The Economist this week has two articles on China's economy. In their leader they warn that a slowdown in China will have global implications although they are not as pessimistic about a "hard landing" in China as some. What worries them is

the prospect of a “twin tightening” of monetary policy in both China and America...If America's Federal Reserve is forced to raise rates more rapidly than expected and this happens at about the same time that China's economy slows sharply, stockmarkets would take a beating and global growth could stall. Monetary-policy announcements from Beijing are still not as important as the Delphic words of Alan Greenspan, the Fed's chairman. But as the weight of China's economy in the world continues to grow over coming years, one day they will be.

The second article is a far more thorough look at China's efforts to engineer a slowdown, rather than the global implications of that slowdown. I'm going to quote liberally from it because it is a fine summary of the issues at stake.

Rumours are rife that the People's Bank of China is about to raise interest rates (one-year bank-lending rates are currently 5.3%) for the first time in nine years. The fact that this is even being discussed shows how concerned the Chinese leadership is about the investment boom...The State Council, China's highest executive body, has issued new guidelines requiring companies to use more of their own capital and less debt to fund steel, aluminium, cement and property projects, the sectors which show most signs of overheating. Provincial government leaders have also been told to be stricter about approving investment in these sectors. On May 9th, the State Development and Reform Commission, the top economic policymaking body, instructed local officials to cap price increases in areas such as utility bills and public transport if inflation, currently 3%, rises much more.

Since last summer, banks' reserve requirements have been raised three times, but to little effect. Banks still have more than enough reserves. Tighter restrictions have been placed on property lending, and the central bank has also tried to use persuasion, asking banks to curb their lending to the overheating sectors—again with little apparent success.

In the year to the first quarter, bank credit surged by 21%, GDP grew by 9.7% and fixed investment by 43%. Inflation has risen from just 0.9% a year ago. Many economists reckon that the economy is even hotter than the official figures suggest. Based on electricity usage, annual growth may really be as high as 12-13%; and the true inflation rate is probably above 5%, as a significant number of prices are still controlled in some way by the government. On the other hand, official figures overstate the growth in investment, because the investment survey now covers more firms than last year. Even so, investment is still growing too fast...

...Hong Liang, an economist at Goldman Sachs in Hong Kong, thinks that talk of a hard landing is premature, because there are several differences between today and the early 1990s. Policy has been tightened sooner this time. In 1993 inflation was already 15% (it rose to 28% at its peak) before the central bank tightened, while money-supply growth then was twice as rapid as today's. In the early 1990s, real interest rates were negative, falling at one point to minus 13%. Today, bank lending rates are positive (see chart). Even so, the level of 5.3% is far too low for an economy where nominal GDP is growing at around 15%.

A second difference is that unlike a decade ago, there has not been a consumer-spending binge. Private consumption grew by only 6% last year, compared with average growth of 14% in 1992 and 1993. That is one reason why last year China had a current-account surplus; in 1993 it had a deficit of 2% of GDP.

The debate over the extent to which China's economy is overheating is sometimes a bit confused. The term “overheating” is normally used when an economy is suffering from excess demand, which then causes inflation to rise. But China's boom has been led by investment, which means that supply is booming as well as demand. As a result, the biggest risk to the economy is not inflation, but overinvestment. A glut of property or industrial capacity could depress profitability, bankrupt firms and swell banks' non-performing loans.

China's banking system, which is virtually all state-owned, does not allocate credit efficiently, and the misallocation of funds gets worse as growth speeds up. Bad debts may already be 40-50% of loans. In the long run, to improve this China needs to commercialise its financial system. That will require financial reform, as well as a transformation in corporate governance. But that will take years. Right now, the government needs to slow the economy to avoid another wave of bad loans.

The measures taken so far have lacked teeth. The People's Bank of China is therefore likely to raise interest rates and to introduce further, stricter quantitative measures to curb lending to the hottest sectors. The recent rash of announcements suggest that the government is starting to panic. The longer the economy grows at its current pace, the greater the risk of a hard landing, which would push up unemployment—something which Beijing cannot afford because of the risk of social unrest.

What do economists mean by a hard or a soft landing? In developed economies a hard landing implies negative growth, but not in China, where growth has averaged 9% over the past two decades. A soft landing would be growth slowing from its current 10% to not much less than 7%, the minimum needed to create enough jobs to absorb surplus rural labour and workers laid off by state-owned firms. Even that could still imply a halving in the rates of growth in industrial production and investment. A hard landing means growth significantly below 7%. Official figures suggest that growth after the early 1990s boom never dipped below 7%—a perfect soft landing. But many economists reckon that growth really slowed to 3-4%.

Indeed, the undervalued yuan is one important cause of China's credit boom and rising inflation. China's capital controls are porous, and investors all over Asia are betting on a currency revaluation by buying property in Shanghai or Beijing or putting their money into yuan deposits to take advantage of interest rates higher than the paltry level available in America. The yuan has been more or less pegged against the dollar since 1995. If, as a result of capital inflows, there is an excess supply of foreign currency, the central bank must buy it and sell yuan to keep the exchange rate stable. This injects new liquidity into the banking system, thereby feeding the credit boom. The central bank has been issuing bonds to mop up the liquidity, but this “sterilisation” is getting harder as the amounts swell. The bank has had trouble selling enough bonds in recent months, so the money supply continues to surge.

China's pegged exchange rate is not only causing problems at home. America accuses China of stealing jobs by keeping the yuan artificially low. In fact, it is not so clear that the yuan is undervalued. On the basis of purchasing-power parity (ie, relative prices) it does look undervalued. But almost all poorer countries look cheap by this gauge, and over the past decade China's real exchange rate has risen. Andy Xie, an economist at Morgan Stanley, calculates that, in real terms, the yuan has risen by 40-50% against both the dollar and the euro since 1993.

But what about another apparently telling piece of evidence: China's huge trade surplus with America? This, argue American politicians, proves that the yuan is undervalued. In fact it does not. China's overall trade balance was in deficit in the first three months of this year, thanks to strong import growth.

A third argument is that China's large surplus on its basic balance (the sum of the current-account and net foreign direct investment) and its huge build-up of foreign reserves are both symptoms of currency undervaluation. Mr Xie again disagrees. The increase in reserves, he argues, partly reflects speculative capital inflows. Moreover, if the capital account was opened (which is unlikely over the next four or five years), allowing firms and households to hold foreign assets, the yuan would probably fall, not rise, as the Chinese diversified their savings.

These arguments help to explain why the Chinese have so far ignored American demands to revalue their currency. It is not just crude mercantilism; there is much uncertainty about the yuan's correct value. The Chinese government says it will move towards a more flexible exchange rate in the medium term, but for the moment it wants to keep the yuan stable in order to support broader economic stability. Yet in fact, a flexible exchange rate can offer more stability, partly by providing a safety valve which helps to protect the real economy.

The strongest argument for a revaluation now is not that the yuan is undervalued, but that an adjustment would halt speculative capital inflows and so mop up the excess liquidity. It would be unwise for China to float the yuan until it has cleaned up its banking system, but it could repeg against the dollar at a higher rate and shift to a currency basket, which is what the government has said it would like to do. The snag, however, is that a small revaluation of only 5% might encourage expectations of a further appreciation and attract more capital inflows. Any revaluation would need to be large enough, say 10-20%, to head off such speculation. But a rise of such proportions would be unacceptable to the government, so the yuan is likely to remain fixed for the moment.

If so, the normal weapon to cool an overheating economy, higher interest rates, is likely to prove partly self-defeating in China because a rise in interest rates would lure in yet more hot money. Besides, interest rates play a modest role in an economy in which credit is allocated with little regard to its price. Despite China's reforms of recent years, the government still controls more than half of the economy. Most state-owned enterprises do not care about the cost of borrowing because they have no need to make profits. Local-government construction, a key feature of the investment boom, also remains unaffected by the cost of money, so long as credit is freely available. Higher interest rates will have the biggest impact on home mortgages and consumer loans. Yet the mortgage business is small, and consumer spending has been relatively weak.

Another way to slow the economy is fiscal tightening. The government says that it plans to trim its budget deficit slightly from 2.9% of GDP in 2003 to 2.5% this year. But if Beijing were truly worried about the economy overheating then surely it could cut public investment and run a budget surplus? Unfortunately, nothing is so simple. Unlike a developed-market economy, China lacks effective tools to fine-tune demand. Just as the interest-rate tool is weak, so fiscal policy is hampered by socio-political factors. That leaves the central bank with quantitative controls as its main policy tool. The risk with such crude measures is that it is easy to overdo things and cause a more severe contraction than intended...

What is China's sustainable growth rate? That is much trickier to answer than it would be for a developed economy such as America's. China's economy is not limited in the same way by the supply of labour or capital. It has a vast pool of surplus labour in the countryside, and masses of capital thanks to unusually high domestic saving and inward foreign direct investment. There is also massive scope for productivity gains as workers move from low value-added agriculture to higher-value activities. In theory, this could allow China to sustain growth of 8% for another two decades. In practice, the limiting factor will be the inability of its financial system to allocate capital efficiently until it carries out financial-market reforms...

China's current pace of growth in investment is unsustainable. Its combination of a badly functioning banking system, excessively cheap money and heavy government meddling is bound to result in some bad investment decisions. It would be wrong, however, to dismiss most of China's investment as wasteful. And even if China's current investment boom turns to bust, it would be foolish to write off China's economic future.