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Why China's Growth May Slow

Can China navigate around short-term obstacles to growth?

Bearemy Glaser, 07/14/2011

We got news this week that China's blistering growth rate slowed slightly in the first quarter of the year. The Chinese economy "only" expanded 9.5% in the first quarter, down from 9.7% during the last quarter of 2010. Given the developed rest of the world's seeming inability to grow at all, these numbers remain impressive. Indeed, many are hoping that the expanding emerging-markets countries (notably China) will help keep the global economy going as austerity and slow growth become the buzzwords in the west. But are these hopes for endless growth justified?

The long-term growth prospects for China are notable as the country carves out an enormous new middle class and begins shifting from a low-value-added export-driven economy to one that serves domestic consumption and tries to move higher up the value chain. But I think in the short and medium term there are real risks of a slowdown in Chinese growth. Here are a few things that could short-circuit the economy.

Inflation

The rapid expansion of the Chinese economy has gone hand in hand with a rapid expansion in price levels. According to official statistics, inflation currently sits at 6.4% with food prices pushing higher the fastest. And it's quite possible that inflation is running even higher than the official government statistics show.

Getting inflation under control is going to be very difficult without slowing down the broader economy. The Chinese government has repeatedly raised the reserve requirements for banks and hiked interest rates in an attempt to rein in lending and tap the breaks on the economy. This is a delicate maneuver, however. Tightening up monetary policy too fast could make it hard for businesses seeking access to capital for expansion purposes, and leaving policy too fast could let inflation get out of control, threatening the underlying strength of the economy.

So far, the government has erred on the side of letting inflation run at a contained but reasonably fast level. It isn't inconceivable that policymakers will get this balance wrong and that the economy could slump because of it.

Housing Bubble?
One of the questions that has been the trickiest to nail down is if China is experiencing a housing bubble that is on the verge of popping. Housing prices have certainly risen at a very impressive clip during the last few years, particularly in the major cities. Home prices that defy gravity naturally conjure up comparisons to those in Ireland or the United States, where housing prices seemingly could never fall, until they did in spectacular fashion.

There are a few things to keep in mind about housing in China. First, lending standards are much tighter than they are in developed countries. Would-be homeowners have to put a tremendous amount of money down, and loan terms aren't overly generous. Secondly, there are restrictions on buying second homes or speculating in properties, so most units are actually owner-occupied. You also have to consider that there is real growth in wealth and the middle class that is driving up demand for these homes in desirable areas.

But even so, the incredible pace of building across the country, the surge in prices, and the apparent frenzy to own a home does seem to point to some mania. A fall in prices or a sag in demand for housing could wreck havoc on the very important construction sector and have a detrimental impact on growth.

Catch-Up Growth Gets Harder
China is now experiencing catch-up growth as the country urbanizes, industrializes, and adopts the best practices from around the world. As a developing country, it has lots of low-hanging fruit it can exploit to improve efficiency and drive growth. And there is still plenty of runway left. Gross domestic product per capita is still far from rich-world levels, and it will take some time for China to completely catch up.

But a lot of the lowest-hanging fruit has already been picked. As the country continues to expand, it will become increasingly hard to increase productivity. Developing remote inland regions is much harder than developing coastal regions with strong links to the outside world. It's not to say it can't be done. However, it will cost more, and returns on investment won't be as strong.

West Is Slowing
At the outset of the Great Recession, it was trendy to speak of China as decoupling from the West. The trials and declines of developed countries in North America and Europe didn't matter to China because the country had become so large it had broken into its own orbit. This turned out not to be the case. Although China was not hit as hard as many Western countries, it did see its growth slow down. The Chinese government had to step in with an impressive stimulus to keep everything running reasonably smoothly.

Yet, now it looks like the developed world might be slowing again. Large austerity measures, the continued housing hangover, bad unemployment, and other factors are holding back much of the West. China depends on being able to export to these markets for its well being. Sure, China has significant trade with the rest of the developing world and a burgeoning domestic market, but a steep fall-off in demand for exports is going to take its toll.

Geopolitical Risk
The Chinese government is dead-set on steady growth because it helps keep its political position. It believes that the key to maintaining the country's position of power is to provide steadily increasing living standards and an opportunity to join the growing middle class. If the economy were to suddenly slow down considerably, there could be greater calls for a more representative government. It's difficult to predict what a mass protest, or crackdown, would mean for the Chinese economy.

And that doesn't even touch area hot spots such as North Korea that could potentially erupt anytime. Many of these events are low-probability, but they could have a profound and sudden impact on the course of the Chinese economy.

Over the long haul, China is going to be a key player in the global economy, but there are several risks to that growth in the short term. The country might very well be able to navigate these risks and continue its upward trajectory, but it is still important that investors see that endless growth is not preordained.

What do you think? Is there a China bubble? Do you expect a sharp slowdown in Chinese growth?

Bearish markets editor Bearemy Glaser is the worry-prone alter-ego of markets editor Jeremy Glaser. Each week, Bearemy will share what's topping his list of concerns and invites you to reply or add your own in the comments section below.

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