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Who hurts if China breaks?
Most analysts think the economy will land softly. It had better -- an awful lot is riding on it.
September 24, 2004: 7:04 AM EDT
By Mark Gongloff, CNN/Money senior writer

NEW YORK (CNN/Money) - The future of the Chinese economy is up in the air, and there's a lot of money riding on how it lands.

Most observers still believe the landing will be nice and easy -- and it had better be. A hard landing could punish China's trading partners, several U.S.-based multinational companies and a host of investors who've been warmed by the glow of China's white-hot growth.

On Thursday, Cisco Systems (CSCO: Research, Estimates) got on board, announcing a plan to spend some $32 million to open a research and development center in Shanghai, perhaps just the first stage of a long Sinological journey for the communications gear maker.

"China will become the IT (information technology) center of the world," John Chambers told a news conference, according to Reuters. "We believe in giving something back and truly becoming a Chinese company."

Chinese officials, riding herd on the world's second-biggest economy -- if the undervalued yuan is adjusted to give it purchasing power parity with the U.S. dollar -- have recently tried to cool things down by clamping down on bank lending and foreign investment.

To some extent, they've succeeded. Gross domestic product (GDP) growth has slowed a smidge, from a rate of nearly 10 percent in the second half of 2003, and money supply has tightened. In fact, some observers hope China will soon loosen the screws a little, letting money flow more freely again.

But inflation keeps rising, China keeps guzzling oil like it's going out of style and foreign investment has barely slowed down, spreading fears the economy is getting so far out of balance that it's at risk of coming to a screeching halt.

Taking the plunge in China
Top 10 U.S.-based holdings in the China-U.S. Growth Fund
CompanySectorMarket cap
PalmSourceSoftware$386 million
Avon ProductsConsumer Goods$20.3 billion
NikeConsumer Goods$20.8 billion
AIGFinancial Services$180 billion
FossilConsumer Goods$2 billion
Axcelis TechComputer Hardware$830.6 million
United TechIndustrial Materials$47.2 billion
DanaherIndustrial Materials$15.7 billion
Yum! BrandsConsumer Services$11.6 billion
SchlumbergerEnergy$39 billion

"I believe that China's tightening has had a limited impact so far, the investment cycle has so overshot that any additional tightening could trigger a major correction, and a major correction would happen anyway over time without additional tightening," Morgan Stanley's chief Asia-Pacific economist, Andy Xie, wrote in a recent research note.

Xie worried that China has a real-estate bubble vulnerable to rising interest rates, but he said rates need to rise nevertheless to control inflation -- which itself could be enough to cause big headaches in the economy.

"Rising inflation will prove to be the starting point for the undoing of the domestic economy," Carl Weinberg, chief economist at High Frequency Economics, wrote in a recent note.

Weinberg said China's government, which in the past has printed some questionable economic numbers, was understating consumer inflation. If prices get too high, Weinberg warned, China's banks will get in deep trouble and foreign investment will dry up, among other dire consequences.

"All this mayhem is very similar to what we have seen in Latin America and in Asia in recent decades," Weinberg wrote. "It is driven initially by inflation. This is what China must act to contain. So far, it has not. So the odds of a hard landing remain high."

Of course, the prescribed cure for what ails China -- clamping down on the flow of money -- may already have caused problems of its own, namely a credit crunch that threatens to snuff out economic activity, according to Virendra Singh, senior economist at

"According to news reports, the credit squeeze is quite widespread, especially among private entrepreneurs," Singh said. "The most dynamic sector in China, the private sector, is feeling a much greater impact."

Reasons not to worry

But these voices are in the minority. Most economists still agree with the Asian Development Bank, which this week predicted a soft landing for China, with GDP growth cooling to a nice, toasty 8 percent rate in 2005.

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One reason to remain calm is the tendency of Chinese authorities to stridently avoid making big, sudden policy moves, and that such moves act with a lag anyway, according to Anthony Chan, senior economist at J.P. Morgan Fleming Asset Management.

"People watching the Chinese trying to generate a soft landing think that, if it doesn't work in five minutes, it must not be working," Chan said. "We're not seeing immediate results, but I think it's incorrect to assume that, a year or a year and a-half from now, we're not going to see some of these effects. We will."

Chan pointed out that China's recent inflation surge follows several years of deflation and could represent nothing more than a temporary pop in the wake of last year's SARS-induced slowdown.

And though Chinese authorities don't quite have the cachet of, say, the Federal Reserve, they are slowly winning converts for their ability to steer such a massive economy through troubled waters, while slowly adopting open-market reforms.

"Show me an example of one other emerging market economy that's made such a transition without huge disruptions along the way -- I would love to see it," said Zachary Karabell, co-portfiolo manager, along with Dan Chung, of the China-U.S. Growth Fund at Fred Alger Management. "I think they have been remarkably successful, and I feel more confident about their ability to make more right decisions than wrong decisions."

What hangs in the balance

The China-U.S. Growth Fund, with about $24 million under management, is just one of the players with a lot riding on China's economy. Other mutual funds include the Dreyfus Premier Greater China fund and the China Regional Opportunity Fund at U.S. Global Funds.

Economic Bubble

In addition to several Chinese and Hong Kong-based companies, the China-U.S. Growth Fund also serves as a "Who's Who" of U.S. multinationals with growing interest in China. Among its biggest holdings are tech companies such as PalmSource (PSRC: Research, Estimates) and Axcelis Tech (ACLS: Research, Estimates), consumer products makers Avon Products (AVP: Research, Estimates), Nike (NKE: Research, Estimates) and Fossil (FOSL: Research, Estimates), restaurateur Yum! Brands (YUM: Research, Estimates), and heavy hitters in industry and energy, including United Technologies (UTX: Research, Estimates) and Schlumberger (SLB: Research, Estimates).

Cisco Systems is a player now, and Citigroup (C: Research, Estimates), the U.S. bank with the biggest stake in China, has been busily extending its reach there.

China's Asian trading partners, including Japan, Taiwan and Singapore, would suffer from a hard China landing, as would Latin American suppliers of wood, copper and other commodities. Some economists fear a meltdown of China's banking system would spread financial pain all the way to the United States.

But Karabell believes the hard/soft landing argument is a moot point for long-term investors.

"Is there a real estate bubble? Maybe. Will there be volatility in Chinese markets? There certainly has been. Is investing in China easy? No," he said. "But China is going to be, at least along with the United States, the most significant force in the global economy in the next five years."  Top of page

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