CHINA HITS ITS MARK - FOR NOW / THE WALL STREET JOURNAL ( HIGHLY RECOMMENDED READING )

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JANUARY 21, 2010, 5:55 A.M. ET.

China Hits Its Mark - For Now .

By ANDREW PEAPLE

Phew - what a relief! China's beat its totemic 8% growth target in 2009.

In fact, at 8.7% for the year, economic growth also defied skeptics who forecast GDP growth would be nearer 5% last year, and leaves China within a whisker of replacing Japan as the world's second largest economy.

But at what cost? There's little doubt China's economy has been kept going in the past year largely on the back of a 30% rise in bank lending, allied to a sizeable fiscal stimulus.

Near-term, the flood of money is creating concerns about inflation and asset bubbles, particularly in the property market. After a year of mostly deflation, CPI inflation spiked to 1.9% on-year in December. New residential property prices are rising by double-digit levels on-year, especially in major cities. Longer term, it's important to consider the contingent liabilities that cloud China's solid-looking balance sheet.

Certainly, with official government debt under 20% of GDP and nonperforming loan ratios under 2% at the country's leading banks, neither the fiscal position nor the financial sector look stretched. But 2009's lending has surely stored up some problems for China's banks. If, say, 20% of 2009's new loans go bad, and 10% of likely new loans in 2010 also run into trouble, total nonperforming loans would reach $381 billion, or 8% of China's 2009 GDP, UBS economist Tao Wang calculates. Nor has China ever truly resolved the bad debts it shifted off banks' balance sheets a decade ago.

Local government debt, too, has been mounting. These figures are excluded from the central government's debt picture. Wrapping them in could at least double the fiscal debt to GDP ratio, it's estimated.

Certainly, it's unfair to suggest that China's stimulus has all been misallocated. China hasn't let a good crisis go to waste, upgrading, for example, its outdated rail network.

Such projects should help the economy in the future, though it's hard to know by how much. But if China wants to create more sustainable growth, the next stage of its development needs to include more reforms -- such as liberalization of the financial sector -- that will help get capital allocated more quickly and efficiently to where it's really needed.

For sure, China may be able to grow out of some of its problems -- such as the bad debts -- being created now. But it'll only do so as quickly as its economy liberalizes. Otherwise, the returns generated with tricks like pumping loans and government money into the economy will prove ever-diminishing.

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