One of the Nation's Big Industrial Advantages Over Other Countries Is Growth That's Virtually

One of the nation's big industrial advantages over other countries is growth that's virtually unchecked by environmental laws. Here's how and when the waking giant may be forced to change.

By Jim Jubak

These are boom times for Shanxi province in northern China. The province produced 25% of the country's coal in 2005 at a time when coal prices were soaring. Shanxi's economy grew by 12.5% in 2005, well ahead of even the astonishing 10% growth for China's economy as a whole.

Or maybe not.

The province is home to Linfen, Yangquan and Datong, the three most polluted cities in China. Life expectancy in Linfen is 10 years below the Chinese national average. Unchecked coal mining -- the province closed 4,800 illegal mines in 2005 -- and the drilling of illegal wells for water have created a chronic water shortage and a steady loss of farmland as it subsides into underground mine shafts and drained aquifers.

If you subtract the costs of air and water pollution from Shanxi's growth rate, local officials have told Deutsche Bank, the province's real economic growth rate is close to zero.

Net growth? Almost nil

Understandably, those officials have chosen to remain anonymous, but official numbers on the national economy confirm the drift of their figures. The central government's most recent report put the cost of pollution at $64 billion in 2004. Subtract that from the country's gross domestic product, and growth in 2004 was closer to 7%.

That's still a growth rate that most countries in the world would love to have, but it's far short of the 10% annual growth that China reports in its headlines -- and frighteningly similar to the 7% rate of growth that most economists calculate as the minimum necessary to create enough jobs for the country's growing population.

It's easy to find economists outside China who are even more pessimistic. The World Bank puts the costs of China's pollution at 8% of GDP. Some economists peg it as high as 10% of GDP. According to this accounting, China isn't growing at all.

Getting it on the books

On one level, of course, this is all academic. No country -- certainly not the United States -- uses accounting like this to calculate its gross domestic product or the growth rate of its economy, although China's Environmental Protection Administration is trying to implement some kind of green accounting.

Polluting the air or water, releasing toxic amounts of mercury, using so much water that a river runs dry -- these are all what economists call externalities. The costs of these externalities aren't paid by the producers of the pollution but are passed along to third parties -- the general public, in most cases -- in the form of increased illness or higher death rates, and they remain external to the country's GDP accounts.

However, today's externality has a way of becoming tomorrow's on-the-books cost. Just ask any U.S., European or Japanese company about what it costs them to clean up their wastewater, scrub their emissions and safely dispose of their toxic waste today. Those were once externalities -- companies used to simply dump their waste into the air, water and ground. Now disposal is part of the cost of doing business.

Closing the 'externality gap'

That will happen in China, too, someday. Today, however, Chinese companies have a sizable cost advantage over their rivals in the developed world because many of the environmental costs of doing business in the United States, Europe and Japan are still externalities in China. Polluting the air, water and ground at no cost to the company's bottom line makes it easy to undercut the prices charged by companies that don't have a right to pollute for free.

Closing the "externality gap" between China and the developed world would eliminate one source of China's cost advantage and slow the country's economic growth rate. If we want to know how sustainable China's current growth rate of 10% per annum is, we need to look at how quickly current environmental externalities will get on the corporate books.

Death by pollution

There are two factors that determine the speed of that process. First, how long will it take until China's environment is at a breaking point that will force an end to polluting for free? Second, how quickly will the global economy force the Chinese economy to change its ways?

The environmental figures out of China, even the official ones, are appalling. More than 400,000 of China's 1.3 billion people die from air-pollution-related illness each year, according to the Chinese Academy on Environmental Planning. About 300 million Chinese don't have access to clean drinking water, and 400 of the country's 668 largest cities are short of water. Acid rain falls over 30% of the country. Of the 20 most polluted cities on earth, according to the World Bank, 16 are in China.

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The situation is getting worse fast. By 2020, 550,000 Chinese a year are likely to die from air-pollution-related illness. Human health costs from air pollution, according to the Chinese Academy for Environmental Planning, now at 2% to 3% of China's GDP, will reach 13% of GDP by 2020, if current trends continue.

Power sector runs amok

But I'm pretty sure that as bad as things are, they aren't bad enough to force much change yet. Oh, the central government in Beijing is convinced of the need to clean up the country's environmental act, but as always in China, what the center wants isn't necessarily what the center gets. As the saying goes, "The mountains are high, and the emperor is far away."

Consider what has happened in the country's power sector. The Beijing government estimates that 20% of China's power plants are illegal and operate in clear violation of China's environmental regulations. The state Environmental Protection Administration knows where these companies are but has been unable to shut them down. Environmental enforcement is in the hands of local officials who routinely protect big polluters because they produce jobs and taxes for the province and big payoffs for local officials. Finally, in desperation, the Beijing agency said that it wouldn't approve new projects by four of China's top power producers unless they met environmental rules.

Are you surprised that the country didn't meet its goal of a 2% reduction in major pollutants in 2006? Instead, by official count, pollutants climbed 2%.

A looming water crisis

Unfortunately, the part of the environment nearest to crisis also presents the toughest nut to crack. China is rapidly running out of water. Industries can't get enough. City dwellers can't get enough. Farmers can't get enough. Parts of the country look like they're headed into permanent drought as surging demand teams up with falling supply -- from desertification and wasteful water-diversion projects -- to produce scarcity no matter how much water the clouds bring.

For the past 25 years, China has been able to feed itself -- one of the country's greatest achievements. But the water shortage is bad enough to put this in doubt. According to James Kynge in his 2006 book, "China Shakes the World," China uses seven to 20 times more water per unit of GDP than the developed countries of the world. All you have to do to fix that is start charging a market price for water that's high enough to produce major gains in the efficiency of water use.

Simple, eh? Well, we haven't managed to do that in the U.S., where water is still priced as if it were in inexhaustible supply. And we don't have 400 million people on the edge of survival. For China's rural and urban poor, and especially for its peasant farmers, a market price for water would push them over the edge.

Transition takes time

Fortunately for China, the global economy may provide the push when Beijing's officials can't provide the shove. It is undoubtedly unfair that China is being asked to make the transition from externality to environmental-income statement in just a few decades, when the developed world had centuries to make the transition.

The air in London, for example, was a miasma unfit to breathe and its water a stew of deadly microbes for centuries before the government forced polluters to spend money to clean up their waste streams. It took a century or more to turn the Cuyahoga River where it flows through Cleveland into such a brew of chemicals that the river would burn -- and the cleanup began only a few decades ago.

The world isn't inclined to give China the luxury of fouling its public air, water and land for centuries. The leaders in Beijing, astute as ever at grabbing the main chance, see this as an opportunity. If the world wants to slow global warming and reduce the global emission of greenhouse gases, Beijing is happy to comply by improving its environmental practices -- as long as the world is willing to put cash into the deal.

Cash incentives

Beijing is working with the United Nations to set up the first carbon-trading exchange in a developing country. The exchange would trade the carbon credits set up under the Kyoto Protocol on climate change. Under the trading system, companies that reduce greenhouse gases generate credits that they can sell to companies that are over their greenhouse-gas quota. China's industries are huge emitters of greenhouse gases, but even small investments in emission controls can yield big improvements. Carbon credits can be quite a tidy profit center. In the first nine months of 2006, developing countries generated $3 billion in carbon credits, and China accounted for about 41% of the total.

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This will give many of China's companies the cash incentives they need to get started on converting environmental externalities into income statement items. And as more Chinese companies develop global brands, they'll get another push from consumers in the developed world, who increasingly want to feel good about the companies they buy from.

Global standards . . . eventually

But this will be just a start. And the cash it will provide to China's companies is just a drop in the bucket. I'd expect that local officials and local company executives will fight tooth and nail for their right to pollute for free.

Eventually, though, Chinese companies will adopt something like the global economy's standards of accounting for pollution. That will help further narrow the cost gap between China and the rest of the world, and slow China's growth rate from the current breakneck pace.The alternative is business as usual in China, with growth at all costs. Go far enough down that road, and the costs of paying for those environmental externalities gets big enough so that even China's booming economy can't pay it.

Coming Feb. 13: China's financial window: thinking about capital as a limited resource.

New developments on past columns

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