CHINA'S SEVEN-PERCENT SOLUTION, PART I
By Gordon G. Chang

"If we didn't have China I would be suicidal," chief Morgan Stanley economist Stephen Roach said this month. "It's the only bright spot in the world economy." And bright spot it is: Beijing announced that its gross domestic product grew 8 percent last year. The rate is so good that some are wondering whether the People's Republic can become the new engine for world growth.

From today's perspective it certainly looks as if it will. No other major economy will report anything near 8 percent for 2002, and many agree that the prospects for future Chinese growth are rosy. "China can still grow at more than 7 percent in the near term, and we don't see anything interfering to drop that rate," says Jonathan Anderson, a senior Goldman Sachs economist in Hong Kong. Despite all the sunny predictions for the world's most populous nation, we have to ask ourselves whether the pace of the country's development is sustainable.

Chinese economic growth in 2002, announced before year end, as is the custom of Beijing statisticians, was largely the result of three factors: record investment flows inward, surging exports and massive fiscal stimulus. The central government notes that foreign direct investment last year totaled US$52.7 billion, the largest amount in 2002 for any country, even the United States. Exports also outperformed expectations, jumping 22.3 percent to US$325.57 billion (imports increased by 21.2 percent).

THE TEA LEAVES
China's leaders predict an even brighter future for themselves. They say, for example, that they will be able to attract at least US$100 billion in foreign investment in each of the years of their eleventh Five-Year Plan, 2006 to 2010. Because foreign investors often channel their funds into the export sector, inward flows of that magnitude should translate into even larger sales abroad in following years. With investment and exports shooting through the roof, there's no question that the nation's leaders will quadruple the size of the Chinese economy by 2020 as they say they will do.

Or is there? Beijing's aspirations are based on extrapolation; in other words, they assume a static world. Take exports, for instance. The Chinese believe that there are an infinite number of buyers, somewhere. Such an assumption is clearly dubious. That fabled guarantor of world growth, the indefatigable American consumer, let us all down last Christmas. As a result, 2002's holiday season was the worst, from the retailers' point of view, in more than a generation. U.S. economic growth for the fourth quarter may fall under 1 percent. Europe and most of Asia are not much better off. The Japanese, China's other major group of customers, are not in a buying mood either.

And declining consumption does not look set to reverse course soon. First, with the prospect for war in the Middle East and turmoil elsewhere, the outlook for the world economy in 2003 is especially uncertain. Optimists say growth will be around 2.75 percent this year. Yet the World Bank thinks last year's GDP growth will come in at an unimpressive 1.7 percent, and that is a good estimate for this year as well.

Second, the continuing consolidation of industry in developed nations and the movement of factories to China mean that even more people will join the ranks of the unemployed. These trends result in decreasing demand for goods, even cheap Chinese-made ones. Joblessness in the United States, for example, is now close to an eight-year high of 6 percent.

Third, the ongoing destruction of wealth in world equity markets will contribute to declining consumption. We have just witnessed the third straight year of declines in many of them. Wall Street has not had three consecutive losing years in over six decades, so 2002 made history of sorts. Many analysts say that 2003 will break the trend and start the cycle upwards, but they said the same thing last year.

Investors are now just beginning to realize that stock markets might not recover soon, especially if corporate earnings continue to fall. Unfortunately, we are making a painful adjustment to a less prosperous world, and this process could create a negative wealth effect. Add the prospect of deflation, and it's no wonder that consumption is peaking in the industrialized world.

THE CURRENCY
In response to these trends, Beijing's technocrats have been depressing the value of their currency. This selfish maneuver ensures that Chinese products remain competitively priced in foreign markets. The central government accomplishes this by pegging the renminbi to the U.S. dollar, buying and selling its currency and the American unit so that the exchange rate never strays far from 8.28 yuan to 1 dollar. Today, the peg means the Chinese currency is sliding downhill in tandem with the greenback. Some analysts, including those at Goldman Sachs, believe the renminbi is now undervalued as much as 15 percent, but further downward pressure on the dollar in the future will probably just add to that figure.

China's defenders say that in the past the pegging has resulted in an overvalued currency, but most of the time the renminbi has been undervalued, as it is now. The fixed currency regime has permitted the Chinese economy to flourish--at the expense of other countries.

And other countries have noticed. Already the Japanese are complaining about Beijing's currency manipulation. "Because this is an issue that concerns the interests of many countries, the related nations need to have a thorough talk," Japanese Finance Minister Masajuro Shiokawa said this month. China's trade surplus against the United States looks as if it might exceed the politically sensitive US$100-billion mark in 2002, and already Washington has politely told Beijing to loosen the peg. There is even talk that the G-7, the world's leading industrial democracies, will take up the issue of China's currency, though at this point no action is expected.

HOW LONG CAN THIS GO ON?
The People's Republic has every legal right to fix the value of the renminbi anyway it wants, but the wisdom of this course of action is open to question. How realistic is it for China to think that it can accumulate large trade surpluses year after year and have the rest of the world simply watch? Should Chinese leaders believe they can drive their currency down while other major trading nations let their's float?

At some point Japan and other nations will take matters into their own hands and manipulate their own currencies downward too if the Chinese insist on maintaining the peg. For a China that depends increasingly on exports to keep its economy going, a series of competitive devaluations, the only course Beijing leaves the rest of the world, would be disastrous.

If change in the currency markets is not orderly, then change will be chaotic. Beijing, as powerful as it is, cannot prevent the inevitable. Chinese leaders can determine what kind of change there will be. No country will benefit from wrecking the understandings that keep the global trading system working. That is why it is important for the Chinese to adopt responsible currency policies now. Their export growth may slow if they do, but shunning selfishness is in China's best interests in the long run.

IN SUM
As exports falter, so will the flow of inward investment. There is today industrial overcapacity in every market segment in the world. Multinationals, by pouring more investment into China, are creating more of it. At some point, export-oriented investment will slow simply because the world will run out of consumers. We are perhaps a couple years from that time.

But will multinationals invest to penetrate China's home markets? It is true that Chinese consumers are buying more these days as they accumulate savings, but predictions of straight-line growth are difficult to accept. There is already too much of everything in the People's Republic: Nagging deflation since the end of the 1990s is the proof of that. Last year marked another period of falling retail prices, and the decline would have been even more pronounced had not the price of imported oil jumped.

In the future only selected sectors will see sustained consumer demand. For example, automobiles and semiconductors will sell in increasing numbers in the coming years due to pro-growth central government industrial policies. Yet even in those sectors where there will be larger sales volumes, profits will be hard to come by because of too much supply--and because of Beijing's policies to develop homegrown industry. In general, the nation's consumer markets are simply not as promising as they seem for foreign businesses.

China, no matter what short-term fix it adopts, cannot escape global trends indefinitely: The country is integrating its economy into the world just as the world economy begins a period of decline. So it's becoming evident that inward investment and export growth are two factors that have just about reached high tide for the People's Republic.

[Upcoming: Fiscal stimulus is creating its own problems for the modern Chinese state.]

Gordon G. Chang is the author of The Coming Collapse of China, published by Random House.

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