Bubble, Bubble, Toil and Trouble

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Think of Hangxiao Steel Structure Co. as a scout on China's economic front line. Its 200 workers in Anhui province rivet together prefabricated structures for factory assembly lines, which churn out goods for stores like Wal-Mart. A year ago business was so brisk that the company imported 70 workers from distant Shandong province to keep up with demand. But the mainland's torrid investment in everything from automobile plants to office high-rises to railroads has boosted the price the company pays for its main raw material, steel, by 24% in just four months. Yet the company hasn't been able to raise its own prices because most of its customers signed contracts last year, when steel was cheaper. "So far," says Hangxiao Steel's vice general manager, Wang Fei, "all we can do is lose money."

China's surging growth has been a welcome tonic in the past 12 months, helping to snap the global economy out of its postwar, post-SARS funk. But, as Wang notes, the country's boom has been a mixed blessing for mainland companies—and it may turn out to be mixed for the rest of the world, too. Concerns that China's economy is rising too fast are intensifying, and efforts by Beijing to let some of the air out of the balloon before it bursts have so far proved ineffective. The latest statistics, released last week, added to the alarm. Despite the central government's efforts to curtail unrestrained bank lending and excessive investment in sectors such as real estate and automaking, China's economy surged 9.7% in the first quarter this year, well above the government's 7% target. Another worrisome sign: fixed-asset investment spiked 43% in the first quarter, with the bulk of it going into the already frothy heavy-industry sector. Raghuram Rajan, chief researcher at the International Monetary Fund, warned last week of "signs of overheating," while Morgan Stanley's chief China economist, Andy Xie, asserted more bluntly that the mainland's economy was a "bubble."

China has suffered previous boom-and-bust cycles in its transition from communism to capitalism. In 1994, GDP growth exceeded 11% and inflation soared to 24%. To restore economic stability, the then Vice Premier and central bank governor Zhu Rongji choked off bank loans to cool runaway borrowing and spending. The subsequent slowdown threw millions of mainlanders out of work, but because China was relatively isolated from the global economy, few other countries shared the pain. Today, a sharp contraction in China would have much wider impact. The mainland is one of the world's largest manufacturing bases and is now its fourth largest trading nation. Last year, China accounted for approximately 70% of Japan's total export growth, 40% of South Korea's and 90% of Taiwan's, according to Morgan Stanley.

Inflation has already returned to the mainland, with prices jumping 2.8% in the first quarter. That might be a harbinger of higher consumer prices the world over. Although cutthroat competition among China's manufacturers has kept prices in check so far, it may not be long before foreign consumers are forced to cover the increased cost of raw materials—meaning higher prices for exported refrigerators, DVD players and a wide range of other products. Says Wang of Hangxiao Steel: "As soon as we can, we'll pass the increases on to our buyers." Morgan Stanley's Xie predicts that "at least in the short term, the world could see global inflation because of what's happening in China." The unhappy knock-on effect: to keep inflation under control, central banks around the world might begin raising interest rates, which would shave corporate profits and make it costlier for individuals to borrow money.

A lot is riding on whether Beijing's technocrats can manage a soft landing. China's investment boom is being driven in part by rampant borrowing, which the central government has tried to curtail by requiring banks to put more of their funds on reserve, thus taking money for loans out of circulation. The strategy seems to be having little impact, partly because China's banks have close ties to local governments, which often have stakes in local companies and property developments—a strong incentive to ignore Beijing and keep lending. "Irrational investments in redundant low-level construction projects ... have not been controlled effectively," admits Zheng Jingping, spokesman for the National Bureau of Statistics.

Beijing has ordered the country's banks to lend less to overheated sectors, including steel, cement and aluminum, and earlier this month dispatched inspection teams to seven provinces to ensure its dictates are heeded. Will it work? In Anhui, Hangxiao Steel recently increased its savings in case loans dry up. That's a good sign: if companies start borrowing less, growth might moderate to a more sustainable pace. From New York to Tokyo, savvy economists will do well to keep a watchful eye on places like Anhui. Now that China is at the heart of the global economy, the future depends upon them—for all of us.