchange to thwart a similar fate. Still, a sudden spike in NPL ratios would reveal to the world that China's economic reform is far from complete. It would show that, despite their record market valuations, Chinese banks are not in much better shape than their Western counterparts.

Government orders

In fact, Chinese banks might feel they are by far the unhappier bunch, because they must continue to endure the blunt instruments wielded by bureaucrats in Beijing. An important feature of many Chinese banks--and companies--is that they remain state-owned entities which must obey government orders whatever the consequences for their businesses. When the government repeatedly jacked up banks' reserve requirements in 2007, they had to forgo profitable loans and park their money in low-interest accounts at the central bank. What is more, they were even saddled with central-bank bonds which the government forced them to purchase at below-market discount rates. These obligations squeezed all banks' profit margins.

Similarly, despite record oil prices on the global markets, the central government has ordered national oil companies to import crude oil, continue refining and sell petrol domestically at mandated prices. Some state oil giants, such as Sinopec and PetroChina, protested by briefly slowing down production. But they ultimately had to obey their government minders' commands to maintain supply. Even China National Offshore Oil Corp, which primarily engages in exploration and drilling, had to build its own refinery to help the state satisfy the country's soaring petrol demand.

Elsewhere, as food prices gallop upwards, the government has asked state-owned agricultural companies to maintain supply at fixed prices. More recently the NDRC has forbidden large food-processing companies, fertiliser-makers and retailers from raising prices of grain, meat, eggs, dairy products and fertilisers without government approval. No one knows how effective these steps will be in fighting inflation.