Is China heading for a hard landing?

China has raised interest rates for the first time in nine years to cool the economy. Will it work? asks Simon Nixon.

Is China over-heating?

Most economists agree it is growing too fast. In the first nine months of the year, it grew 9.5%, far above the 7% that analysts consider to be a sustainable. Growth has been driven in part by a huge surge of foreign investment totalling some $53bn already this year - up 30% on the year before. This has helped drive up prices in China. In the third quarter, inflation hit a seven-year high of 5.2%. But the most worrying evidence that the Chinese economy is over-heating is in the property and construction sector. House prices in 35 of China's biggest cities surged 9.9% in the third quarter and the price of land was up 11.6% on a year ago.

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Why is this a problem?

Because the longer the boom continues unchecked, the greater the risk that the economy experiences a major bust. The fear is that too much money is flowing into speculative property ventures, just as it did in the Asian crises in the mid-1990s, and that sooner or later the bubble will burst. A "hard landing" for the Chinese economy would be a disaster for everyone given that last year China accounted for a third of global growth.

What has China done to cool the economy?

Earlier this year, it tried to restrict bank lending by increasing bank capital requirements. It has also imposed administrative measures to cool investment in certain sectors, including tougher rules on converting farmland to industrial use. These measures have had some success in cooling the boom. Investment growth fell from 48% in the first quarter to 26% in the third quarter and growth in steel production capacity fell from 100% in the first quarter of 2003 to 20% in July this year. Moreover, rising oil and commodity prices have checked the pace of growth.But many economists still fear that China is heading for a hard landing. Hence the People's Bank of China (PBOC) decision last week to raise interest rates for the first time in nine years.

Will higher interest rates helpThe main aim of the rate rise was to put a further break on the booming construction sector, while helping to rebuild bank deposits. The problem is that, with inflation above 5%, real interest rates are negative. Under the circumstances, the PBOC fears savers will be reluctant to put cash on deposit and will instead do what English and US investors would do in the same position: borrow money to buy property. The last thing the rickety Chinese banking system needs is a combination of falling deposits and increasing property loans. A hard landing for the economy could lead to the collapse of many of these speculative property investments, putting immense strain on China's fragile financial system.

Why were rates left so low?

Because the PBOC was worried that a rate rise would trigger an even greater influx of foreign funds into China, which would put further pressure on the exchange rate. The yuan is pegged to the US dollar and many think it's very undervalued against the dollar. For the most part, this arrangement suits both China and the US. The weak yuan underpins China's position as a low-cost manufacturing hub, while the US benefits from cheap imports, allowing Americans a higher standard of living. Moreover, China recycles its giant trade surplus with America into dollar assets, thus enabling the US to fund its vast current account deficit and to live well beyond its means.

Is this state of affairs sustainable?

Probably not. The US deficit is now running at an annual rate of $600bn or 5.5% of GDP and is predicted to rise to 7.8% in 2008. No other country could get away with a current account deficit on this scale. The US only succeeds because the dollar's status as the world's reserve currency provides it with a degree of protection from the normal disciplines of the markets. But this cannot continue indefinitely. The dollar has already fallen sharply against the euro, but this has made little difference to the deficit since the eurozone does not have a significant trade surplus with the US. To lower the deficit, the dollar needs to fall against those Asian currencies that are pegged to it - above all the yuan. But so far the Chinese have refused to devalue.

Will the Chinese revalue?

A revaluation seems inevitable, but the Chinese won't be rushed. They fear that if the currency peg was removed, there could be a run on China's rotten banks, triggering a financial crisis. Besides, the world has much to fear from a sudden yuan appreciation. Faced with higher import prices, America would have to tighten its belt and raise interest rates to hold off inflation. Both US and Chinese growth would slow, plunging the global economy into recession.