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Asia Economy Last Updated: Aug 24, 2010 - 4:49:58 PM

Is China ready to become the next economic superpower?
By Michael Hennigan, Founder and Editor of Finfacts
Mar 29, 2010 - 4:59:08 AM

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Photo taken on Sunday, March 28, 2010 shows the Bund of Shanghai, which reopened after nearly three years of renovation designed to improve the landscape and facilities for visitors to the World Expo. The word "bund" means an embankment or an embanked quay, and comes from urdu. The area was originally developed by the British and it was the financial centre of Shanghai before the Communist takeover in 1949. Photo: Xinhua

US ratings agency Standard & Poor's, asks in a new report if China is ready to become the next economic superpower?

China was the world’s largest economy until 1890 and today, while the US contributes 28% to world GDP, China accounts for only 5%. The whole of Asia, from Turkey to China, contributes 24%, less than the US alone.

The Chinese edition of the Organisation for Economic Cooperation and Development (OECD) Development Centre’s Chinese Economic Performance in the Long Run was published in 2008 and was an update of the 1998 best-selling volume by Professor Angus Maddison for the Centre. For this edition, Professor Maddison extended his projections for China to the year 2030 and revised some of his growth figures upwards. Instead of using the exchange rate to measure the level of Chinese performance, which greatly understates China’s role in the world economy, Maddison used purchasing power parity (PPP) to convert yuan into US dollars and found that China accounted for 5% of world GDP in 1978, 15% in 2003 and that this is likely to rise to 23% in 2030.

SEE: Finfacts articles:

Mar 2010: Demographic outlook for the BRICs varies greatly; India's working-age population to rise by stunning 240m in 20 years compared with 10m in China

Nov 2009: Industrial overcapacity in China is “wreaking far-reaching damage on the global economy”

Oct 2009: China celebrates 60 years of communism/ capitalism; Ready to reclaim pre-1890 status as world's biggest economy?

S&P says views about China seem as volatile as financial markets recently. Last year, many marveled at the resilience of the Chinese economy and its economic superpower destiny. So far in 2010, however, predictions about an economic hard landing in China fill more newspaper pages but the truth is likely to lie somewhere in between.

The agency says the Chinese economy is almost certain to grow steadily in international importance. In terms of size, its GDP is already on track to rank behind that of only the US this year . But stark differences remain between China and other top economies. Average income in China is far lower. Its economy depends significantly more on exports. And very little of the intellectual property critical to its high-valued exports originate in the country.

Moreover, China will find it increasingly difficult to maintain its current pace of growth as the gap narrows between its average income and those of developed economies. The rate of deceleration in growth hinges on how well policymakers resolve existing economic distortions to improve the efficiency of Chinese investments. These distortions--including heavy government influence, overcapacity in some industries, and excessive domestic liquidity--are important reasons why many are fretting about an impending sharp economic correction in China and the potential social implications.

Despite the warning signs, S&P's Ratings Services sees only a modest risk of instability and doesn't expect the Chinese economy to falter significantly over the next two to three years.

Fueling the Greater China locomotive: China's 8.7% real GDP growth in 2009 gave the world economy a much-needed boost. In Asia, this helped many economies surpass earlier growth forecasts, even as the developed economies largely performed to expectations. This year, China's forecast growth of almost 10% will once again provide an important boost to the region. This will be felt especially keenly in the other parts of Greater China.

Real GDP Growth In 2009
  April 2009 IMF forecasts Official estimates of actual performance
Japan (6.2) (5.2)
Korea (4.0) 0.2
China 6.5 8.7
Taiwan (7.5) (1.9)
Hong Kong (4.5) (2.7)
U.S. (2.8) (2.4)
U.K. (4.1) (5.0)
Eurozone (4.2) (4.1)
Source: International Monetary Fund (IMF) World Economic Outlook April 2009, Eurostat, various national sources.

S&P forecasts 4% real GDP growth in Hong Kong this year partly on the expectation of continued strong growth in China. For many Hong Kong industries, China is an alluring growth market, but it's also the source of increasing competition on their own doorstep.

Taiwanese businesses are beginning to draw more economic advantages from China now that ties are warming. One such benefit: Tourist arrivals from China are growing steadily. Mainland tourist arrivals are particularly important to the financial health of casino operators in Macau. Visa restrictions in the first six months of last year led to a sharp revenue decline. But a strong rebound in mainland arrivals in the second half of 2009 helped to keep annual gross gaming revenue rising.

S&P says it's now accepted wisdom that one must start with economic projections for China before making economic predictions for the other Greater China economies. The importance of economic trends in the developed world is no longer as great as it was a decade ago. This could also be true for an increasing number of other economies in Asia over the next 10 years. 

Official data underestimates the size of the Chinese housing bubble, according to Takatoshi Ita from University of Tokyo on Tuesday, March 23, 2010. He suggested the Chinese government look to Japan in the 1980s to learn the right lessons and prevent a repeat experience:

A G-2 Future?: The economists say some excited observers predicted the dawn of a "G-2" era in which China and the US would shape the future of the global economy. Economic projections from reputable sources, such as PricewaterhouseCoopers and major international banks, showed China displacing the US as the senior partner in this grouping in less than two decades. Chinese dominance in geopolitical influence, military strength, and even space exploration in the near future was no longer considered far-fetched.

These views may not be as misguided as Cold War fears of Soviet dominance. But they rest on optimistic assumptions that extend China's record of strong economic growth into the future. In the S&P view, this optimism is only likely to bear out if China deepens its structural reforms to promote greater economic efficiency. Otherwise, existing weaknesses in China's economic structure could become an increasing drag on its economic development.

An inefficient domestic sector is one drawback:China's manufacturing prowess notwithstanding, a large part of the country's economy is still operating relatively inefficiently. This includes the domestic services, agriculture, construction, and real estate sectors that make up the bulk of the Chinese economy. Despite China's sizable exports, equal to about a quarter of GDP (in terms of US dollars) in 2009, their contribution to the economy is disproportionally small. The latest available data, for 2007, showed that industries producing half of the country's exports were responsible for only about 10% of the total value added that year.

The reason is that much of the value in Chinese exports accrues to parties outside the country. Apple's iPhone may be put together in the southern Chinese province of Guangdong, for example, but activities relating to its conceptualization, technology development, and marketing mostly occurred in the US. Even the factories that produce the iPhone are foreign owned and, thanks to government incentives, pay limited taxes.

China is trying to change this situation. It's pouring more money into supporting research and development, and it's encouraging Chinese companies to make foreign acquisitions that come with advanced intellectual property. Major infrastructure project and equipment purchase contracts often have technology transfers to Chinese firms as a condition. However, S&P says it remains to be seen if state funding leads to the same success in scientific fields as it has in international sports competition.

It's also uncertain if China can substantially boost domestic industries' productivity. The majority of operators in the export markets are foreign and domestic private firms, but state-owned enterprises (SOEs) often dominate the domestic-oriented industries. Laws or regulation largely prohibit non-state firms from participating in some sectors, such as tobacco production and telecommunications. In other sectors, SOEs' advantages of being government-backed and the related problem of overcapacity make it difficult for private companies to thrive.

Government influence is a key factor:Government influence in the management of SOEs is a major reason for their inefficiency. Government-owned monopolies or oligopolies either generate high profits at the expense of high prices for their customers (e.g., mobile telecommunications) or are inefficient and unprofitable (e.g., the postal service). In other industries--including highway construction, steel production, and cement--excessive competition and overcapacity constrain profits for all firms.

The economists say that efforts to raise productivity and reduce overcapacity in these industries face strong political challenges. The permitted monopolies or oligopolies often control either Chinese natural resources or sensitive industries. Entrenched views in the government argue that these industries need tight ownership and control. In the highly fragmented domestic industries, the central government seems eager to see much more consolidation. However, local governments sometimes rely significantly on SOEs to circumvent their budget constraints and therefore often obstruct necessary company failures and industry consolidation.

Macroeconomic consequences trouble policymakers: The structure of the Chinese economy also has significant implications. A relatively large proportion of national income accrues to foreign firms in the export sector and to public enterprises in the domestic sector. In neither case is income passed on to Chinese consumers. This contributes to the unusually small share of household consumption in GDP and an equally unusually high domestic savings rate.

One consequence is a constant risk that liquidity pressures will push Chinese asset prices beyond levels that fundamentals justify. Strong capital controls that strictly limit foreign investment options for Chinese residents are additional constraints. The country's underdeveloped financial markets mean that the strain is strongest on real estate and share prices. Despite tax and credit regulations that aim to prevent asset bubbles, concerns of overheating in the real estate market once again emerged early this year.

In S&P's view, strict regulatory oversight is necessary to prevent liquidity pressures from engulfing banks. Some observers fear that if the government removes the current credit growth quotas for China's commercial banks, bank lending will fund investments with poor expected returns. This risk became evident last year when domestic credit rose more than 30% after the government lifted loan quotas as part of its economic stimulus package. Much of the new lending reportedly went to companies known as "financing platforms" that Chinese local and regional governments own. Concerns about a future surge in non-performing loans at banks have now followed the credit boom, due to the weak credit profiles of the borrowers.

China's pent-up savings create other challenges for monetary authorities. They are the primary reason for the constant appreciation pressure on the exchange rate. When Chinese interest rates rise relative to other major economies, capital inflows intensify this pressure. Despite formal capital controls, which China has tightened recently, sufficient funds have managed to find their way into the country to reduce the impact of policy tightening. This increases the complexity of the central bank's monetary policy calculations. It also makes it more difficult for China to rely more on interest rates, rather than lending growth quotas, to manage the economy.

A side-effect of this problem is large foreign exchange mismatches and exposure to the credit risks of foreign governments that have built up on the central bank's balance sheet. The build-up is attributable to the central bank's ongoing accumulation of massive foreign exchange reserves as it uses renminbi to buy foreign currencies to stabilize its exchange rate. Policymakers are fast recognizing this vulnerability as government debts in the developed countries increase sharply. Efforts to mitigate this risk, such as seeking to expand the international use of the renminbi and encouraging SOEs to pursue foreign acquisitions, are unlikely to change the situation meaningfully in the near term, according to S&P.

Slower growth is likely if administrative controls remain dominant:China has maintained economic stability and kept growth at a fast clip so far through layers of administrative controls over many aspects of the economy. But these controls can't stop the occasional trouble spots from appearing. Worries about asset bubbles, industrial overcapacity, and bad loans at banks are recurrent. Despite recently voiced concerns among many observers, S&P sees only a small risk of an abrupt slowdown in the Chinese economy or destabilization of major commercial banks. In part, this reflects a view that continued economic expansion, rising urbanization, and adequate capitalization at the main commercial banks will help ease some of these pressures.

But China's economy is rapidly growing in size and complexity. Policymakers are likely to find it increasingly difficult to make the right decisions on a timely manner for the economy. At some point in the next 10 years, their preference for directly managing the economy may be a binding constraint on further economic development. Without a significant increase in reliance on indirect market-based policy tools, the economic growth rate could fall sharply from the current lofty levels.

The S&P economists say that indirect policy tools are likely to work well only if the environment allows them to. In developed economies, where such tools are widely used, firms tend to care more about their bottom lines than policy objectives; banks refuse loans to ailing firms rather than look to local government when making lending decisions; and the capital regime allows savers to allocate their savings globally according to their investment objectives. Reforms to reduce government control over individual enterprise and allow freer capital outflows could help create these conditions in China, too, and create a more responsive policy environment. This could ease some of the economic imbalances troubling policymakers, according to the ratings agency. If China implements these reforms quickly enough, S&P believes the country may yet meet optimists' forecast for its ascension toward becoming an economic superpower. And Greater China economies will likely hold on to its coattails.

Millions of jobs have been lost due to our trade deficit with China, according to a new study by the Alliance for American Manufacturing & the Economic Policy Institute, and the area hit hardest was technology.

The updated study released March 23, 2010, blaming widespread US job losses on trade with China is again based on flawed analysis and distracts from the real challenges facing the US economy and the trade relationship with China, the US-China Business Council (USCBC) said.

"The Economic Policy Institute's latest study, 'Unfair China Trade Costs Local Jobs' is once again built on the faulty assumption that every product imported from China would have been made in the US otherwise. As I said two years ago, this assumption is clearly wrong--several decades wrong, in fact," said John Frisbie, USCBC's president.

"Think about the television in your home. The label on the back probably says 'Made in China.' Fifteen years ago the label likely would have said 'Made in Japan'--but it was still an import." Frisbie continued, "Much of what we import from China replaces imports from other countries, not products we make in the US today. A jobs impact study that ignores the facts undermines its own credibility."

Scott Paul discusses the findings with CNBC:


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