Can China's Economy Stay Strong?

Editor's note: This was previously published by Knowledge@Wharton. With Monday's announcement that China's gross domestic product (GDP) growth rate for the first nine months of 2008 dropped to 9.9% (2.3% lower than the same period in 2007), it is being republished as a bonus for TheStreet.com readers.

The U.S. narrowly averted a full-blown crisis on Oct. 3, when the House of Representatives approved a $700 billion bailout package. But even at best, the American economy has entered a period of deep uncertainty. Meanwhile, U.S.-style credit problems are popping up in Europe, where economies were already beginning to slow. Given these gloomy developments, what is the outlook for China, the world's third-largest economy?

According to six economics and finance experts based in Hong Kong and mainland China, the country's prospects are reasonably good. Exports to Western markets are declining, but fast-growing Asian countries are taking up some of the slack. Wages are rising, boosting domestic spending and improving quality of life, while rising production costs are helping to eliminate polluting, low-value-added factories -- a process that is encouraged by Beijing.

And unlike in America and parts of Europe, China's banks are in good shape, largely because the government has prevented them from lending aggressively. Domestic consumption and investment are also showing robust growth. In addition, the government has some powerful tools that it can use to support the economy. As a result, say analysts, GDP growth in China will probably cruise along at 9% to 10% for the next couple of years. That may be lower than the previous 12% growth, but it is still a high rate for such a giant economy.

TheStreet.com TV: China Watch: Shipping Life Boats (Video, Oct. 20)

RealMoney contributor and value investor Sham Gad pops in to tell us how China's slowing consumption of iron ore plays into shipping stocks' recent battering, and points out where the attractive opportunities are.

To watch the video, click the player below:

"There is no doubt the economy is growing more slowly, but we are not looking at a doom and gloom situation," says Terrace Chum, senior portfolio manager at MFC Global in Hong Kong.

Nonetheless, the U.S. credit crisis and the ongoing slowdown in Europe are likely to have some effect on China. "Our view, even at the beginning of the crisis, was that China would be resilient, but there is no such thing as decoupling, because the world is so integrated," says an investment banker based in Hong Kong. "That resilience, as we get further along in this crisis, will be increasingly tested. Even though countries like China are going to continue to hold up relatively well, and most of our economies in the region should avoid a recession, it is still going to be painful."

The Chinese government is clearly concerned. On Sept. 15, after raising interest rates steadily for more than six years, the government abruptly changed course, dropping the benchmark lending rate by 0.27%, to 7.2%. Then, on Sept. 25, the economy received another boost: After raising bank reserve requirements for two years, Beijing unexpectedly lowered them by 1.0%, to 16.5%. The sharp change in policy shows that Beijing has recently become worried about the slowing growth, and there is no more talk of "overheating."

"The government's policy concern has shifted," says Wensheng Peng, head of China research at Barclays Capital (BCS Quote) in Hong Kong. "Three or four months ago, inflation was clearly the number-one concern, but now [that has changed] because growth slowed to 10.1% in the second quarter of 2008, while in 2007 the overall growth was close to 12%, which is quite a significant slowdown." [Update: GDP growth slowed to 9% in the third quarter of 2008.]

China's economy has entered a period of structural change: Wages and land prices are rising, the RMB [China's currency] is appreciating and commodity prices are high. Those factors increase the cost of exports, while at the same time, key markets like Europe and the U.S. are suffering slowdowns, casting a further cloud. And now the property market, a pillar of the Chinese economy for the last 10 years, has suddenly begun to cool, with no recovery in sight.