China's Infrastructure Trap

China is making vast and impressive improvements to its transportation systems, but it may not have the demand required to finance the projects.

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In this Monday, June 27, 2011 file photo, a CRH high-speed train leaves the Beijing South Station for Shanghai during a test run on the Beijing-Shanghai high-speed railway in Beijing, China. China's bullet train builders have conducted a test run of their showcase Beijing-to-Shanghai line amid controversy over the system's high cost. The investigation into a bullet train crash in China last summer that killed 40 people has come and gone with scarcely any fresh information about what led to the disaster.

James Rickards is a hedge fund manager in New York City and the author of "Currency Wars: The Making of the Next Global Crisis" from Portfolio/Penguin. Follow him on Twitter: @JamesGRickards.

One of the most infamous remarks ever made by a westerner returning from a visit to a Communist society was that of journalist Lincoln Steffens. After a 1919 visit to Soviet Russia, Steffens proclaimed, "I have seen the future, and it works." Of course, the future Soviet Union did not work at all, and after decades of slave labor, show trials, purges, and famine, it finally collapsed in 1991. Ever since Steffens, visitors to Communism have been well advised to take apparent progress with ample grains of salt.

Last week I visited Shanghai and Nanjing in China. This included travel on the new high-tech train between Shanghai and Nanjing, which reached a top speed of 305 km/hour. Some of the progress I saw was monumental, even breathtaking. Yet, there is room for serious doubt.

In 2009, China was reeling from the same collapse in global demand that had affected the United States after the Panic of 2008. China's policy response was a ¥4 trillion stimulus program (equal to about $600 billion) directed mainly at investment in infrastructure. The United States launched an $800 billion stimulus program at the same time. However, the U.S. economy is more than twice as large as China's. On a comparative basis, China's stimulus was the equivalent of $1.2 trillion applied to the United States.Three years after the program was launched, results are now visible.

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They are spectacular. The new trains are not only fast but also comfortable and quiet. The Nanjing South Railway Station where I disembarked is almost beyond words. It has 4.9 million square feet of floor space, 128 escalators, took more than 20,000 workers to build, and generates over 7 megawatts of power from solar panels. Ticketing and entry to platforms are highly automated and efficient.

The Nanjing station is not unique but one of thousands of stations, airports, subways, highways, container ports, railroads, and other infrastructure built or under construction all over China. There is no question that all of this infrastructure works. The question is whether I was seeing the future, or if something else is in store.

The problems begin with the fact that much of this infrastructure binge is debt financed. It is not clear at all that empty buildings, excess manufacturing capacity, and subsidized transportation will generate anywhere near the revenue needed to pay the loans.

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More troubling is that China's addiction to growth through infrastructure shows no signs of abating. For example, a new master plan is now being implemented in the Jiangning Development Zone south of Nanjing. The land has been cleared and graded and foundations, roads, man-made lakes, and a subway system are already in place. Soon to follow will be seven or so medium sized cities each with its own office towers, high-end shopping, luxury hotels, and housing linked by roads, rail, and telecommunications with an adjacent airport built expressly for the zone. Development projects like this are springing up all over China.

One high-tech laboratory I visited was massive with spacious offices, conference rooms, and lab sites surrounded by attractive grounds and good transportation. For the time being it was empty, but officials assured me that 1,500 experts would soon arrive. This puts the concept of "if you build it, they will come" on steroids.

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Yet, the most talented tech experts need more than nice offices. They want an entrepreneurial culture, close proximity to cutting edge university research, and access to the kind of start-up financial mentoring that comes with more than just a checkbook. Whether these x-factors can be supplied along with the buildings is an open question.

This points to the second weakness in China's plans, after the financing issues. Where will the businesses, people, and commerce needed to make these projects viable come from? No doubt some business will relocate from existing less attractive locations. However, the scale of these projects is so massive it is difficult to see how the service, technology, and luxury sectors can use the capacity. This is especially true if a high Chinese savings rate is needed to prop up the bank lenders thus stifling consumption.

If the United States has fallen into a liquidity trap, China may have fallen into an infrastructure trap from which there is no easy way out. Those 20,000 workers who labored on the Nanjing South Railway Station may well be employed in Jiangning today, but where does this end? The bad debts are piling up, the excess capacity is piling up and China has no consumption model to replace its infrastructure model despite such proposals in its 12th Five Year Plan.

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In the short run, China can continue its infrastructure binge because it has unused borrowing capacity to finance new projects and paper over losses on the old ones. Economic growth in the second half of 2012 may well exceed expectations as China tries to smooth over political turmoil and keep its corrupt party officials, cronies, and financial warlords happy.

However, there is a limit to this kind of expansion and the Chinese leadership know it. In the end, if you build it, they may not come. Then the hard landing begins.

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