Demystifying the Chinese economy, a noted economist has said the Asian giant is living on 'borrowed growth' and this "surreal economy cannot continue indefinitely."

"China is a paradox. It is the fastest growing economy in the world - average annual rate of growth 8.6 per cent - but, by some measures, it is also among the most inefficient," says Weijian Shan, a partner at Newbridge Capital, a private equity firm, in an article in The Wall Street Journal.

The banking system is the main symptom of China's weakness. The bad loan ratio is put at 50 per cent, i.e. the official estimate. This is particularly worrying because bank loans currently make up almost 98 per cent of the total financing for Chinese companies, says Shan.

This squandering of resources can coexist with growth because the country has two 'advantages.'

One is the abundance of capital. China's 40 per cent savings rate is one of the highest in the world.

The second is capital controls. Chinese citizens cannot convert their money into foreign currency for the purpose of investing abroad.

In such a system, growth can only continue as long as households continue to save at a high rate and the government maintains capital controls so those savings are not allowed to flow out of the country in search of better returns.

Standard & Poor's estimates it will cost some $518 billion, or more than 40 per cent of China's GDP, to clean up the country's banking system. These costs, plus the equity write-off of those companies that will go bankrupt without continued funding from banks, translate into years of negative growth.

China's growth, therefore, can be regarded as being borrowed at a very high cost, which will need to be repaid sooner or later, says Shan.

Can capital controls sustain China's 'borrowed growth?' The answer is no, because its high savings rate will likely decline in about 10 years' time, if not sooner, for two reasons: an aging population, which will mean less savings and more withdrawals, and the change that is starting in the culture of frugality.

Furthermore, by joining the WTO, China has committed itself to letting foreign banks conduct local currency business without restrictions, beginning in 2007.

Foreign banks are unlikely to fund inefficient producers. Unless China's own banks adopt sound banking practices, it will become difficult for them to compete for deposits.

Therefore, the game will be over for inefficient producers.

Finally, China has committed itself to full convertibility of the yuan, without which many of its economic ambitions will not be realised.

For example, Shanghai has long aspired to be an international financial centre. But it will not succeed until China allows the free flow of capital across its borders.