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.

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"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) 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.

Rising Manufacturing Costs

The increasing labor costs and high commodity prices are taking a toll on Chinese manufacturers. "We've been seeing corporate profitability in the manufacturing sector squeezed by these factors, in particular those industries that are dependent on a high level of labor," says Matthew Lee, head of greater China equities at MFC global in Hong Kong. "And in those industries that rely on raw commodity input, we have seen companies' profit margins squeezed in the last six months."

The pressure on manufacturing costs is severe: Wages in China soared 18% in the first six months of the year, while the RMB has gained 21% against the U.S. dollar since mid-2005, with another 5% appreciation expected in the next year or so. High commodity prices are also a worry, but analysts see the recent spike as cyclical, not structural -- a view that is strengthened by the easing of commodity prices in the past few months.

However, analysts say, the rising costs are not all bad. "In many ways some of these rising costs that China is facing are actually quite a good thing," says Paul Cavey, head of China Economics at Macquarie Securities in Hong Kong. "For example, rising wages are raising incomes across China and boosting welfare, and higher commodity prices are an important spur to begin moving China away from more environmentally unfriendly manufacturing practices."

As part of the government's process of weeding out unwanted factories, it has raised taxes on steel, aluminum and garment companies, and it has boosted incentives for investments in services, agriculture and high-tech. It is encouraging dirty and inefficient factories to merge, and in September, the national legislature introduced a new law designed to put the country on a faster track to sustainable development, with firmer requirements for saving energy and reducing pollution. The new law, to take effect on January 1, 2009, will require manufacturers to meet much stricter -- and more expensive -- energy-saving standards. The balancing act is delicate: Beijing wants to push industries further up the value chain, but at the same time, it must keep an eye on employment and GDP growth.

"The government does not want to provide blanket support to everything," says Peng of Barclays Capital. "They want to combine this support with some structural changes that will support long-term sustainable growth in the economy, so they will not support every sector with the same intensity."

The rise in wages is another trend that seems to have at least some encouragement from the government, because earlier this year a new wage law was introduced that, according to Macquarie, has boosted average labor costs for companies about 5% to 10%.

The most worrisome aspect of higher manufacturing costs is that they raise the price of exports. "The government is concerned about this, because exports are one of the growth pillars for the Chinese economy, and much of the manufacturing output is destined for the export market," says Chum. "If you look at export growth in Guangdong province, which is a good indicator of export growth in China, that has started to come off."

So far, the drop off in exports has been modest, says Jian Zhuang, senior economist at the Asian Development Bank's Resident Mission in China; booming Asian countries have picked up some of the slack. "Resilient demand from developing economies helped offset in part slower industrial-country export orders, so overall export growth was a robust 22% in the first half of 2008, which is down 2% from the second half of 2007," says Zhuang. "Exports will stay at around 18% to 19% growth in 2009, and exports should maintain double-digit growth in the next three to five years."

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."

On the monetary side, too, Beijing has weapons in its arsenal. "The good news about China right now is that the banks haven't lent particularly aggressively in recent years, and the reason is that the government has stopped them from doing so," says Cavey. "China has a very huge reserve requirement ratio in the banking sector of 16.5%, and if the government wants to support growth, it is easy to cut that reserve requirement ratio, and I think these kinds of monetary policy measures will be used to support growth going forward."

Much of the monetary stimulus is aimed at the manufacturing sector. "What the government has been trying to do is to begin to relax bank lending to some of the manufacturing companies, to help offset some of the slowdown," says Chum.

However, monetary stimulus is not an open-ended, continuous course of action, says Cavey. "Obviously they will come to an end in this process, and if exports in the rest of the world don't start to pick up, and this monetary policy stimulus has already happened, then probably growth in China will start so slow more sharply. But while China still has ammunition, I think it is less likely that growth will slow a lot."

Inflation

Ultimately, inflation is the wild card that could cause the most damage to China's economy. If the consumer price index (CPI) rises too sharply, the government would not be able to use its policy tools to kick-start economic growth, because the stimulus would cause inflation to rise further. "If inflation is still high, there is limited room to stimulate domestic demand, because if you stimulate domestic demand, that may raise inflation," says Peng. "But now inflation has come down quite significantly, so that is less of a concern."

Inflation is indeed falling: The CPI peaked at 8.7% in February, year on year, before gradually retreating to 6.3% in July and 4.9% in August. With the fall in commodity prices, inflation is likely to fall further, say analysts. That leaves Beijing free to inject more money into the economy, as it is now doing, either by fiscal means -- tax cuts or infrastructure spending -- or by loosening credit restrictions and lowering interest rates.

"If inflation does pick up, then China has to take more aggressive action to slow down growth," says Mr. Cavey. "I think that's the ultimate risk here -- that we see more inflation coming through -- but that doesn't seem to be a big risk in the next six months or so."

If GDP growth were to drop below 9%, the government would move aggressively to support the economy, says Peng. "At that level, they would be really, really concerned and would take quite drastic measures to stimulate demand."

The most likely scenario, according to some, is that China's economy will continue to grow at 9% or so for the foreseeable future. "In my opinion, China cannot sustain double digit growth," says Zhuang, of the Asian Development Bank. "In the next few years, annual growth will most likely be around 9%, with a (CPI) inflation rate of about 5%. It will be different from previous years, when growth was 10% to 12%, and inflation was very low."

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