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A few days ago, I wrote about how China could be bigger than you think. A couple of factors, namely China’s hidden income and the undervalued yuan, suggest that there could be more than meets the eye to the Asian giant’s 10.3% year-on-year growth.

But if you think that China’s double-digit growth is too good to be true, it probably is. Here are a couple of reasons why China’s GDP could be smaller than it seems:

1. Environmental damage

The first potential GDP downer is environmental degradation. After all, you can’t expect to produce boatloads of electronics without emitting tons of smoke, right? He Ping, Chairman of International Fund for China’s Environment, believes that China will have to spend at least 2% of its GDP per year to clean up 30 years of industrial waste. That’s equivalent to Vietnam’s annual GDP!

Apparently, the speed of pollution is gaining momentum, and the government’s failure to address it could weigh on economic growth. For one, the cost of health problems could burn the pockets of the average Chou and hurt consumer spending. Also, sick workers produce less output, which could weigh on company profits. Lastly, polluted land and water lessen crop and fish yields…or produce alien crops and fish.

Though China isn’t the only economy facing this problem, we can’t deny that its threats are magnified in China’s case. Of course, there still isn’t any official measurement for environmental degradation, but that doesn’t mean we should only factor that in later when it’s too late to reverse its effects.

2. Misallocated investments

Next, there’s the case of misallocated investments. Before you get your eyebrows all furrowed, allow me to explain.

Countries make investments in hopes of getting more bang for their buck. For instance, if you invest $20, then you’re expecting to get more than $20 in return. But that’s not always the case. Sometimes, the investments turn out to be duds, and the returns actually turn out to be less than the cost of the investment.

It doesn’t take a genius to see that keeping this up will eventually result in disaster. How can you possibly sustain growth for a long time when you’re throwing money away on poor investments? Effectively, this means growth will be overstated NOW, while growth will be understated tomorrow.

Some estimates say that up to 1-2% of China’s current GDP growth can be attributed to this. If you need an example of how the misallocation of investments can skew GDP figures, look no further than China’s neighbor, Japan!

Japan used to post GDP growth of around 6% and actually accounted for about 18% of global GDP prior to 1990. But these days, it has difficulty posting growth above 2%, even if household spending is much healthier now.

If you think about it, the effects of misallocated investments are similar to the effects of environmental degradation. China’s GDP may receive the returns of misallocated investments and gains from abusing the environment in the short-term, but the costs will eventually catch up with it in the long-term.

If you combine that 2-4% of GDP spent on cleaning up China’s environmental waste and the 1-2% of growth attributed to misallocated investments, that’d mean that China’s GDP could be overstated by roughly 5% each year. Wait a minute… That also means the 10.3% growth in 2010 should be cut in half!

Then again, just like Japan, China could wait a few more years before it starts paying for its sins of the past. Before long, the costs of environmental damage and misallocated investment, on top of the prudent monetary policy measures the PBoC plans to put in place, could soon take their toll on China’s economic growth.

Well, that just puts things in a whole different perspective, doesn’t it? Major economies, who are feeling down in the dumps for not performing as well as China, can feel a wee bit more hopeful that they aren’t too far behind. They still have a chance to catch up!