Is China's Recovery a Fraud?by James Quinn
The China growth miracle has resumed its vertical trajectory. We know this because the Chinese government says it's so. And, of course, governments never massage economic numbers for public consumption, right?
If you believe the data, China's GDP has tripled since 2000, with annual growth rates ranging from 8% to 13% over that time frame.
While we can't be entirely sure about the numbers, we are sure that China produced while America consumed, and that while China saved, America borrowed. This is the formula that made the world go round until September 2008, when the wheels came off the worldwide financial system.
In the first quarter of 2009, China's GDP fell to an annualized 6.1%, the lowest since 1999. In an attempt to reboot the economy, the Chinese government unleashed a colossal $586 billion stimulus package, equal to 14% of GDP.
That stimulus appeared to have the desired effect, with Chinese GDP growth ramping back up to 10.7% in the fourth quarter, allowing the country to exit 2009 with a reported 8.7% growth rate. 
China's Reported Recovery
There is no disputing that China has achieved tremendous economic progress over the last four decades. China's GDP in 1970 was $92 billion. Today, it is $4.9 trillion, a 5,326% increase in 29 years. They now command the third largest economy in the world and will surpass Japan as the second largest economy on the planet within the next two years. Remarkable for a totalitarian regime operating a command-and-control economy that, among other actions, can order banks to make loans without consideration for whether the loan has a chance of being repaid.
Pundits and the mainstream media have bought the China miracle hook, line, and sinker. They speak of China in the same revered tones they worshipped Japan in 1988. Back then, the "experts" concluded Japan was unstoppable. Japan's miracle economy proceeded to implode under the weight of bad debt and malinvestment, leading to a 20-year downturn that continues today.
Of course, history has shown us that centrally planned economies appear to be strong from a distance but eventually rot from within. The malinvestment created by the economic cronyism inherent in such a system is almost certain to lead to collapse (e.g., Soviet Union circa 1989, United States on or about 2015).
Even so, the figures reported by China are remarkable, with capital investments soaring over the last decade. The real question is, were these investments made wisely or have billions been squandered on worthless plants, equipment, and infrastructure? If the latter, then the excessive overcapacity will likely prove the pin that pops the Chinese bubble.

General Economic and Financial Indicators, 2001-2008

(All figures are in billions of RMB or percent unless otherwise indicated)

Main indicators
2001
2002
2003
2004
2005
2006
2007
2008

GDP
10,965.50
12,033.30
13,582.30
15,987.80
18,321.70
21,192.40
25,730.60
30,067.00

Real GDP growth (%)
8.3
9.1
10
10.1
10.4
11.6
13
9

Consumer price index
0.7
-0.8
1.2
3.9
1.8
1.5
4.8
5.9

Fixed-asset investment
3,721.30
4,350.00
5,556.70
7,047.70
8,877.40
10,999.80
13,732.40
17,229.10

% growth
13
16.9
27.7
26.8
26
23.9
24.8
25.5

Retail sales
4,305.50
4,813.60
5,251.60
5,950.10
6,717.70
7,641.00
8,921.00
10,848.80

% growth
10.1
11.8
9.1
13.3
12.9
13.7
16.8
21.6

Exchange rate (RMB/$)*
8.28
8.28
8.28
8.28
8.07
7.81
7.3
6.83

Foreign exchange reserves ($ billion)
212.2
286.4
403.3
609.9
818.8
1,066.30
1,528.20
1,946.00

Foreign debt ($ billion)
170.1
171.4
193.6
228.6
281
323
373.6
NA

Notes: NA = not available. *All state-owned industrial enterprises and all non-state industrial enterprises with revenue from principal business of more than RMB 5 million.

Sources: PRC National Bureau of Statistics (NBS), China Statistical Yearbook 2007; NBS website; USCBC
To answer the question on overcapacity, it is important to first understand the nature of the China miracle. It is quite simple.
The Chinese Miracle
The average Chinese factory worker earns $3,544 per year. In comparison, the average U.S. production worker makes $32,320. The Chinese have tied their currency to the U.S. dollar, so as the dollar has fallen, Chinese goods have become cheaper to the rest of the world.
The Chinese have leveraged their cost advantages to aggressively compete for market share, in quick order becoming the manufacturer for the world. From just $250 billion in 2000, Chinese exports have grown to over $1.5 trillion today.
One consequence of this global manufacturing shift has been that China has piled up huge trade surpluses. The trade surplus with the U.S. alone has exceeded $200 billion per year over the last five years.
This relationship satisfied the desires of both countries; using their houses as ATMs, the Americans ran up unprecedented levels of debt to buy cheap stuff produced in China. Which, in turn, allowed the Chinese to provide employment to millions of peasants flooding into the urban areas from the countryside in search of work.
All was well until the debt-induced U.S. housing bubble burst, bringing a grinding halt to the worldwide economic boom. The U.S. and Europe have experienced the worst recessions since the Great Depression, with consumer spending plunging and imports tumbling. That begs the question, with the consumers of its products prostrate under their many debts, and suffering from rapidly deteriorating economic conditions, how could China grow its GDP by 8.7% in 2009?
Or, to be blunt, are the GDP figures reported by the Chinese government fraudulent? To paraphrase the smoothest of U.S. presidents, it depends on what the meaning of the word "fraud" is. The definition of GDP is:
GDP = private consumption + gross investment + government spending + (exports – imports)
China's foreign reserves stand at $2.4 trillion. This surplus has permitted Chinese officials the flexibility to roll out their enormous stimulus plan and give them the confidence to instruct government-controlled banks to make $1.4 trillion of loans.
As you might imagine, these loans to businesses and consumers have resulted in dramatic increases in consumption, housing, commercial real estate construction, and construction of new plants. The government has also directly undertaken infrastructure projects related to roads, public transit, dams, and earthquake rebuilding.
In addition, due to year-end inventory restocking, Chinese exports have stabilized and are once again contributing to GDP, albeit to a far lesser degree than in the go-go days of the recent bubble past.
Therefore, it is likely that their GDP figure of 8.7% is a realistic number. But that doesn't mean that China is out of the woods. Far from it.
Consequences of Malinvestment
In my view, the tsunami of liquidity unleashed by the government will lead to a classic crack-up boom. With their nation's money supply growing at 28%, it's as if Chinese bureaucrats went to the Greenspan/Bernanke school of creating financial collapse. 
With the Chinese recovery artificially created through credit expansion, we can turn to famous Austrian economist Ludwig von Mises for an explanation of what happens next: 
"There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."
All of the signs of a coming crash are present.
Hedge fund manager Jim Chanos, renowned for smelling out the Enron fraud before everyone else, had this to say about the Chinese real estate market: "I do see all of the signs of a credit-induced real estate bubble that I think is going to be a doozy."
Supporting that view, it is worth noting that there is now 30 billion square feet of commercial real estate under construction in China. Annual car production has surpassed 10 million units, even though the average cost of a car is three times the average annual salary of a Chinese worker.
Additionally, the ratio of average home prices to average annual household income is almost 10-to-1 in China; in most developed economies, it is no higher than 5-to-1. Home prices are rising at an annual rate of 18%. Prices of new apartments in Beijing and Shanghai leapt by 50% during 2009. Total fixed investment jumped to 47% of GDP in 2009, 10% more than in Japan at its peak. The P/E ratio of the 300 largest Chinese stocks is 39. The Chinese small-cap index P/E ratio is 76.
In other words, all of the elements for a collapse are in place. Only a trigger is needed.
Chinese authorities have started to tighten lending requirements in the last few weeks. The result has been that Shanghai stocks have fallen to the lowest level since October 31. Whenever central bank bureaucrats think they can fine-tune a multi-trillion-dollar economy, the unintended consequences engulf them. As the U.S. recovery peters out by mid-year and the bankrupt countries of Eastern Europe drag the rest of Europe back into recession, Chinese exports will resume their decline.
Combined with a real estate collapse, the Chinese miracle will reveal itself to be another debt-induced fraud. This will be another step towards the Greater Depression. The investment implications are that worldwide stock markets are likely to retest their 2009 lows by the end of 2010. Industrial commodities are likely to plunge. Gold and silver would surely correct in the short term, but as faith in all fiat currencies declines, they will resume their place as a currency that can't be manipulated or created out of thin air.