Bubbles losing air in China

China's 10 per cent growth never quite feels right when you're walking the streets of Shanghai.

That's the thing about the nation's booming coastal cities. Growth often feels like 20 per cent, or higher. What tamps down official gross domestic product figures is the fact that most of China's 1.3 billion people live nowhere near the skyscrapers, bright lights and construction cranes of Shanghai.

We are seeing cracks in this virtuous dichotomy. Growth slowed to 9.6 per cent in the third quarter from 10.3 per cent in the second and 11.9 per cent in the first. Yet inflation, which many believe is already understated, accelerated to the fastest pace in almost two years. It's a sign frothy China needs to get serious about overheating risks before they spread everywhere.

Now, something may be afoot to put China on more stable turf: the end of the "Wen put," China's version of America's "Greenspan put" that propped up asset prices in dangerous ways.

The next two years are make-or-break ones for China. President Hu Jintao and Premier Wen Jiabao aren't lame ducks as they reach the twilight of their periods of influence. The dynamic is the opposite of, say, the US. As China's leaders spend their political capital and choose successors, they have a remarkable chance to reform an economy showing signs of strain.

China's leaders often seem more about censorship and blocking Google's search engine than big changes that would make the most populous nation more sustainable ten years from now. Thankfully, the more reform-minded Wen appears to be on the case.

Gloves are off

The gloves are coming off. China's central bank raised interest rates last week for the first time since the global crisis. It's far more important to dispel the notion that the government will dogmatically keep GDP above 9 per cent and prop up asset prices.

One of Federal Reserve Chairman Alan Greenspan's lasting legacies was his penchant for rescuing markets when things got dicey. A libertarian on paper, Greenspan was a monetary socialist in practice. China conjured up its own version of the "Greenspan put" in recent years, something that helped drive property prices into the stratosphere.

Investors always take such implicit guarantees too far. The International Monetary Fund last week said Shanghai's property market and some wealthier areas of Beijing may be starting to overheat. So, national data mask the severity of bubbles in China's showcase cities — ones on which foreign investors focus.

There are signs that the "Wen put" is undergoing a makeover. Far more talk of reform has hit the airwaves of late, and it's about time. China needs more balanced growth, greener industries and a narrower gap between rich and poor. We could soon see less empty investment that paves the way for an explosion of bad loans. More productive use of China's savings will leave the nation stronger in the decade ahead.

Obvious steps China could take include pushing its currency higher. It would accelerate the process of moving away from sweatshops toward services and better-paying high-value-added industries. The yuan isn't likely to strengthen significantly, though. China sees a weak exchange rate as a vital shock absorber as it tweaks its model. It's all about balance.

It's a point that's missed in the furore over China's curbs on rare-earth exports. It's also about creating jobs and domestic wealth. China has failed in articulating the latter strategy to irked trading partners.

Bubbles abound

Another perception that needs addressing is the state's readiness to make risky bets worth investors' while. When you chat with investors in Hong Kong and Shanghai and suggest bubbles are growing, you often hear some variation of: "Yes, but do you really think the government will stand by and let stocks or real estate plunge? No way."

There's the rub. China needs to get out of asset markets, publicly and transparently. Yes, markets will gyrate, investors will complain and politically connected executives will work the phones. Yet this is a vital step China needs to take to become a more stable economy in the long run.

Zero rates around the world mean that Chinese rate hikes will only attract more hot money as investors seek higher yields. The sobriety China's economy so badly needs must come from government policies.

Wen has until 2012 to roll up his sleeves and see to it that China doesn't just grow faster, but better. Proving that China isn't some giant insurance company for investors is a great way to start.