Surprise, Surprise! China Economy May Accelerate

By William Pesek

The biggest economic surprise of 2006 -- a Chinese economy that refused to slow -- will probably repeat itself this year.

As predictions go, more of the same is never exciting. Yet in 2007, the odds favor China accelerating rather than trying to cool down the world's fastest-growing major economy.

"The slowdown steps are likely largely over," says Donald Straszheim, chairman of Newport Beach, California-based Roth Capital Partners. The consensus view -- that China will slow, partly a result of policy steps taken to date, further tightening to come and a slower U.S. economy -- is wrong, he says.

On the one hand, officials in Beijing realize things aren't overheating as expected. On the other, they may fear a slowdown would do more harm than good. Straszheim thinks Chinese growth will accelerate to 11 percent this year from 10 percent in 2006.

Two important caveats are worth mentioning here. First, China may be growing far in excess of official numbers anyway. Suspicions come from the fact China's 31 provinces often report higher growth rates than the national one. Also, many China-based executives suspect official figures are off the mark.

Second, faster Chinese growth would be seen as a plus for the global economy. Rich nations like the U.S., Japan and many in Europe are relying on poor, developing economies for growth as never before. Anything China can do to give global output an extra tailwind would be greatly appreciated, particularly amid talk of a U.S. slowdown.

Delaying Action

The problem is that China may merely be punting its economic challenges into 2008. As the history of financial crises demonstrates, problems only get bigger and more destabilizing if not treated expeditiously.

The thing about China that's important to remember is that it's an experiment of sorts. If John Maynard Keynes, Adam Smith or Karl Marx were around today, China's rise would send them back to the drawing board. While policy prescriptions for avoiding overheating abound, the breadth and complexity of China's challenges confound doctrinaire approaches.

How the central bank uses interest rates to cool growth without a developed bond market is an open question. So is how officials in Beijing exert control without a cohesive fiscal policy. The popular view that China is a tightly controlled command economy is belied by the fact fiscal control rests with provincial leaders scattered across the nation.

Uncharted Territory

China's economic managers are bright people, yet they're in uncharted territory. Getting control over an economy with so many moving parts would be hard enough without worsening pollution, a widening gap between rich and poor and pressure from abroad to strengthen the currency. China also thinks it can stimulate entrepreneurship while censoring the flow of information and access to the Internet.

The daunting list of things that might go wrong in China explains why traders betting on big upward moves in the yuan may be disappointed. Exports are the driving force behind China's growth and the social stability that's so important to Communist Party leaders.

"One of the few recipes for a wide-scale economic downturn in China begins with a sharp yuan appreciation that forces the closure of many of the companies in the export sector, throwing millions of people out of work at once," says Carl Weinberg, chief economist at High Frequency Economics in Valhalla, New York.

Quid Pro Quo

Henry Paulson's visit to Beijing last month augured poorly for bold currency moves. There, the U.S. Treasury secretary's plans for a "strategic economic dialogue" between China and the U.S. ran into a snag: China expects the U.S. to fix its imbalances if Beijing is to boost the yuan. Paulson probably hadn't expected this developing quid-pro-quo relationship.

It's hard not to sympathize with China's reluctance to slam on the brakes. With the Asian Development Bank reporting that 42 percent of its 1.3 billion people live on less than $2 a day, China could use all the growth it can muster. And the lack of a slowdown is just fine by Asia, which is relying on China the way it once did on Japan.

Trouble is, Asia is beginning to depend too much on a developing economy that faces huge risks. If the world's fourth- biggest economy hits a wall in the next couple of years, the region's outlook will darken significantly.

Rolling the Dice

For better or worse, China seems keen on rolling the dice and keeping the party going. Putting fast growth in the short run above the risk of inflation could backfire and cause considerable instability. The rest of the world has little choice but to hope for the best if Beijing offers a so-far-so-good argument that skeptics will be at pains to counter.

China is to economies what the U.S. dollar is to currency markets. The dollar's drop, perhaps a sharp one, that just about everyone agrees is coming never seems to happen, regardless of how much U.S. current-account and budget deficits swell. And while virtually everyone thinks China needs to put on the brakes to avoid problems, its growth never seems to slow and still its inflation figures inspire little alarm in markets.

Amid scant evidence of the meltdown many observers fear, China may be more willing to test the economic boundaries. That could mean faster growth in the short run and bigger problems down the road.