Prognosticating for China is extraordinarily difficult; optimists and pessimists see an entirely different future for the country. China has neither political freedom nor a true market economy, and its economic statistics are as unreliable as those of the old Soviet bloc. Thus conventional economics is useless. Economic forces with the inevitability of gravity in a free market system appear to have no effect; with neither sail nor compass, navigation becomes impossible.

For no other country is there such divergence. China optimists, who look at the country’s industrial performance and international competitiveness, forecast rapid economic growth and emergence as an economic as well as political superpower. China pessimists, who look at the banking system and the spiraling level of bad debts therein, see a catastrophe waiting to happen. Back in 2001, when the world was in recession, pessimists seem to be winning the intellectual argument; in the 2003-06 world cheap money expansion, optimists have swept the field.

Statistics in a centrally planned economy or, as in China’s case, an economy with a large state sector controlled by an authoritarian government, are highly uncertain because there is no guarantee that the output of state factories consists of products that anyone wants to buy. The government produces statistics, but they may be rubbish – in 1989, for example, so august a publication as the Economist Desk Diary claimed that the centrally planned East Germany was richer than Britain – which visitors to the country knew at the time to be rubbish and was soon proved to be rubbish by the collapse of Communism. Thus all Chinese statistics should be “benchmarked” against other economies in the true free market, to see if they are plausible.

Some Chinese economic statistics are pretty solid. We know fairly precisely what Chinese exports are; they’re mostly products you can drop on your toe. We have a fair idea of total Chinese retail savings – approximately $1.8 trillion in March 2006, compared with official Gross Domestic Product of about $2.5 trillion in 2006.

Other statistics, when examined closely, seem distorted or very unlikely. We are told that Chinese consumers are saving more than 40% of their incomes, and that China is investing more than 40% of output. Both figures seem extraordinarily high, and have risen substantially over the last decades as the Chinese economy has grown. Further, official Chinese GDP at $2.5 trillion is less than a third of Chinese GDP calculated at “purchasing power parity” – currently around $9 trillion.

Official growth figures, currently above 10% per annum, but hardly ever falling below 8% per annum over a period of more than two decades, also look a little fishy, since only a modest part of the Chinese economy has yet emerged into “Asian tiger” status. Inflation is currently officially recorded at 2%; this too looks odd when anecdotal evidence is that it is more like 10%, wages in the modern sector are increasing by 15% or more and substantial increases in energy prices have been implemented.

Then there’s the banking system. Ernst and Young estimated in March 2006 that the Chinese banking system contained bad loans of around $900 billion, compared with the official figure of around $200 billion, but was then forced to retract this estimate under pressure from the Chinese government. However informed observers estimated as early as 2001 that bad loans totaled $500 billion, and 2003-05 was marked by an orgy of dubious real estate lending. In a period of easy money worldwide, it seems likely that Ernst and Young’s estimate may be conservative rather than liberal.

The official Chinese savings and investment rates of more than 40% are historically far too high to be plausible – even Japan, a notoriously thrifty society, managed only 30% during its economic miracle years of 1955-85. Since the figures for Chinese savings and investment are fairly solid, this suggests that the figures for Chinese GDP and personal income are too low. This is also suggested by the divergence between actual and purchasing power parity GDP, which should be converging as China gets richer and joins the western economic world. In an authoritarian but inefficient society like China there is likely to be a huge unofficial economy – anecdotal evidence on Chinese small business creation suggests that this is indeed the case. If you estimate China’s GDP at $3.5 trillion and add about 50% to personal income (putting the savings rate at or just below 30%) you’re likely to be far closer to the true picture. Chinese consumption – all those Buicks and fancy apartments – also makes more sense for a population 40-50% wealthier than the official figures show.

Thus the error in China’s GDP figures this case seems likely to be in the opposite direction from that of East Germany in 1989 – too low rather than too high. If Chinese GDP is larger than official figures state, Chinese growth rates and export ratios are correspondingly deflated (the unofficial economy may be declining as a proportion of the total, even if it is expanding in absolute terms) and the Chinese economy makes correspondingly more “sense” when benchmarked against its Asian competitors.

The banking system is primarily state owned, and most of the bad debts from pre-2003 cycles were to state owned companies. In the 2003-05 lending boom, private sector bad debts may well have arisen, but there has also been a huge surge in lending to municipalities and parastatal entities for real estate construction. In a free market, the banking system’s bad debt levels would have caused it to collapse long ago, as did the banking systems of South Korea and Indonesia. However the majority of Chinese bad debt is public sector, not private, and its expansion continues. With China’s prime domestic lending rate currently at 5.85%, inflation almost certainly above that level, and little chance of a loan turndown if you’re a public sector entity with good political connections, bank lending is, unsurprisingly, increasing rapidly – new lending was 2.1 trillion yuan ($260 billion) in the first five months of 2006, compared with a full year target of 2.5 trillion yuan.

Thus most of the Chinese banking system’s bad debts are really part of the public sector borrowing requirement. State companies, the People’s Liberation Army and its corporate empire, and local governments borrowing at below-zero interest rates through a state-controlled banking system are not equivalent to even the doziest arms-length private sector lending bubble, they are instead an innovative means of financing the public sector wish list.

If most of the $900 billion of bad debts identified by Ernst and Young can be assumed to be public sector and around half of the new debt being assumed currently is also public sector, then of the $400-500 billion of new debt to be assumed in 2006, around $200 billion, the expected addition to “bad debts” in 2006, should properly added to public spending.

Instead of a state budget deficit of $32 billion, the true deficit is thus likely to be $232 billion, more than 9% of official GDP, though only 6.7% of “guesstimate” GDP. Adding in the bad debts in the banking system, public debt rises commensurately to about 65% of official GDP or 45% of “guesstimate” GDP.

China’s situation is thus unsound in three respects: it is running a true state budget deficit that is close to an unsustainable level, it is financing that deficit through a cockamamie scheme that may destabilize the banking system and it is running an unsustainably stimulative monetary policy with negative real interest rates. All this is pretty similar to the position of the United States and much of Western Europe, albeit more extreme, with only the additional twist of the banking sector involvement. It doesn’t promise imminent collapse, or anything like it.

It does however suggest that China will be particularly badly affected by the tightening in liquidity that is currently taking place worldwide. If real interest rates in China become positive, the financing costs of the public sector entities will increase rapidly, putting an intolerable additional strain on the banking system. Once the true public sector deficit hits around 10% of GDP, it will quickly become unfinanceable.

While new private sector savings exceed the production of bad debts, the banking system can be sustained – effectively the Chinese people are pouring their savings down the public sector rat hole. However when the banking system’s bad debts get close to the $1.8 trillion in private savings (the remainder of the deposits in the banking system are interbank and corporate/government, thus mostly themselves “funny money”) the banking system won’t have the liquidity to operate, at which time collapse will occur.

There are a number of palliatives that the Chinese government can adopt to mitigate the problems that such an eventuality would bring. For one thing, they can allow their currency to appreciate in the international markets, thus attracting international liquidity to their banking system and enabling them to keep domestic real interest rates negative and the machine turning (this is inflationary, but only fairly slowly.) With $800 billion of international reserves, China has plenty of money to bolster its international position, even in a crisis.

Another palliative, which the Chinese government is currently adopting, is to attract foreign equity capital into the banks. The advent of foreign minority shareholders will increase confidence in the banking system, and those shareholders, while imposing controls on dangerous lending in the private sector, will certainly be careful not to audit the banks’ existing debt portfolios too rigorously, since to do so would both upset the Chinese government and destroy the value of their investment.

If illiquidity does occur, the Chinese government can replace a high percentage of private savings in the defaulted banking system with foreign currency bonds issued under its full faith and credit. If all such savings were replaced with government debt, China’s public debt to official GDP ratio would rise to around 100%. Provided the Chinese export machine remained in operation, even such a large issue of new bonds would in most markets find a reasonably deep secondary market among international investors, thus preventing more than modest loss to Chinese savers. (Experience, for example in Yugoslavia and Latin America, has shown that nothing is more destructive to an economy than looting the domestic private savings base; it is to be hoped that the Chinese government is intelligent enough to avoid such a catastrophic blunder, even in difficult circumstances.)

Crisis in China is thus inevitable; the current Chinese financial and economic system is unsustainable. It’s a little like the U.S. financial and economic system in its early period of growth, after Andrew Jackson had removed state deposits from the Second Bank of the United States in 1834. The long term prospects were excellent, but the instability of the banking system combined with excessive debt levels to produce a deep crisis in 1837, followed by the default of the State of Pennsylvania and a deep recession lasting half a decade.

The big losers from the U.S. crash of 1837 were foreign investors. In China, too, this is likely to be the case; in particular the foreigners rushing to invest in minority stakes in Chinese banks are almost certain to lose their money.

But then, isn’t that what foreign investors are for?

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

This article originally appeared on United Press International.