Can China's Economy Stay Strong?

Consumption and Investment: Still Strong

Much of the optimism surrounding the positive outlook for China hinges on two of the country's key economic supports -- domestic consumption and investment -- and those two indicators have remained healthy. "Actually, this year the foreign direct investment (FDI) figures have been very strong," says Cavey of Macquarie. "That could reflect speculative investments into China, to buy the appreciating RMB, but it certainly doesn't look like FDI has slowed down very much."

Indeed, FDI is pouring into China. Barclays Capital predicts a year-end FDI figure of US$151 billion for 2008, up from US$121 billion in 2007. Manufacturing and property in Shanghai, Beijing, Shenzhen and Guangzhou have traditionally been the top targets of foreign investors, but interest in those areas, while still considerable, appears to have reached a plateau. The new growth areas for foreign investment are in services, sustainable energy and communications, and many of the target cities are now in the interior. "Companies are beginning to invest more in services and M&A, rather than these green-field manufacturing projects which were the main growth engine for FDI in the 1990s," says Cavey.

Fixed-asset investment, which covers everything from apartments and airports to sports stadiums and bridges, is also growing at a respectable rate. According to the Asia Development Bank, fixed-asset investment grew by 26% in nominal terms in the first half of 2008, about the same as the previous year, although in inflation-adjusted real terms, investment growth slowed to around 15% from 22% in 2007.

Domestic consumption, another key pillar of GDP growth, appears to be on a steady, long-term growth path. Retail sales in nominal terms grew 22% in the first seven months of 2008, according to the Asia Development Bank, while real consumption growth, adjusted for inflation, was about 13%, compared with 12% in the first seven months of 2007. "If you look at domestic consumption, it is still quite strong," says Chum.

Government Policies and Tools

Another reason for optimism about the Chinese economy is the powerful arsenal of policy tools that the government has at its disposal, both fiscal and monetary. The government is in a strong fiscal position, giving it plenty of room to cut taxes or increase spending, while on the monetary side there is much room to further cut interest rates and lower the bank reserve requirement. China's banks are in good health as well, because they have been prevented from making the sorts of disastrous loans that brought the U.S. banking system to a crisis.

On the fiscal side, Beijing has already been active in its support of the economy. Among other measures, the government has lowered taxes for some exporters, provided subsidies to certain high-tech industries, reduced personal income taxes, and accelerated its massive, countrywide infrastructure buildup. Those steps are in addition to the new uniform tax code that took effect at the beginning of the year, which sharply reduced income taxes for most domestic companies in China.

If it wishes, the government could become much more aggressive in its fiscal stimulus. "Last year, the government recorded a strong surplus, and it is in a very strong fiscal position, so it can pursue expansionary fiscal policy such as cutting taxes and increasing spending," says Peng. "Slowdowns in export markets are beyond the government's control, but it is more able to boost domestic demand, and it has quite a lot of room to do that if inflation is slowing down."