Moving Too Fast?

SHEN YU/IMAGECHINA
China is the world's largest producer and consumer of televisions

Old Chinese bomb factories rarely die. They just become car plants. At least that's what has happened at Qin Chuan in the northern city of Xi'an. The aging state-owned enterprise, which a decade ago made 130-mm artillery shells, now houses assembly lines that stamp out a boxy four-door hatchback called the Flyer. It built just 17,000 vehicles last year; many of the underpowered and unattractive cars were bought by local taxi companies on the order of provincial officials looking for a captive market. But even that didn't dismay factory managers trying to cash in on China's booming car market. In February, BYD, a maker of lithium batteries in Shenzhen in southern China, bought the Flyer factory. Although the new owner has no experience making cars, it still plans to invest a war chest raised on the Hong Kong Stock Exchange to build a new facility that will start producing four models of Flyers as early as next year. "Once we're established," says Liu Zhenyu, the factory's general manager, "we'll use our batteries to make electric cars."

The business plan of BYD, which stands for Brings You Dollars, might sound fanciful, but it is far from unique. With demand for cars soaring purchases of passenger cars increased 75% last year China is now the fourth largest car market in the world, behind the U.S., Japan and Germany. But unlike the more mature markets of the top three, China has more than 200 carmakers, ranging from creaky communist-era holdovers and former washing-machine manufacturers to modern joint ventures run by the likes of Volkswagen and General Motors. Most have responded to the growing demand with massive capacity expansion. Accounting firm KPMG predicts that within two years China will be able to build 4.9 million sedans a year roughly the output of Germany and will outstrip even China's fast-growing demand by 2.3 million cars a year.

It's a recipe for glut that could reverberate around the globe, and not just in cars. From microwaves to T shirts to sheet steel, China is building up excess capacity at a breakneck pace. The country's economy grew 9.1% last year and attracted $53 billion in foreign investment, second only to the U.S. economy. The emerging middle class pushed retail sales up 9% in 2003, but industrial output shot up 17%. Economists warn of a crash waiting to happen: if too many factories make too many goods chasing too few buyers, the results are likely to be deflation, widespread business failures, layoffs, loan defaults and shaky banks. And with many other Asian countries retooling their economies to fuel China's boom, the knock-on effects down the supply chain could be devastating. "Overinvestment will lead to a supply shock that will affect the whole world," predicts Dong Tao, chief Asia economist for Credit Suisse First Boston.

Tao might seem like a killjoy. After all, China at the moment is the star on the world economic stage. The country's soaring need for a host of goods, especially commodities such as oil, iron ore and aluminum, is a major contributor to global economic recovery. China is poised this year to pass Japan as the world's third largest importer. But the government needs to keep the economy superheated just to provide jobs for the 12 million to 15 million people coming into its labor market every year. That means finding ever larger markets both internal and overseas to soak up all the goods the country is producing. The U.S. already has a massive $120 billion trade deficit with China, which has prompted some members of Congress to call for punitive tariffs. Other countries are equally fearful of a deluge of cheap goods from China.

Those closest to the gears of the global economy were the first to notice the coming storm in China. Albert Stahl, a London ship broker, watched the spot-market price for cargo-vessel leases rise last winter to $22,000 a day for a ship big enough to transport iron ore. He assumed the spike was due to the impending Iraq war. But through the summer the price kept increasing; shipowners even stopped giving quotes in expectation that prices would jump again the following day. Then Stahl began hearing reports of vessels the size of three football fields anchored off the Chinese coast for up to two weeks waiting for a berth, sometimes paying $100,000 a day for the privilege. Finally, he pieced it together. "There's a shortage of available ships in the world because of congestion in China, and nobody knows how to deal with it," says Stahl, a director at CTI Transport and Logistics.

There are other signs that China's economy is overheating. Chinese state-run banks, already technically insolvent, have in the past year been shooting out new loans for factories, roads and real estate as if from confetti cannons. According to China's central-bank numbers, lenders last year handed out about $335 billion, 50% more than the year before. It's just not possible that China's banks suddenly found so many new creditworthy ventures, says Nicholas Lardy of the Washington-based Institute for International Economics. "We've seen the greatest credit expansion in the past 25 years," he says. "I'd expect companies that borrowed heavily to face difficulties when the next downturn starts."