Dark clouds gather on the horizon for China

[Pastor Dale Morgan]

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Dark clouds gather on the horizon for China*

While it may look to the world as if the growth of the eastern giant's
economy is unstoppable, there are mounting concerns, says Heather Stewart

* Heather Stewart
* The Observer, Sunday 17 January 2010

China economy

As strong as the Chinese economy is, it is not likely to emerge from the
global downturn without suffering problems. Photograph by China Span
Keren Su/Sunset/Rex Features Photograph: CHINA SPAN Keren SU / Sunset / R

Barely a week goes by without yet another stunning fact from the Chinese
economy. Last Friday brought news that despite spending billions on the
world's largest fiscal stimulus package to help escape the global
downturn, China's vast foreign exchange reserves shot up by another 23%
in 2009, to a stunning $2.4tn (£1.4tn) – almost twice the GDP of the UK.
Official figures this week are expected to show that while the rest of
the world was struggling to emerge from recession, Chinese growth was
running at a rampant annual rate of more than 10% in the final three
months of the year.

With China barely breaking stride during the Great Crash, and set to
surpass sickly Japan as the world's second-largest economy by the end of
2010, it would be easy to see the turmoil of the past two years as
setting the seal on the inexorable rise to dominance of the eastern giant.

However, dark clouds are gathering on the horizon. First, there are
mounting fears over China's dramatic bounce-back – bubbles are inflating
in the stock market and housing that could burst, with catastrophic results.

Capital controls protecting the currency from a financial exodus mean
it's hard for domestic investors to send their surplus funds abroad – so
with banks directed to pump up lending, cheap cash is pushing up asset
prices at home. Bank lending in December was more than 95% higher than a
year earlier, according to the People's Bank of China.

"Ample liquidity and capital controls, having protected China from the
worst of the global financial crisis, now threaten economic and
financial stability," said Ben Simpfendorfer of RBS in a note last week.
"Investors are searching for yield, but are limited in their choices.
Higher inflation and the state council's reluctance to raise interest
rates may only accelerate the rush into equities, property, and,
increasingly, into repackaged loans."

The Chinese authorities are well aware of the risk of a bubble, and have
taken a series of steps in recent weeks, including increasing banks'
reserve requirements, to try and cool things down. "They've got very
scared that they can't control it," says Mark Williams, senior China
economist at consultancy Capital Economics.

With China battling to secure enough raw materials to feed roaring
growth, inflation is also a considerable risk, and analysts believe the
authorities will raise interest rates by the end of this year to prevent
it running out of control – though with rates so low in the battered
western economies, that risks attracting an unwanted influx of foreign
funds. "These problems are big, they're real," says Gerard Lyons, the
chief economist at Standard Chartered, who travels to China regularly.

Second, even if fears about financial and economic instability prove
unfounded, there are political obstacles on China's path to permanent
prosperity.

Google's contretemps with the Chinese government last week underlined
the fact that Beijing has achieved its extraordinary economic rise
without playing by the west's rules. But the spat over business ethics
is likely to be dwarfed in the coming years by the bubbling tension over
China's trading relationship with the US and Europe.

Williams, of Capital Economics, believes that China will escape the
risks of overheating or out-of-control inflation, but that its growth
will create increasing political confrontation. "It's obviously good if
incomes are going up; that's good for hundreds of millions of peasants,
you can't begrudge that – but it's throwing up all these challenges;
there's a lot of frictions," he says.

Even before the credit crunch, congressmen in America's rust-belt states
blamed China for "currency manipulation" – fixing the yuan at an
artificially low exchange rate against the dollar, so that it could
benefit from cut-price exports, and get a leg up the world economic
league tables.

Now, with the Asian recovery in full swing, exports of goods from China
are exploding, stealing market share from the traditional manufucturing
powerhouses of Germany and Japan, both countries desperate to use their
traditional export-led growth model to restore their economies to health.

There have already been a series of protectionist moves against China
since the downturn began. The US has invoked World Trade Organisation
rules to slap tariffs on Chinese tyres, paper and steel products; the EU
has done the same to exports of aluminium wheels and steel products, as
their producers struggle to compete with the Chinese juggernaut. The
chorus grows ever louder from politicians around the world calling for
Beijing to allow the yuan to appreciate. Japan and the eurozone in
particular are likely to feel that China is growing at their expense.

Not every analyst agrees that the right solution for China is to float
its currency, cross its fingers and hope for the best. Its enormous
trade surpluses and mountainous foreign exchange reserves partly result
from weak demand at home – because Chinese consumers save so much of
their income, around 35%.

That forces the government to keep exports surging ahead to maintain
rapid economic growth, and avoid the social and political crisis that
could result if the economy slowed down and millions of jobs were lost.
Solving that problem and generating domestic-driven growth could
arguably do as much to tackle the "global imbalances" of vast surpluses
in China and deficits in the US, as a depreciation.

Stephen Roach, chairman of Morgan Stanley, Asia, backs Beijing's
insistence that the best way to tackle its sickly consumer demand is not
to unleash the forces of the foreign exchange markets on the yuan, but
to use domestic policy. The Chinese authorities have recently announced
plans to improve social safety nets, so that families don't feel the
need to salt so much of their income away for a rainy day, and switch
spending from shiny new construction projects that may never be
occupied, to education and health.

"There is good reason to believe that China gets it – and is about to
take dramatic steps in rebalancing its domestic economy in a fashion
that would provide a sustained and meaningful reduction in its current
account surplus," Roach says.

Qu Hongbin, HSBC's China economist, agrees that what he calls "China's
New Deal" will help to boost consumer spending, so the country can
continue expanding without overheating. "We believe the jump in
government spending on the social safety net, combined with surging
consumer credit, will encourage consumers to loosen their purse-strings
and lower their savings rate by five percentage points over the next
three years," he says.

Lyons says: "If you're going to pick an economy that's going to come out
of this well, it's China – but if anyone thinks it's going to be a
smooth path, with no bumps along the way, they're wrong. The west has to
realise there's a business cycle in China."