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Trouble Looming in China

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The Chinese economy is posting impressive growth of almost 8% annually, even as the rest of the world is going through excruciating economic pain.

How is that resilience possible? After all, China is dependent on selling to the US and Europe. Western consumers are in cash preservation mode, dramatically cutting back. China's economy should logically be shrinking, but it isn't.

The answer is that the Chinese government has been artificially inflating its economy.

Until the global economy turned down, the Chinese were exporting vigorously, and growing legitimately. America was in the habit of borrowing money from China and using that very money to buy Chinese goods. That created growth on both ends.

Now, fearing the vagaries of the downturn, the Chinese government is simply propping the economy up. They are doing so by printing money, and by forcing the government controlled banks to lend that money. Money supply in China is up significantly, and companies are borrowing and spending at a quicker pace. Because it is a closed system, some of those loose bank loans flowed into the stock market, which is up over 80% this year.

Of course, forced lending to state-owned enterprises is not a productive way to build an economy. Large-scale stimulus is not sustainable, and it will have dire consequences. What will ensue is a credit bubble and bad loans that will make sub-prime look respectable.

Remember, also, that China is not converting the money it receives in exchange for its products. It holds massive foreign exchange reserves of over $2 trillion, because it does not want its own currency to rise. That will make China less competitive, thus hampering growth. China's most important export to the US is low interest rates, which suits both sides fine.

Alas, they are forgetting what is perhaps the most important lesson in economics (and one of the hardest to learn). A nimiety of money is not synonymous with prosperity. It doesn't matter how many pieces of paper are being moved around, but what they buy.

The Chinese leaders feel they have no choice but to stimulate. After all, if they did not create the illusion of economic growth, they would have widespread hunger and mass riots on the streets. They hope to be able to keep this charade going until the global economy recovers.

The last time the world experienced a severe global recession, the ensuing social unrest resulted in the rise of totalitarian regimes of the worst kind human history had ever seen. People like Stalin, Hitler and Mao used their people's despair to commit unspeakable atrocities.

China is already a country with no tradition of liberty, no rule of law and no transparency. In addition it is a nuclear power, which emboldens its leaders and makes them almost impervious to political pressure from the outside. What's more, facing over-capacity and bad debt, they are furiously engaged in holding together the tattering economy in the rough seas of the global Great Recession. Those issues have to be dealt with, and not via temporary measures and artificial schemes, or there will be hell to pay.

Is such a country an appropriate place for investors? Would you like your retirement to be riding on China's political stability and bogus economic growth?

Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles-based investment firm. Email at aschram@wellcappartners.com