Why China is rooting for a US slowdown

By BusinessWeek

In China, some people might be looking forward to a U.S. slowdown. That's because an American recession could do what Beijing has not been able to accomplish -- namely, cool off China's overheated economy, which in 2007 grew at its fastest pace in 13 years.

China's economy expanded 11.4% in 2007, government officials announced Jan. 24.

"China tried to achieve a soft landing but was not able to," says Qing Wang, an economist with Morgan Stanley (MS, news, msgs). "In 2008, China may be able to mainly because of a (possible) U.S. recession."

Since last summer, China's economy has been growing at a slower pace due to weaker demand from Americans for "made in China" imports. The world's fourth-largest economy grew 11.9% in the second quarter, 11.5% in the third quarter and 11.2% in the fourth quarter.

Tao Wang, an economist in Beijing with Bank of America (BAC, news, msgs), expects China's economy to grow around 10% in 2008. "We'll probably see export growth start to slow down," Wang said.

The People's Bank of China, the country's central bank, has been tightening monetary policy to try to tame inflation and curb the overheated economy, with little success. The consumer price index rose 4.8% in 2007, above the government's 3% target.

The central bank responded by raising interest rates six times last year, bringing the benchmark one-year deposit rate to 4.14%. It also jacked up banks' reserve ratios to the highest level in two decades.

Not a lot of options

But those policies haven't worked because rising food costs are the main reason for higher consumer prices. The government earlier this month reinstated price controls to try to stem the rise in food and energy costs.

Nor have the higher lending rates dissuaded Chinese banks from approving loans for real-estate and infrastructure projects. China's banking system is flush with liquidity from last year's record $262 billion trade surplus. Investments in real estate, airports and other fixed assets rose 24.8% in 2007, up from 24.5% in 2006. Last November, authorities ordered banks to stop lending to new investment projects for the rest of the year.

While a U.S. downturn could buy policymakers some time, China's overheated economy remains a big headache.

The causes of the overheating -- a massive balance-of-payments surplus, excess liquidity sloshing around the banking system and soaring inflation -- have not been resolved.

Food prices and credit growth will likely pick up in the second half of 2008, because China hasn't done enough to alter the liquidity situation, said Paul Cavey, an economist in Hong Kong with Macquarie Securities.

If and when China's economy starts to overheat again this year, financial mandarins in Beijing will find their policy options more limited than before.

With the U.S. Federal Reserve cutting interest rates to try to stave off a recession, Chinese policymakers are concerned that so-called "hot money" -- in the form of foreign reserves -- will flow back to China in search of higher returns.

"We will adopt measures to lessen the negative impacts from the slowdown in the U.S. economy," National Bureau of Statistics head Xie Fuzhan told journalists at press conference Thursday in Beijing to announce the 2007 economic indicators.

The Fed's cuts have made further interest-rate increases by the People's Bank of China less appealing, as it would run the risk of driving up the cost to mop up China's excess liquidity. Already, Beijing has quietly allowed the yuan to rise at a speedier pace since October. The yuan has climbed at an annual rate of 13% against the dollar, the fastest clip since China unpegged its currency from the dollar in July 2005.

Most economists expect China's economy to grow at a more moderate pace due to a slowdown in export growth. But unlike other Asian countries, China's exports account for 9% of production-side GDP, according to estimates from UBS AG (UBS, news, msgs), keeping the economy's buoyant momentum relatively insulated from a global downturn.

Robust domestic consumption and investment spending into real estate should keep the economy growing 10.5% in 2008, J.P. Morgan Securities economist Frank Gong wrote in a note to clients. Others, however, are less bullish. Economist Stephen Green of Standard Charter predicts China's economy will grow 9.5% this year as Chinese exporters, unable to find buyers overseas, bring their goods back home to sell, putting downward pressure on prices and eating into corporate earnings.

This article was reported and written by Chi-Chu Tschang for BusinessWeek.