Middle Kingdom's anti-gravity act

It's officially OK now to recognize that China urgently needs economic reforms. Premier Wen Jiabao said so. So did Vice Premier Li Keqiang, who is likely to take over from Wen when the Communist Party can sort out its power squabbles.

Every other economist has taken up the cause. Christine Lagarde, the managing director of the International Monetary Fund, noted in Beijing last month that "Re-engineering of the growth model is being advocated at the highest levels of government, and this is highly desirable."

The buzzwords are "rebalancing the economy". A quick glance at the structure of China's economy shows the problem. Consumption has fallen to 35 percent of gross domestic product, almost unprecedentedly low by world standards. India, Japan, Taiwan and Thailand have consumption of 55 to 60 percent of GDP and the U.S. has 65 to 70 percent. China's fixed investment is 46 percent of GDP, between 10 and 20 percent higher than Japan and South Korea at similar stages of their economic development.

Officially the new course has been set and supertanker China is changing direction smoothly and capably under its Communist captains. Zhu Min, deputy managing director of the IMF, reiterated in Hong Kong that China's GDP depends too much on investment, which is "not sustainable", but he added confidently that "China's heading for a soft landing."

With the remarkable rapid shrinking of China's current account surplus, from 10.1 percent of GDP in 2007 to 5.1 percent in 2010 and to 2.7 percent last year, some Chinese economists have already declared victory. With rising wages and growing retail sales of consumer goods, there is little need to worry, according to the optimists.

Skeptics point out that rebalancing will not be so easy, and the domestic economy is still dangerously out of kilter. Adrian Mowat, J.P. Morgan Chase's chief Asian and emerging-market strategist, declared: "If you look at the Chinese data, you should stop debating about a hard landing. China is in a hard landing. Car sales are down, cement production is down, steel production is down, construction stocks are down. It's not a debate any more, it's a fact."

Satyajit Das, who has worked in financial markets for 30 years, declares that China's recovery from the global financial crisis was a result of "Botox economics." He claims that, "Using the advantages of a centrally controlled, command economy, Beijing boosted output through government spending and directed bank lending to maintain growth."

Since 2008, Das notes, almost all of China's growth has come from "government influenced expenditure." China's headline growth of 8 to 10 percent a year has been driven by new lending averaging between 30 and 40 percent of GDP. Up to 25 percent of these loans may prove to be nonperforming, amounting to losses of between 6 and 10 percent of GDP.

Professor Michael Pettis of Peking University makes an important point in his China Financial Markets newsletter, arguing that the promises of the Chinese leadership to bring changes are too often taken as fact: "Too many analysts overemphasize the intentions of the Chinese leadership when projecting China's future. If Beijing announces that it plans to accomplish a certain goal — raise the consumption share of GDP, or double the length of railroad track — analysts quickly incorporate that goal into their projections even when it isn't at all clear how Beijing will do it."

He adds that the same caution should be applied to the statements of political leaders everywhere, when they talk about debts.

Pettis has a very useful analysis of why China must rebalance its economy and, more important, how this can be accomplished. The key issue is that "China must stop transferring income from households to the state and must reverse those transfers. As Chinese household income and wealth become a greater share of the overall economy, so will Chinese consumption." Pettis lists Beijing's five options for change.