China's Economic Slowdown

Workers are losing factory jobs at the fastest rate in decades. Automakers—having failed to anticipate today's sales slump—are lobbying politicians for bailouts. The stock market is a crash heap, home prices are down by 35 percent or more in many cities and toxic assets have begun to weigh heavily on banks. America in 2008? Try China, where the global economic downturn now looks certain to end the country's 30-year growth boom, posing the greatest leadership challenge to Beijing since pro-democracy demonstrations threatened one-party communist rule back in 1989.

That's not the conventional take on China—yet. But with most industrialized countries now in recession and countries the world over hoping against hope that the planet's most buoyant major economy might somehow dampen the global downturn, it's a forecast that increasingly rings true. The reasoning goes something like this: China, despite its deep pool of savings and $2 trillion in foreign reserves, is unprotected from the fall in global demand that began in earnest in mid-2008. Notwithstanding all the hoopla about the rise of China's billion consumers, the body blow that's now landing in the industrial heartland will debunk the notion that China has already begun transitioning toward a new growth model based less on exports and investment and more on household consumption. "We would love to believe it too, but it just ain't so," wrote Standard Chartered bank's highly respected China economist, Stephen Green, last month. He says expecting Chinese spending to save the world from recession is "a pipe dream."

With China at the vanguard, Asia as a whole stands dangerously exposed to external shock. Since the late 1990s, household consumption as a share of China's GDP has fallen from roughly half to 35 percent. On the flip side, the share of Asia ex-Japan's output devoted to exports is now more than 45 percent, or roughly 10 points higher than it was on the eve of the 1997–98 Asian financial crisis. When juxtaposed with America's debt-driven gluttony, Asia's puny appetite for the goods it produces reflects a global economy that's staggeringly out of whack. "We are where we are because of massive imbalances that policymakers and politicians have allowed to build up over the last decade," argues Stephen Roach, chairman of Morgan Stanley Asia. "Those imbalances were never sustainable, but the longer they went on the more they seduced people. And now we're paying the ultimate price for that seduction."

The tab, in fact, has yet to be tallied, but don't be surprised if Beijing gets stuck with the biggest portion of the bill for the simple reason that China's rebalancing act is actually much tougher than America's. For U.S. households, today's crisis means saving more and consuming less (recent consumption data suggests that is happening quite rapidly). Yet in China, where total household consumption is just 5 percent of America's by value, the challenge is to sustain an economy that's largely investment- and export-driven, which means finding ways to perpetuate industrial overproduction. Michael Pettis, a professor of finance at Peking University, says America found itself in the same bind back in 1929. "The U.S. in the 1920s ran a huge trade surplus and had the largest reserves in history to that point," he says. "So was the U.S. immune to the global crisis? No. It was the country that suffered the most. In that sense it is exactly like China today."

Beijing realizes the growth trap it's in. Why else would it unveil on Nov. 10 a $590 billion stimulus plan—a package nearly as large as Washington's $700 billion financial bailout—just days after it announced that China's economy expanded by 9 percent in the July–September quarter? The consensus view is that China's economy has slowed markedly since then. Year-on-year growth estimates for 2009 are mostly in the 7s, with the latest forecasts adding the scary caveat, "or less." This month the Royal Bank of Scotland said 5 percent growth in China next year couldn't be ruled out. China's economy, which grew by 11.9 percent last year, hasn't dipped below 6 percent annually since 1990.

Beijing's stimulus plan has won plaudits internationally not least because it indicates that Chinese leaders won't stand idly by as the crisis deepens. But just as in Washington at the beginning of the Great Depression, policy miscues could cost China dearly—especially if they undermine the global trading regime that China's economy relies on more heavily than any other major economy in the world. In the early 1930s, America's self-defeating mistake was to cut off world trade, particularly in the Smoot-Hawley Tariff Act, at a time when it was the leading exporter in a world burdened by massive industrial overproduction. Today, China is the lead exporter, the world again faces massive overproduction, and the mistake Beijing must avoid is moving too hard to sell more manufactured exports at the risk of flooding an already weak market, and triggering a protectionist backlash. That will only push the global market toward deflation—the downward spiral of falling prices leading to falling demand, as stressed consumers wait for even better bargains.

The doubts about China's stimulus plan arise in part because it's all broad strokes with no fine print. Conceptually, however, it seems intended to split the difference between promoting consumption at home, and export sales. It includes commitments to fund rural infrastructure, boost social spending on health and education, and mount an "economic housing" scheme for migrant workers in major cities—all of which, if implemented, would raise household spending over time. But it also contains perks for heavy industry, value-added tax cuts for the export sector and lending provisions that will channel bank funding to state enterprises engaged in road and rail construction and away from private companies. "The two focuses are definitely exports and infrastructure. That's what we're getting from everything we're picking up," says Green. "And that the health and education spending, although it has been listed as one of the eight priorities, is not going to be [well] supported." Economists estimate that only a quarter of the $590 billion is new money as opposed to previously announced spending, future tax cuts and unfunded mandates passed down to local governments. There's reason to expect that much of the promised social spending—and the consumer empowerment it represents—may not materialize. One warning signal is that Beijing has entrusted much of the safety net stuff to the provinces, which historically have put a low priority on building schools, unless the order to do so comes with earmarked funding from Beijing. One new concern: local tax revenues are shrinking due to the economic downturn. Roach says investment in the social safety net would "reduce the precautionary saving that is inhibiting broad-based consumption growth across the nations [of Asia]," though he adds: "China has from time to time flirted with that, but they really have dragged their feet."

To understand the linkage between social services and household consumption, visit a Chinese hospital. At check-in, patients are required to deposit money up-front, and when that funding runs dry they're tossed out onto the street, healthy or not. According to the World Health Organization, China spends less than 1 percent of its GDP on health care, which ranks it 156th out of 196 nations the U.N. agency tracks. Likewise, poor kids can't attend school without paying fees, and most migrants are uninsured against job-site accidents at any price. Families cope by saving an estimated 25 percent of their disposable income, just in case.

That isn't a social contract conducive to the "harmonious society" President Hu Jintao has advocated since 2006, or so concludes a new report co-produced by the United Nations Development Program and the China Institute for Reform and Development. It calls on China to overhaul its social-welfare system to provide universal basic health care, education, unemployment and retirement benefits for the country's 1.3 billion people. It stresses the need to vest forgotten segments of society including farmers, migrant workers and the poor. And it claims that such expenditures—which it estimates would cost $55 billion a year—actually offer a bigger bang for the buck than would the construction of new roads, railways and bridges.

The risk today (and it's one that's already materializing in a mounting exodus from shuttered factories in Guangdong province) is that these workers could, like the boxcar-hopping hobos of America's Depression era, become the flotsam and jetsam of the economic bust. Almost since China's reforms began three decades ago, Beijing insisted that sustaining economic growth rates above 8 percent was paramount to employing the millions of workers pouring in from inland villages. The further growth drops below that level, the higher the percentage of an estimated 15 million workers entering the labor force each year lands in the ranks of the unemployed. Yet even as policymakers stoked fast growth with every means at their disposal, little was done to transform these workers into foot soldiers of a different sort: new consumers with sufficient social protections to save less and spend more.

The prescription for change has been obvious since the late 1990s. It includes balanced growth between booming east and lagging west; efforts to narrow the yawning income gap between China's superrich and everyone else; and policies that channel the massive earnings logged by the state-owned conglomerates that dominate China Inc. back into government coffers to fund social spending. Yet campaigns with names like Go West meant to spur investment in the hinterland never amounted to more than propaganda exercises, and a long-mulled plan for the government to charge state companies dividend on their huge profits remains a small-scale experiment. In October, Standard Chartered noted a "gulf between aspirations and actual policies" illustrated by Beijing's long-standing bias toward investment and exports, and support for "state-protected oligopolies." Pettis argues that Beijing's persistent mercantilism has prepared it for the wrong crisis—specifically, an external debt shock akin to the one that ravaged Asia in 1997-98, against which China's huge savings and foreign reserve pools would make it "superbly protected." Yet as with America in 1929, China is the nation most exposed in the world to a collapse in global demand today.

As such, Beijing finds itself in a fix as 2008 winds to an ignominious close. Export promotion offers a viable short-term means of keeping the factories of China running—yet grabbing more market share amid a global downturn is the surest way to incite protectionism. During the recent gathering of G20 leaders in Washington, much public emphasis was placed on shoring up the global financial architecture and defending free trade. Yet former New Zealand prime minister Mike Moore, who headed the World Trade Organization from 1999 to 2002, believes the backroom talks focused on the imperative that Asia not try to export its way out of today's crisis. It was "the elephant in the room; how China, and to a lesser extent India and the Southeast Asians, must become consuming countries," he says. "It's overwhelmingly in [their] interest to become a lot less reliant on exports, and it also does right by the people they represent. Not to do it could trigger something that's very, very unpleasant." Global trade slumped 70 percent in the 1930s, and any return to the virulent economic nationalism of that era "would turn crisis into catastrophe," warns Moore.

That presents Beijing with a leadership challenge very different from the one it confronted with tanks and soldiers in 1989. Today, it must work to maintain enough harmony in the global trade arena so as not to lose access to vital overseas markets, while telling the Chinese people that fast growth isn't their birthright. In essence, Beijing must offer a new social contract in which consumption bolstered with a social safety net replaces the export-driven growth engine that has powered China's economy for 30 years. FDR did that in America in the 1930s, but it took a decade. Might China's leaders fare any better? In the late 1990s, then Premier Zhu Rongji refrained from devaluing China's currency when many of its neighbors did so; the decision lost China some export momentum but gained its leadership a reputation for responsible global action. Today's leaders have maintained that reputation, but given the enormity of the economic challenges at hand, the only safe bet is that their helmsmanship will be tested to the extreme in 2009. Especially if the pessimists are correct and China's economy grinds to a halt.