Can China Tap the Brake?

Once a growth manager, Beijing now has to slow things down. The task is a tricky one

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Illustration by Quickhoney for TIME

In a remarkably short time, China's economy has blossomed into the second largest in the world. Only five years ago, China's GDP was half that of No. 2 Japan, which the Chinese eclipsed earlier this year. Next stop: the mammoth U.S. economy — a milestone that is a decade or two away and yet all but certain.

China's epic growth is an old story; its economy has been racing along at 8% to 10% annual growth for 30 years. But now, with a GDP approaching $5 trillion (vs. $14 trillion in the U.S.), China is such a powerhouse that its every move ripples around the globe.

Which is to say you can't ignore China — even if you aren't directly invested — at least not for the next 100 years or so. Pay particular attention to China's latest move, which has been to rein in its breakneck growth. Most countries would love to have this problem. China raised interest rates last month for the first time in three years and has taken other steps to slow bank lending and cool a sizzling property market. Growth slowed to 9.6% in the third quarter, down from 11.9% in the first and 10.3% in the second.

This is a delicate situation. A growth rate much lower than 8% would feel like a recession and produce global fallout. So China's ability to tap the brake without causing a jolt will impact everything from the prices of copper and oil to the stock prices of companies such as FedEx and Procter & Gamble. And, oh, yes, neighboring economies throughout Asia, which just might fall off a cliff if things don't go smoothly.

Global investors are betting that China will manage to slow the growth with aplomb. Chinese shares, while down 6% for the year, have been roaring back from an earlier steep decline. Shares were up 12% in October. "We think they are doing a great job managing their economy down," says Tony Roth, chief investment strategist at UBS Wealth Management.

Yet success is hardly assured. China's torrid growth has left it with escalating inflation (now running at 3.6% annually) that is making it difficult for the country's poor to buy food and secure shelter. Food prices are rising at a rate of 8% annually; rampant real estate speculation has probably created a bubble. So there is immense pressure to act decisively before riots break out.

China's leaders have proved capable macroeconomic managers in the past two decades. But this is a different challenge. "Managing the decompression of a bubble is not an easy thing," warns David Darst, chief investment strategist at Morgan Stanley Smith Barney. If growth slows too much, he says, "you could have knock-on effects both geographically and in markets that are psychologically associated with China demand." In other words, a China slowdown could devastate emerging Asian economies like those of Indonesia, Malaysia and Singapore and reverberate among natural-resource-oriented countries such as Russia, Australia, New Zealand and Brazil, which supply raw materials for China's infrastructure. Commodity prices would fall.

It would hit home in the U.S. too. "To the extent that we have a recovery here, it's been on the back of China," says Kevin Carter, CEO of AlphaShares, an investment firm that specializes in China. "It's the Caterpillars of the world that are adding jobs." Caterpillar, a maker of construction equipment, is among a host of U.S. industrials that have prospered from the build-out of China's infrastructure.

China is battling other demons too. Its latest five-year plan, unveiled last month, emphasizes the domestic economy in a bid to make the nation less dependent on the rest of the world to buy what it produces. "They are speeding urbanization into suburbanization," says Ed Yardeni, chief investment strategist at Yardeni Research.

This is a natural progression, and Western nations are lining up to sate the appetites of an emerging middle class that has acquired a taste for cars, modern appliances and premium foods. The problem is that this domestic economy hasn't really developed. China's people are mostly poor; the country ranks 130th in terms of GDP per capita. Counting on domestic consumers to keep growth above 8% is a dicey prospect.

So while the popular bet is that China will manage, until the planned slowdown plays out, you might want to curb your enthusiasm, just a bit, for commodities and emerging-market stocks, which are most at risk. The same goes for U.S. infrastructure companies that have been riding China's growth, like Cat, General Dynamics, Dow Chemical and Emerson Electric.

Long term, of course, the growth story is intact. If you believe the Chinese can manage their economy with precision, then the smart move is to get positioned for domestic demand, with global consumer stocks like Starbucks, Nike, Yum! Brands and P&G. But with all that China's up against, navigating this won't be easy.

This article originally appeared in the November 22, 2010 issue of TIME Asia.