NEW YORK (CNN/Money) -
Chinese officials recently said the Chinese economy grew at 8.5 percent in 2003 and most observers say the real pace of growth was much higher than that. But that is last year's story.
The story for this year is that China is likely to slow as its government, worried over overheating, tries to bring the economy in for a soft landing. The danger is that the economy slows too much -- an outcome that would have profound consequences around the world.
Signs abound that the Chinese economy is already running too hot. With investment from overseas gushing into the country, a laundry list of industries -- from steel to mobile phones to automobiles -- are seeing their production capacity grow at a breakneck pace. Money supply is up sharply. China's M2, which includes cash in circulation and money held on deposit, grew by 19.6 percent in 2003.
Heap on the more anecdotal evidence of overheating. Credit Suisse First Boston chief non-Japan Asia economist Dong Tao points out that there are 86 subway lines under construction or being prepared for construction in the country. Morgan Stanley China economist Andy Xie notes that despite electricity production growing by 14.3 percent in the first 11 months of the year, China experienced frequent brownouts in the summer. And then there's the traffic.
For officials, reining in growth is a bitter pill. Rural Chinese are flocking to the country's urban centers in droves, and the economy must grow quickly in order to absorb the flood of workers -- or risk civil unrest.
Yet there are signs the government is starting to move. In September, China's central bank lifted banks reserve requirement ratio to 7 percent from 6 percent. Many observers also believe that, in a shift, Beijing now believes that the prospect of inflation is now a bigger threat to the Chinese economy than deflation.
"It's clear that China needs to slow down a little bit," said Lehman Brothers chief international economist Russell Jones. "We think that the government can engineer a softish landing."
When a butterfly flaps its wings in China...
Even a slightly slower China could have important ramifications for investors, points out Carlos Asilis, a portfolio manager at the hedge fund Vega Asset Management.
- A wide array of commodity prices -- copper, cotton, nickel, to an extent even oil -- have been pushed up because of heavy Chinese demand. China slows, and those prices could get pushed lower. Bad news for commodity producing companies and bad news for the commodity producing countries of Latin America.
- A slowdown would also likely mean that China's trade surplus with the United States would widen, since it would slow domestic demand, reducing the demand for imports and prompt Chinese companies to export more in an effort to maintain profits.
- This would leave China with a lot of dollars on its hands and, because the country's currency is pegged to the dollar, it would have to park those dollars someplace. (The peg may be adjusted in 2004, but is extremely unlikely to be abandoned.) China, already a big buyer of U.S. Treasurys and agency securities, could step up its purchases in the year to come. This would keep U.S. interest rates lower than one might otherwise expect.
- Asian economies would also suffer, first because China has been an important driver for growth in the area, second because if Chinese companies up their exports in reaction to a slowdown, other exporters in the region will get shouldered out of some sales.
Many of these effects could get dangerously amplified, however, if China's slowdown isn't mild. The potential for a sharp drop in growth cannot be discounted, according to Julius Baer head of international equities Riad Younes.
The way Younes sees it, much of China's growth story is due to the huge amount of foreign investment that continues to pour into the country. Last year China's foreign direct investment came to $53.3 billion according to official figures, but it's important to understand that total economic effect goes beyond the dollar figures. You build a plant that employs 2,000 people, that means somebody is going to build 2,000 apartments, somebody is going to sell 2,000 air conditioners, etc.
You cut the capital off, things slow in a hurry. And Younes reckons that, as foreign companies come to understand that they are adding far more production capacity in China than they need, the capital will get cut off.
"When foreigners realize that they're overbuilding, then we may get a hard landing," said Younes.
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