China Faces More Challenges

A Little History of China's Economy

With China's economy growing at an average of 10% over the past 30 years, the Asian nation has earned its rank as the second largest economy, surpassing Japan in 2001, and now right on the heels of the first-ranked US. So, what led to China's relatively steady 10% growth over the years?

In 1978, China embarked on a series of economic reforms that gave its economy the potential to grow, but only after its communist ruler, Mao Zedong, died. Mao had established an autocratic socialist system that imposed strict controls over everyday life, which consequently limited workers' productivity. After Mao's death, his successor Deng Xiaoping, led a movement for economic reforms. Deng was a politician who had a vision of China becoming a socialist market economy. He successfully pushed for greater openness in both the social and political arenas, and that led to more foreign investment and trade within global markets. The reforms encouraged the formation of private businesses, relaxed state control over some prices, and led to large investments in industrial production and in the education of workers.

After the economic reforms were implemented in 1978, China's growth took off, with millions of Chinese citizens being lifted out of poverty as the per capital income nearly quadrupled. The driving force behind China's growth can be partly attributed to its ability to build, acquire and use new factories, and to manufacture machinery and communications systems, all of which caused a sharp increase in worker productivity. A report by the IMF states that from 1979-1994 productivity gains accounted for more than 42% of China's growth.

China GDP Growth (RMB & %) Since 1978

China's Economy Today – More Challenges Despite Growth

Although only 50 years ago China had a closed and centrally planned economic system, today China plays a more open and international role as the world's largest exporter. Its exports now represent over 30% of its nearly $6 trillion GDP—which is about half of the US’s GDP. Still, despite China’s extraordinary growth, its per capita income remains below the world's average and the Chinese government faces many economic challenges.

One major economic challenge China faces today is an unusually high domestic savings rate of 51% and, consequently, a low domestic demand, leaving China exposed to international demand for its exports. Another challenge is sustaining adequate job growth. After the economic reforms of 1978, Chinese workers flocked out of rural farmlands and into industrial cities, picking up jobs in manufacturing and service sectors. This caused a high supply of workers, but the number of new jobs has not kept up with that growing workforce, creating an imbalance that has kept workers' wages relatively low. Thus, while cheap labor may make it attractive for multinational corporations to make foreign direct investment in China, the low wages have limited the standard of living of the Chinese workforce.

China also faces other challenges: reducing the corruption of government officials, mitigating environmental damages from air pollution and soil erosion, and addressing the consequences of its “one child” policy, as China is now one of the most rapidly aging countries in the world. Moreover, China’s sustained growth has led to inflation exceeding the government’s target of 3%. China, therefore, has been raising interest rates to purposely slow economic growth and steep price increases. Still, raising rates is a double-edged sword; while raising the rates will slow the lending that, in part, led to the increases in real estate prices and inflation, the higher rates will also encourage the citizens to save even more money, and that could further hurt domestic demand for goods.

Although China’s economy has experienced extraordinary growth over the past 30 years through rapid growth in investment, increases in worker productivity, and decreases in population growth rate, China has also developed many deep-rooted economic problems. Today, China’s government promises to continue implementing economic reforms to deal with such economic problems. For now, however, if China’s economy continues to grow at a 10% growth rate, it will become the largest economy in the world by 2035. However, will China's economy really continue to grow that fast in the next 23 years?

Hard Or Soft Landing In China?

China's growth has slowed to 9.2% in 2011 and many analysts suspect that this slowdown (soft landing) will continue during 2012. But will China's economy instead take a huge dive (hard landing) as it faces a real estate bubble, high inflation, local government debt problems, and less global demand for exports with continued weakness in Europe? Or, will China’s government be able to further exercise its fiscal and monetary controls enough to mitigate these problems before they explode?

While I believe that policy makers in China have the ability to mitigate these issues, I also believe that addressing them with fiscal and monetary policies alone will not be enough. A primary reason for anticipating a hard landing in China is because it is not a consumer based economy. The Chinese save much of their income for a variety of social reasons, including the “one child” policy. This emphasis on saving reduces domestic demand for goods, leaving China very exposed to global demand. If that global demand falls –for example, in response to the European crisis-- China will be significantly impacted. Another potential problem may arise if China continues to import more and export less, possibly creating a significant deficit. These issues, combined with local government debt issues and higher than desired inflation caused by China's stimulus in 2008, all point to a potential hard landing in China this year.

While many analysts maintain that China now, and in 2012 is headed for a soft landing, FXI, an iShares Index ETF that follows the performance of the 25 largest companies in China's equity market, was down 17.5% this past year. Thus, the markets seem not to agree with the idea that China is simply in a slowdown, and that is causing much uncertainty. In fact, Lawrence Summers, former Secretary of the Treasury and economic adviser to President Barack Obama, said "China is the great unanswerable question... whatever you think the range of possible outcomes is [for China] over the next 25 years, it is wider."

No one can accurately forecast global demand for China's exports, especially with the continued uncertainty in Europe, but it seems that if China continues down its current path without making significant structural changes, as it did in 1978, it may eventually have a larger economic slowdown. To maintain a strong economy, China, as Robert Zoellick, President of the World Bank, once said, "needs to develop its domestic markets, allow small firms access to capital, and allow for more innovation."

Opinion: China's Growth Will Continue To Slow If No Structural Changes

Many analysts predict that China's economic growth in 2012 will be between 7 and 8.5%. Although I agree with analysts that China will continue to be a leader in economic growth in coming years, I believe that without large structural changes, the level of growth it will experience will continue to slow. Such slowing growth may cause investors to panic, as they fear a possible hard landing. For this reason, I recommend paying close attention to China's import/export markets and its domestic demand, as they may be good indicators of a hard landing.