Lehman Dynamic Spreads Through Chinese Economy: William Pesek

Commentary by William Pesek

Oct. 22 (Bloomberg) -- The Beijing Olympics sure do seem like a lifetime ago.

It's not that television viewers forgot the impressive images from August or even China's first spacewalk in September. It's more about the astonishing news of late, including Wall Street's collapse, outrage over Russia's tussle with Georgia, violence in Bangkok, chatter about Kim Jong Il's health and geopolitical flare-ups.

China's milk scandal also has dominated headlines and delivered the latest blow to the Made-in-China brand. Previous safety scares involved seafood, dumplings, pet food, toothpaste, medicine and toys. A move by Mattel Inc., the biggest toymaker, to recall tens of millions of Chinese-made products was a public- relations debacle.

The brouhaha over tainted milk brought things to another level. That would be less problematic if trends in the global economy weren't weighing on China, as evidenced by the slowest growth since 2003.

What's interesting about China being hurt by Wall Street's meltdown is that its own quality-control woes derive from similar circumstances.

At the heart of the crisis that toppled Lehman Brothers Holdings Inc. is an out-of-control system built on debt. At the heart of China's problems is frantic development that also cuts corners to meet overambitious targets. The habits of both have huge implications, but aren't easily changed because they are ingrained. The common dynamic is greed, meeting over-inflated goals, creative accounting and a sense of hubris.

Subprime Crisis

As the U.S. subprime crisis deepened a year ago, pundits said the fallout was containable and overblown. So did Chinese officials more recently as infected milk powder began sending children to the hospital.

Over time, it became clear melamine-laced milk products that killed at least four babies and sickened about 53,000 in China were everywhere. More than 20 countries and markets worldwide banned Chinese milk and foods. It wasn't unlike the process of realizing just how many countries were exposed to hard-to-price collateralized-debt obligations or Lehman bonds.

Just as the credit crisis has shaken Wall Street to its core, safety concerns are a bigger problem for China than many realize. It's one thing to fake DVDs and Prada bags. When a lack of regulation and oversight forces companies such as Unilever, Cadbury Plc and Japan's Kanematsu Corp. to recall goods, China has a true dilemma on its hands.

Crisis Territory

China's economy grew 9 percent in the third quarter, the weakest since the epidemic of severe acute respiratory syndrome, or SARS, shook Asia five years ago.

If Donald Straszheim is right, things could get worse. The Newport Beach, California-based vice chairman of Roth Capital Partners says Chinese growth will slow to about 8 percent in the fourth quarter and 6.5 percent in 2009. If you are the U.S., Europe or Japan, that kind of growth sounds splendid. For developing China, it would be crisis territory.

When the central bank cut its one-year lending rate by 0.27 percentage point recently, analysts assumed China was being a good global citizen. It's now clear the move reflected recognition of how vulnerable China's export-driven economy is to a deep U.S. recession. It also suggested deflation is a bigger worry than inflation.

Still Overheating?

It's a difficult balancing act. Economists such as Diana Choyleva of Lombard Street Research in London say China ``is still overheating'' even as it considers efforts to boost growth.

That problem may take care of itself as the global outlook darkens. ``Upstream inflationary pressures from commodity and energy prices have softened and will pass on to consumer-goods prices in the months ahead,'' says Jing Ulrich, chairwoman of China equities at JPMorgan Chase & Co. in Hong Kong.

All this will contain an element of whiplash for those who believed China would avoid the U.S.'s woes. As the U.S., Japan and perhaps Europe experience a contraction, there's little that China can do to shield itself.

A critical mass of China's 1.3 billion people isn't ready to create a domestic market. Nor can China easily find other export markets to offset Group of Seven economies. China can keep cutting rates, increasing infrastructure spending and tweaking taxes, yet that may not be enough.

Different This Time

That also goes for the Communist Party's aim to double rural incomes to boost domestic consumption. Such steps include extending the tenure of farmers' leases and increasing their ability to trade and borrow against land. Three years ago, that might have helped. Coming in late 2008, as the global credit crisis spreads, the impact may be eclipsed by falling income as exports slow.

Investors in the past tended to lose money betting against China. The country has a remarkable track record of steering its way around crises. It dodged Asia's 1997 meltdown, the technology-stock implosion in the early 2000s and the gloom following the Sept. 11 attacks.

This time, things really are different. Just as Wall Street needs to change its ways, China must diversify its economy. In both cases, it's easier said than done.

The worst financial crisis since the Great Depression won't leave China unscathed. If things get that bad, Chinese officials will have more to cry over than tainted milk.

(William Pesek is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: William Pesek in Tokyo at wpesek@bloomberg.net