China's Uncertain Economic Future

TAIPEI (TheStreet) -- The International Monetary Fund is estimating China grew 7.8% last year, within range of predictions that it would cool from more than an annual 9% over the past decade. The fever has passed.

Unless it hasn't.

Although the IMF also predicts 8.2% growth for China in 2013, the longer-term trend points toward quite a bit less. That's not just fallout from a turbulent global economy, though dulled export demand would have a lot to do with the 2012 figure.

It's because newly appointed central leaders want to rebalance the world's second-largest economy, to make it sustainable for China itself, by easing it away from growth steroids such as investment and commodity-intensive industry.

Services and retail would wean China off these substances, which would meanwhile be throttled by stronger rules on getting capital and running an honest business.

Drops of this new formula have already started to show. Domestic consumption, a core policy mission enshrined in the 2011-2015 Five-Year Plan, jumped from 37.3% to 51.6% of the GDP in 2011, a strong omen for services and retail.

If the medicine really takes hold in the longer term, it would push China's annual economic growth into the 5%-6% range, predicts George Magnus, senior economic adviser with UBS Investment Bank in London.

The Rx would get China over a BRIC wall, away from a looming middle-income trap and on the way to a more modern nation, he argues.

The shift would fuel business for the foreign fast-food chains such as the ever-popular McDonald's ( MCD) and Yoshinoya's (9891.T) Japanese noodle bowls and maybe someday, when the rules are more relaxed, for financial services such as those offered by Goldman Sachs ( GS), known for its ability to make private equity deals in China despite a not-so-level playing field.

Without a rebalancing -- also in the Five-Year Plan -- the old economic growth prescription will lead to overcapacity, poorer investment returns and more unpaid bank loans, Magnus says. Existing business rules and low interest rates will also make it too easy for developers or factories to grab money that should otherwise be injected into the country's under-medicated health-care system for the masses.

"Whether they make headway or meet resistance remains to be seen," says Magnus. "That's a 64 trillion-yuan question."

Why so uncertain? In China, reformists don't always get their way. They sit at the top of the central government, but no matter what phase of Chinese history you look at, central leaders seldom have the support of every old-school mayor, provincial governor and People's Liberation Army general. The country is too big for Beijing to monitor every pupil in the massive reform school.

Local officials have been told over the past 20 years to find ways to make money for their enterprises without handouts from Beijing. As China remains a state-run, planned economy, government agencies often own not just infrastructure or factories but also hotels, hotpot restaurants and even racy nightclubs. Those compete ever more with the private sector as the economy liberalizes.

So local governments and even the army, with its non-military enterprises, hope they can keep turning to the ever-reliable money-making machine of new projects. Factories that spit out high-value stuff make money on output, while Chinese citizens widely suspect that new construction such as high-rise housing and freeway flyovers puts money in officials' own pockets as they usually take cuts from contractors who are happy to have the jobs.

(Yes, this would be graft, and no, you usually won't get caught for it.)

Naturally these satellite governments would oppose any new rules to push China toward a rebalanced economy. Rebalancing may call for higher interest rates, stronger rule of law (a customer could sue a state enterprise and win) and tougher corporate governance. Business would cost more but be cleaner.

But if the local fiefdoms get their way over the kingdom, that's good for a different sort of China investor. Regions of China, the western city of Chongqing for example, that prioritize factories and infrastructure tend to welcome foreign investment in priority industries.

This old-school, still-prevalent growth formula would continue to benefit the types of foreign firms that have gained now for easily a decade. They're the automakers from Detroit to Germany, computer makers from Taipei to Silicon Valley and food packagers whose names might appear in your own kitchen cupboard.

Apple ( AAPL) may squelch factory suppliers in China over child labor issues, but IBM ( IBM), for example, opened one last year and Taiwan's touch-panel maker TPK Holdings (3673.TW) said it would build one there for $487.1 million.

That said, foreign firms are taking a harder look at China's once-fertile manufacturing bases as labor and material prices rise and Asian frontier markets become more attractive.

I won't predict whether the assembly lines eventually slow down for good, but in history Chinese reformists don't usually get their way without a long struggle, a palace coup or a disaster such as the 2003 SARS coverup that enrages the kingdom enough to shake down all its fiefdoms.

Most edicts go nowhere without punitive surgery. I couldn't help noticing that HSBC's purchasing managers' index for China reached a two-year high in January of 51.9, above the magic 50-point level that means manufacturing is going places.

At the time of publication the author had no position in any of the stocks mentioned.

Ralph Jennings is on LinkedIn.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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