By Kevin Yee | September 22, 2009

The current financial crisis emanated from souring US subprime loans and has led to a shutdown in global credit and slowdown in world trade.  Financial markets worldwide are in disorder and most major economies have been crippled.  However, once again, China is managing better than its Asian counterparts, and the rest of the world for that matter.

The central government believes that China’s stimulus is expected to push GDP growth to 8% or more, and Premier Wen Jiaobao reiterated that the government would introduce more stimuli to further boost the economy.  The current $4 trillion Yuan stimulus (18% of GDP), contains $1.18 trillion Yuan of new spending.  With retail sales and fixed asset investments achieving double-digit growth, China may be able to achieve 8% growth in 2009.

Accolade has been given to China for its efforts to bolster its economy.  Global financier, George Soros has called China a “positive force” in the world and in the markets, and believes that China will grow faster than most expect in the near future.  He also expects China’s influence to increase along with its economic power.  While most other Asian currencies have been falling due to weak exports and less FDI, the Yuan has maintained its strength.  On the contrary, the relative strength of the Yuan negatively impacts China’s exports.

To be clear, this does not imply that China is immune to the financial crisis.  The country’s GDP has dropped from 11.2% to 9% in 2007 and 2008, respectively.  In the first quarter of 2009, GDP growth has dipped to 6.1%, well below the government’s target.  Coincidentally, a minimum of 8% GDP growth is required to absorb the new labor into the workforce and prevent unemployment from spiking to levels that would cause civil unrest.  Whether 8% GDP growth is a modestly achievable figure or a naïve political target, China’s focus is not only to emerge from the financial carnage in good shape, but also to achieve unprecedented growth during this time.

China is addressing a few key areas to overcome the financial crisis, namely: aggressive bank loans, reinforcing manufacturing exports, and a potential shift toward domestic consumption growth.

China’s Future Economic Growth

AFC and the Crisis Today:  China’s Perseverance

If China’s emergence from the 1997 Asian Financial Crisis is any indication of how it will handle the current Financial Crisis, then there is no reason to doubt their future strategic vision.  Many of the policies implemented to solve this crisis parallel those employed a decade ago.  Some of these similarities include: spend on public housing, expansion of fiscal policies, relaxed monetary policies, and currency stability via maintain the RMB peg to the USD.

To cope with current challenges, China has undertaken some extensive changes since persevering through the AFC.  In particular, sections of the stimulus package address issues related to healthcare, energy conservation and the environment, and an increased proportion spent on infrastructure.

In the financial industry, the banking sector was gradually liberalized.  While global investors endorse the change, experts such as Nobel laureate Joseph Stiglitz believe that “capital market liberalization may not always be good as the only two major developing countries to be spared [by] the crisis [are] India and China”.  This was true for China during the AFC, and may also true for the current crisis.  Chinese banks were less invested and minimally exposed to the complex securities that imploded and had not invested much in mortgage-backed securities.

 Investments, FDI, and exports helped the region emerge from the AFC.  The strategy worked due to demand from the U.S and Europe. With global demand weakened and exports dropping, Asian countries such as China can no longer rely on the same strategy help their economies return to high growth.  Therefore, China is shifting its source of growth from external buyers to domestic consumers. 

Once a Dragon, always a Dragon?

Although the overall demand for exports will decline this year, China’s unrivaled supply chain network and manufacturing capabilities remain formidable.  Looking ahead, labor-intensive products such as apparel and toys still stand to capitalize on the average $1.26 per hour factory wage.  In technology-based industries like consumer electronics, China retains an edge as a top assembly destination due to its parts supply chain throughout the region.  Charitable government incentives support rapidly expanding industries such as renewable energy and cars—areas that have a massive total factor productivity potential.  These indications support the theory that China is reluctant to relinquish their status as the world’s manufacturing capital at this point in time, perhaps especially in the face of the financial crisis.  As a result, China may emerge from the financial crisis relatively unharmed.  Who can blame China for sticking to their strengths and maintaining a tested model for growth at the possible expense of short-term thinking? 

However, there are glaring indications that (re) adopting this strategy may not be so easy.  China’s once-fearsome advantage in manufacturing may soon become restricted to select industries.  Outsourcing to China is not as reactive as it once was, and emerging countries like Mexico are now viewed by the US as an ideal destination for an increasing number of products.

In a growing number of cases, price savings has reached a negligible difference by the time US outsourcers receive their Chinese-made goods.  Add to the mix challenges of quality, logistics, and language, US companies are forced to reconsider the hassle of manufacturing in China.  Moreover, dealing with an average lead-time of 45 days for goods to reach US shores causes great discomfort for companies in an age when lean processes and inventories are becoming the norm.

Despite these pressures, China’s attitude toward export-driven growth remains relatively undaunted.  China continually invests in manufacturing and infrastructure and has increased tax rebates on a range of exports.  This has spurred concern that China will fall back on exports in the short-term to weather the financial crisis storm.  Due to the recession, many US manufacturers are postponing major disruptions to supply chains right now.  This has afforded China some valuable time to retool and reconsider its long-term strategy.

Save Less and Buy More—of the Right Things

China may be able to reach 8% GDP growth target with its stimulus package in 2009, but it is difficult for any country to maintain high growth rates based on high government spending and high levels of lending for extended periods of time.  For the past decade, China has pursued a growth strategy based on investments (both domestic and FDI), manufacturing, and exports.  This strategy paid off handsomely, allowing China to achieve high growth for more than a decade.  However, whether this strategy will continue to yield the same payoff in the future has been—and will continue to be—a hot topic of debate.

The Chinese government has recognized that the growth of the economy will need to be less investment- and more consumption-driven.  In 2008, China’s consumption as a percentage of GDP was 37%, greatly lower than the 70% in the U.S and 58% in Hong Kong.  Few would argue that China’s emphasis on investment in the past was detrimental to its growth.  More attention has been given to the possibility of overinvesting, and that China’s current trajectory will lead to an inefficient allocation of capital.  Total factor productivity is diluted if China invests excessively in infrastructure—underutilized ports in Dalian—and will not contribute to economic growth.

More Money ≠ More Consumption

China has a very high savings rate because of strong cultural norms and a weak social safety net.  The Chinese have developed a habit of saving a large percentage of their income for numerous reasons, including: medical costs, retirement expenses, rural to urban migration, and education.  Most of these savings stem from an ingrained culture that comes with the inherent responsibility to take care of one’s family.  With China’s one child policy enforcing population control, GDP growth per capita was kept in line with GDP growth.  This allowed wages to increase and helped improve standards of living, but did not directly translate into greater consumption.  In fact, China’s savings and investment as a percentage of GDP increased from 39% to 51% in 2001 and 2008, respectively.  Although Chinese laborers earned more, the extra money was correlated with an increase in investments and savings, not consumption.

Policies have since been implemented to address this issue and further promote a domestic consumption-driven economy.  China has dedicated 150 billion RMB in its stimulus package for healthcare and education.  An additional 850 billion RMB has been budgeted specifically to provide basic, universal healthcare for 90% of the population by 2011.  By improving the country’s social safety net, China hopes that the people will be less inclined to save and more inclined to spend.  These actions will definitely help advance the government’s push for domestic consumption.  However, due to the Chinese propensity to save, it may take an adjustment period before observing any dramatic results.  (On a side note, it also remains to be seen whether the people will trust the healthcare system provided by the government.  China Road is a good read about the local government covering up the HIV epidemic in Henan province.)

Conclusion

Today, China holds $2 trillion USD in foreign reserves, is the largest holder of US Treasuries, and the largest foreign creditor of the US government with $1 trillion in securities.  Often accused of currency manipulation to boast an unfair trade advantage, China is closely monitored as the country navigates through the current financial crisis.

During a recent trip to China, US Treasury Secretary Timothy Geithner pressured China to alter their economic growth strategy toward sales to domestic consumers and less on export sales.  He encouraged China to offer more support in healthcare, welfare, and education to persuade the Chinese to reduce precautionary savings.  The implications here are that the US is interested in reducing mounting trade deficits with China.  Geithner stopped short of controversy and was cautious about recommending the RMB to move freely against the USD.

Only time will tell what the future holds for China.  Although the central government has explicitly expressed its desire to shift to a consumption-driven economy, many short-term actions imply reinforcing its reliance on exports.  Despite China’s strength in manufacturing, there are telling signs that their advantage is slowly eroding.  Other countries like Mexico are competing for a share and becoming an increasingly attractive alternative for (US) outsourcers.

With government reforms aimed at encouraging domestic spending, all indications point toward the importance of a domestic consumption-driven economy.  It remains to be seen how quickly and the degree to which the Chinese consumer will respond to these initiatives to stop saving and start spending.