The coming China crisis: trouble in paradise.

• Author: Delfeld, Carl

That China has been an incredible growth story pulling many millions from poverty is undisputable. In 1990. China's GDP was roughly equal to that of Taiwan. Now it is ten times bigger.

But China's investment-led industrial growth, already into its twelfth year, is looking long in the tooth. Real fixed investment has increased at a faster rate than GDP in nine of the past ten years. Furthermore, research by Pivot Capital Management shows that the longest previous period of investment-led economic growth was nine years, experienced by both Thailand and Singapore.

As China's leadership celebrated the sixtieth anniversary of Communist party rule with chants of "Nothing can stop us. Go. Go. Go," I have some unwelcome news. The country has substantial overcapacity in manufacturing, real estate, and infrastructure as well as deteriorating credit quality and weakening export markets. Unfortunately, its brittle political system will make the chances of adjusting to consumer-led economic growth remote at best.

All of these factors will lead to a growth rate far below that expected by the markets and that will, in turn, lead to a China crisis, circa 2010.

China's approach to producing double-digit economic growth is not new but drawn to a great degree from the Asian model playbook. Heavy investment in industry leads to rapid growth in manufacturing output and this leads to rapid export growth and huge trade surpluses. From 2001-07, the export share of China's output rose from 20 percent to 36 percent, a surge that coincided with a rise in the global export share of world output from 24 percent to 31 percent.

This is not much different than the model which Japan, Thailand, or Singapore followed and it was coupled with policies that kept interest rates and wages low and respective currencies weak, all in the name of attracting foreign direct investment and increasing export competitiveness.

For China though, investment (gross fixed capital formation) is at 70 percent of GDP and the return on every marginal dollar invested in China is decreasing. In 2000, it took $1.5 of credit to generate a dollar of GDP but by 2008, it took $7 of new credit to generate a dollar increase in GDR The global macro picture will accelerate the China crisis because it will shine a spotlight on China's shrinking export markets and industrial overcapacity. Some examples of Chinese overcapacity are its steel capacity equal to that of America, Japan, Russia, and the twenty-seven...