To stay out of the red, China needs to go green

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This century, watch China. That nation's explosive development is reshaping the global economy. Its inexpensive exports, for example, are squeezing profits for business competitors in the United States and other nations. Its huge appetite for raw materials threatens to heat up inflation overseas. Well aware of these effects, the finance ministers and central bankers of the world's richest nations - the G-7 - meeting last week in Washington agreed that China should ease the trade pressure by letting its currency move upward.

US officials even talked of giving China a role in that club of powerful nations.

Before it joins the world's biggest economies, however, China faces two huge internal challenges. And surprisingly, the biggest one may be neither economic nor political but environmental.

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The drought in northeast China, for instance, has created a water shortage that shut down nonessential enterprises in Dalian, a port city. In Taiyun, a coal-producing region, water scarcity meant the city had the stark choice of moving 3 million people, shutting down heavy industry, or diverting a major river. It chose the last option.

Water shortages also mean crop losses. In Qianghai, some 2,000 lakes and rivers have dried up, with serious implications for the flow of the crucial Yellow River. Already a quarter of China, about the size of the United States, is desert.

Air pollution is also serious, creating health problems that mean days lost on the job. Beijing roads carry 2 million cars now, with 3 million predicted for next year. Traffic cops, breathing foul air, live 40 years on average.

That's some of the environmental damage toted up by Elizabeth Economy, author of "The River Runs Black," a new Council on Foreign Relations book. The damage imposes huge costs. Lost output runs between 8 and 12 percent of gross domestic product a year, she estimates.

For example, because millions of farmers are leaving the land, especially degraded land, China must build new housing. It needs to add the equivalent of a city the size of Houston every month.

Environmental protection issues are dealt with primarily by local officials. Wealthier regions of China with strong leaders and international ties are defending their local environments, Ms. Economy notes. But she would like it done better than American-style suburbanization. Shanghai, for instance, plans to build 10 "satellite cities," or suburbs - without adequate mass transportation.

China's other big challenge is a delicate balancing act: to maintain growth without overheating. Since 1978, when Premier Deng Xiaoping set economic reform in motion, China's GDP has grown at a spectacular average real rate of more than 9 percent a year. Two weeks ago, Beijing officials announced that the nation's output grew at a 9.7 percent rate in the first quarter.

That's too fast. Runaway growth can cause imbalances and real estate bubbles. These eventually burst. That's why the People's Bank of China is braking the economy. But that also carries risks.

For example, China's banking system is fragile, says Minxin Pei, a senior associate at the Carnegie Endowment for International Peace in New York. About 45 to 50 percent of bank loans are not being repaid on schedule.

Because of a huge expansion of credit, various new plants making aluminum, steel, autos, and so on may face a market with excess capacity in the next two to five years, worsening the loan situation.

Bank loans to inefficient state-owned enterprises are also not promising.

Worrying a bit about a financial crash, Mr. Pei says: "The problem is whether the Chinese people will retain their confidence in the banking system."

But Ken Zhao, a China specialist with the Bank Credit Analyst in Montreal, says the banking problem is a red herring. Since China doesn't owe huge amounts of money to foreigners and has massive US dollar reserves, it can handle a banking crisis by providing new credit - printing money. And, he adds, the Chinese have a fantastic savings rate of 40 to 45 percent.

Pei says China's leaders are fully aware of these problems and will tackle them. The China story, adds Zhao, "will dominate this century for 50 years."

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