The Coming China Meltdown.(International Edition; POINT OF VIEW)(China's overcapacity)

Byline: Michael Pettis; Pettis is a professor of finance at the Guanghua School of Management at Peking University.

If China continues to force excess capacity onto a struggling world, it could result in a trade war.

Economic crises have a way of concentrating minds. In the midst of recession, the United States and China have an unprecedented opportunity to rebalance their economies, one that they must seize in order to mitigate further global economic fallout from the downturn. American policymakers--and, it seems, significant parts of the Chinese policymaking establishment--do not yet fully appreciate the impact of the global crisis on Chinese economic prospects.

Although official estimates put urban unemployment in China at just over 4 percent of the workforce, most unofficial estimates are much higher--closer to 8 percent--and nearly everyone agrees that the figure is set to rise significantly in the next few months. Some credible estimates suggest that even if China were able to achieve the 7.5 percent growth projected in 2009 by the World Bank, unemployment would nonetheless double before the end of the year.

Things will get worse. China has a huge overcapacity problem, with total production exceeding consumption by about 10 percent of GDP. In the past China has been able to export this excess; now markets in the United States, Europe and elsewhere are contracting rapidly, and it will be all but impossible for rising domestic demand to plug the gap. In addition, collapsing corporate profits will put a sharp dent in new investment, nearly two thirds of which has been funded, in the past, out of retained earnings. Exports and investment have been two of the biggest sources of Chinese growth, and the outlook for both is poor.

China needs to achieve two major objectives. Domestically, it needs to increase employment. Globally, it needs to reduce the amount of overcapacity it is exporting to the rest of the world. But these two goals are at loggerheads in the short run. For example, in order to boost employment, Chinese policymakers have forced banks to increase their lending so rapidly that it will almost certainly lead to a future explosion in bad loans. But because of the structure of the Chinese financial markets, all this new lending is being channeled into the manufacturing and infrastructure sector. Although this will naturally contribute to global demand if it takes Chinese workers off the unemployment line, the consequent increase in production may easily counter this gain. China would thus continue to export too much to a world struggling with collapsing demand.

Within China, ...