China at the Crossroads

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China at the Crossroads

China's spectacular presentation of the 2008 Summer Olympics provides a perfect metaphor for its economy.  While viewers around the world were impressed by the images and sounds on their television screens, much of it could not hold up to closer scrutiny.  From the computer-generated fireworks to the lip-synching child singer, China projected an idealized vision to the rest of the world — a vision that had little in common with reality.

That's exactly what a close look at China's supposed economic strength reveals:  The appearance doesn't match the reality, and the country faces a series of very real challenges that it will not be able to hide from the world.

One challenge it faces is the fallout from the U.S. subprime lending crisis.  As American consumer spending is squeezed by tight credit and lower real estate values, people are buying fewer products made in China.  According to a Chinese ministry official interviewed for a special BCA Research report on Global Investment Strategy, Chinese GDP growth will lose half a percentage point because of the U.S. subprime crisis.1  Because of this and other factors, the official foresees China's growth falling from its recent 11 to 12 percent rate to as little as 8.6 percent over the next year or two.

Most of China's economic growth will be due to domestic spending.  Capital expenditures will provide 4 percent of GDP growth, and domestic consumption will account for another 4.6 percent.  Export growth, meanwhile, will add a maximum of 2.6 percent.

As you can see, the questionable component is exports.  Here, China faces a big challenge due to the weakness of the U.S. dollar.  Since the beginning of 2006, the value of the yuan has appreciated by more than 15 percent compared to the dollar.  That, of course, leaves the Chinese exporters with two options, and neither of them is good:

They can raise their prices, which would mean that cheap Chinese imports would no longer be so cheap in America.  This would be a disaster for the Chinese, because American companies would inevitably find lower-cost providers in other Third World countries. 

They can absorb higher costs without raising their prices.  This is precisely what the Chinese exporters are doing, now.  As a Chinese official explained to BCA, oil prices have climbed 72 percent over the past two years; bank loan interest rates have gone up by 122 basis points; and the yuan has appreciated 15 percent as mentioned earlier; yet the exporters cannot pass along these cost increases...

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