Global Economics

Why Taming the China Dragon Is Tricky


Slowing down China's high-speed economy is devilishly hard to do, and may even be beyond Beijing's control

It's a problem a lot of developing countries would die for. Yet Beijing faces a policy quandary of the highest order. China's $2.6 trillion economy, which blew away market expectations and clocked 11.1% growth in the first quarter, is rushing along like some blisteringly fast, runaway maglev train. Chinese President Hu Jintao's economic team in Beijing has been trying to tap the brakes to avoid a reprise of the painful boom-and-bust scenario that hit the country in the mid-1990s, yet hasn't managed to do so despite three years of effort.

China's seemingly unstoppable surge was a big topic on the podiums and in the hallways at the 2007 Boao Forum for Asia, a gathering of regional leaders and executives held in the southern province and resort island of Hainan on Apr. 20-21. Another prime subject: the global economic risks of a China that might jump the rails.

While China's restrictive currency policy that has kept the yuan relatively cheap gets much of the blame, Beijing is having trouble wrestling with this economic beast for lots of reasons that cut to the basic structure of China's economy. Among them is a massive savings glut in the corporate sector, the globalization of manufacturing networks, and the still vast developmental needs of an economy that must generate 15 million-plus jobs annually to avoid widespread joblessness and social unrest. Here is a quick guide to some of the issues:

Just how strong is the Chinese economy right now?

The world has never seen such a sudden and sustained rise of an economy that was so desperately poor just three decades ago. China has averaged 9.6% growth rates for 30 years and is now the fourth-biggest economy in the world—and likely will overtake Germany as No. 3 in the next year or so. It's the third-biggest trading nation: Two-way trade between China and the rest of the world hit $1.76 trillion last year.

China's nearly $1.2 trillion stockpile of foreign currency is the biggest on the planet, a reflection of the mainland's role as the biggest creditor economy and massive capital power. Lured by cheap labor and a white-hot Chinese domestic economy, foreign companies pumped about $60 billion in direct investment last year, and the country's global trade surplus came in at a record $177 billion. "No nation has moved as fast as China in establishing a global footprint," marveled Pakistani Prime Minister Shaukat Aziz at the Boao gathering.

Sounds like party time. Why are Chinese leaders worried?

Lost in all the breathless talk about China's overall economic performance is the cold, hard reality that the country's per capita gross domestic product is only $2,000 per person. There are huge income imbalances between China's big-city and rural provinces, years of rapid development have ravaged the environment, and the pressure to create fresh jobs and provide adequate social welfare policies is awesome in a country that is home to 1.3 billion people, about one-fifth of humanity.

"China remains a developing economy that has a long way to go before it can achieve modernization," says Wu Bangguo, chairman of China's National People's Congress standing committee. A big runup in inflation or an economic bubble that bursts would be absolutely catastrophic for hundreds of millions of Chinese families barely making ends meet—not to mention for Hu and his comrades running the show in China's one-party Communist regime.

Why doesn't Beijing just ratchet up interest rates to cool things off?

China did so in March, when the People's Bank of China increased a key benchmark, the one-year interest rate, by 27 basis points, to 6.39%. The one-year deposit rate was nudged up by the same amount, to 2.79%. It was the third such interest-rate hike in the past 12 months—and one or two more credit tightening moves are likely in 2007.

Yet here's the thing: China needs to slow down investment in factories and public works projects, which drive 40% of overall gross domestic product growth. Slowing down loan growth helps, but not in a country where all manner of state-owned companies (about 50% of the corporate sector) are enjoying double-digit profit growth and don't have to pay dividends like big publicly traded companies in the West. They are awash in cash and will keep investing into overcrowded sectors like autos, steel, cement, and construction.

China has an enormous pile of savings (the national savings rate is an awesome 50%), and the retained earnings the corporate sector is now generating is a big reason for this. Gang Fan, an economist and president of the Beijing-based National Economic Research Institute, points out that 5% to 10% of the national income the economy generates is now getting socked away by state-owned companies because the government doesn't require a dividend payment, which publicly traded foreign companies have to pay to shareholders. "It's quite a serious problem," he says, regarding the efforts by Beijing to slow things down.

What about throwing some ice water on the export sector by letting the yuan appreciate?

Beijing financial authorities probably could do more in this area, but it is not a magic bullet for two reasons: the weak consuming power of most individual Chinese consumers and the mainland's critical role as a final assembly platform for global companies. One big driver of China's rapidly expanding trade numbers is that ordinary Chinese families aren't spending enough on foreign goods.

True, there is plenty of conspicuous consumption in prosperous coastal cities such as Beijing, Shanghai, and Shenzhen, but there are also 700 million Chinese in the hinterland who don't buy Rolls-Royce Phantom sedans and Gucci handbags. China is reluctant to risk a major slowdown because these folks would get crushed. Beijing needs to keep the economy stoked in high-speed mode until China's vast income gap closes more. "The income disparity is behind the low consumption," figures Yifu Lin, a professor and director of the China Center for Economic Research at Beijing University (see BusinessWeek.com, 4/30/07, "China's Cautious Consumers").

Consider, too, that some of the biggest exporters out of China are actually foreign companies from Taiwan, Japan, the U.S., and Europe. There are some 600,000 overseas-funded companies operating in China. They import goods, assemble them on the mainland with cheap labor, slap on the "Made in China" label, and then ship mobile phones, desktop computers, and sedans to the rest of the world. These products get counted as Chinese exports but are really pieced together with components from around the world.

China can't really order Honda (HMC) or Nokia (NOK) to export less out of China. And the kind of trade sanctions being contemplated by trade hawks in the U.S. would ultimately hurt foreign corporate interests in China, too. "This is a problem of economic globalization," not just Chinese policies, reckons Yongtu Long, a former Chinese trade negotiator and secretary general of the Boao Forum.

What's the way out of all of this?

Short term, China needs to boost private consumption by shifting tax breaks away from the cash-rich corporate sector and toward Chinese families. A stronger social safety net—more affordable health care and education and secure pensions—would give them more confidence in their futures and get them spending more.

Beijing also needs to crack down on banks and local governments that keep lending and spending, despite the risks to the entire country if the economy overheats. Phased-in liberalization of the yuan, interest rates, and capital flows is another needed reform. This would allow market forces to send price signals to policymakers and executives alike about when to slow down and speed up.

Yet this is going to take many years, if not a decade, to realize. Chinese authorities, naturally enough, are far more concerned about the living standards of their own people than those of the comfortable middle class in the U.S. They probably will do just enough to avert trade sanctions from the U.S. It would take a dramatic currency shift to really improve the trade balance with the U.S.—but that would risk destroying China's fragile social balance. From China's perspective, "it's about hundreds of millions of rural workers," says Chinese economist Fan.


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