WAKE UP AUSTRALIA: China's wings are clipped

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Beijing's recent move to tell Chinese banks to cut back on lending comes as a timely reminder of the tensions in the Chinese economy that threaten to undermine long-term growth.

Beijing wants its banks to cut back lending because it is worried that economic activity is too strong, which could fuel inflation.

On the face of it, the Chinese government is in a much better position than most of its Western counterparts that are faced with moribund economies, because it's easier for governments to slow economies than to generate growth.

But there's a more troubling side to Beijing's orders, because it indicates how key parts of the Chinese economy – including interest rates and the exchange rate – are subject to government directive, rather than market forces.

For all the excitement about the transformation into a market economy, important elements of the old, state-directed economy persist.

When Beijing wants the banks to lend less, they have two choices. They can increase the banks' reserve requirement (the amount of money the banks must keep in reserve and can't lend out).

Or they can simply tell the banks to stop lending.

Banking isn't the only industry subject to tight control from Beijing. Other industries such as energy, telecommunications and oil are also dominated by the state. As a result, the Chinese government is able to dictate what happens in major areas of the economy.

This is exacerbated by the fact that the central government, and the various-state owned enterprises, continue to dominate most of the nation's resources.

As a result, there are huge inefficiencies in resource allocation in China.

This is particularly true when it comes to investment.

There is undoubtedly a strong residue of the old central planning doctrine in Chinese investment planners. One of the cherished beliefs of central planning bureaucrats is the importance of pushing resources into the capital goods sector, at the expense of the consumption goods sector.

To this day, China persists with investment rates that are extremely high in comparison to the Western world.

But this rate soared last year when the Chinese government launched a massive fiscal stimulus. Some estimate the country's investment rate hit a massive 50 per cent.

This has two main effects. The first is that the Chinese consumer is squeezed. In China, the consumer accounts for only one-third of the economy, compared with more than two-thirds in the United States.

The Chinese consumer is further constrained by soaring property prices. China's growing middle classes are saddled with huge costs of renting, or paying for mortgages, and lack the disposable income to spend on cars, or plasma TVs.

But the bigger problem is that when you have such high investment levels, there's invariably a lot of inefficiency.

China's critics argue that even before last year's investment boom, the country had already built too much manufacturing capacity (see Cracks in the China story, January 21) .

The extent of the problem wasn't masked as long as the US consumer was happy to borrow against their houses, or to run up astronomical credit card bills.

But those days are over. The US consumer has discovered thrift.

When they decided to build new factories and office blocks, the Chinese would have been projecting that demand for their products by Western consumers would continue to rise at a relatively healthy clip.

But the advanced economies look set to record painfully weak growth rates for the next decade. And governments will be looking hard at ways they can boost employment by persuading consumers to buy locally-made goods and services.

And that's one outcome that neither Chinese government, nor its private sector, were anticipating on when they made their investment decisions.