China's Economic Recovery: Miracle or Mirage?

Last week, as U.S. President Barack Obama was preparing for his first visit to Beijing and the China-as-rising-superpower meme was center stage, a story on Politico.com posed a provocative question: Is China headed toward collapse?

The Nov. 10 story noted that, despite conventional wisdom that a rejuvenated Chinese economy, which grew 8.9% in the third quarter, could pull the global economy out of recession, several skeptics were arguing the Middle Kingdom's performance was unsustainable — and even that it was mostly a mirage. Chief among these naysayers is billionaire hedge fund investor Jim Chanos, who famously sold Enron short in 2001 after concluding that the rosy reports and projections about the company were not based on facts. He has come to a similar conclusion about China, according to Politico.com, and is shorting the country just as he did Enron.

"I think the [China miracle] story is getting harder and harder to believe," Chanos said on CNBC in September. "You have to keep in mind that the last command economy that really saw this kind of growth was the old Soviet Union and what happened was the misallocation of resources into inefficient plants, dams that burst, nuclear plants that had accidents and so on and so forth, as well as the fairly large defense budget," he said. "China's heading the same way."

Skepticism about China is not new. Lawyer Gordon Chang published The Coming Collapse of China in 2001, and he's been waiting for the thud ever since. In a recent column in Forbes magazine, Chang insisted China's third-quarter GDP growth this year is unlikely to be "anywhere near" the official 8.9% cited by Beijing.

Never mind that the World Bank, International Monetary Fund, Moody's Investor Service, and various research houses and investment banks take the number at face value. Chang says "Beijing's statisticians have gone back to their old tactic of making up figures to support the Politburo's predictions." He points to inconsistencies in other statistical indicators: car sales jumped 94.7% in August, for example, yet gasoline sales rose just 6.4%. "There are reports that central government officials have ordered state enterprises to buy fleets of vehicles and that these businesses are storing them in parking lots across the country," he says.

Like Chang, Chanos claims a "wholesale fudge factor" in Chinese statistics, including unemployment numbers. "Economic activity isn't necessarily building wealth," Chanos argues. "If you have to keep putting up the same bridge every five years because it falls into the river, you're going to show a lot of GDP growth as you keep rebuilding the bridge [but] you're not generating any wealth for your countrymen."

Another China skeptic is Pivot Capital Management, investment manager of the $505 million Pivot Global Value Fund. In an August report, it makes the startling claim that China is not 45% urbanized as the World Bank and other international agencies estimate. That figure could be "understated as much as 20%," says Pivot, "meaning that instead of about 350 million people, only 100 million actually would need to be urbanized."

This is key, Pivot says, because it indicates in coming years there will be a dwindling in GDP-boosting activities such as construction. China's "industrialization and structural modernization are largely complete," according to Pivot's report. As a result, new investments will end up funding unneeded factories, buildings and roads. He concludes that the country's capital spending boom is unsustainable because it is "outstripping previous great transformation periods" experienced by Thailand and Asia's other tiger economies, as well as Germany and Japan.

Unlike Chang, Pivot Capital appears to accept China's reported growth in 2009 at face value, but says the "burst in economic activity has been inflated by a front-loaded stimulus package and a surge in credit growth," two drivers that will run out of steam in 2010. "The chances of a hard landing are increasing," the report warns. "The coming slowdown in China has the potential to be a similar watershed even for world markets as the reversal of the U.S. subprime and housing boom."

It's hard to tell if the skeptics are right. China is like the proverbial elephant being described by blind men: anyone can say anything depending on which part they happen to be touching. Jim O'Neill, head of global economic research at Goldman Sachs, is dismissive of the doubters. "I've seen similar sorts of stories about 20 times this year," O'Neill said last week during an interview on Bloomberg TV. "These are generally written by people that obviously just don't follow closely or study China." He maintained that, if anything, China's economic strength is being underestimated. "The latest data we got earlier this week, in addition to the month before, suggest that GDP was actually stronger than 8.9% in the third quarter," he said.

Not that he minds doomsday predictions. "I like seeing those stories because this tells me that there are [still] so many unbelievers out there," said O'Neill, who has been visiting China for 20 years. "There will [then] be plenty of people to realize the power of recovery, and more importantly as it relates to China, to start to recognize what is quite simply the most important economic story of our generation and quite possibly our children's."

Translation: global markets will remain buoyant longer than expected as the short-sellers are forced to cover their anti-China bets and the unbelievers finally come around and belatedly take long positions. For the sake of 1.3 billion Chinese and the rest of us, let's hope it's Jim O'Neill that's right, rather than Jim Chanos.