As the US sub-prime fiasco continues to wreak havoc on global markets, the China Securities Journal looks at China’s prospects for escaping the fallout

The deepening integration of the Chinese economy with global economic and financial markets has exposed the country to fallout from the current recession in the US economy. As a result, the Chinese government, which feared its economy is over-heated, may now fear it is not heated enough.

The US sub-prime crisis has hit credit markets in the US and the across the world and the Federal Reserve is likely to further cut interest rates. Investors will become increasingly cautious in a highly volatile financial market.

Now the US economy is sick, China’s close connection with the US, Japanese and European economies is drawing more attention than at any time since the end of World War II.

China’s real GDP growth rate is forecast to slow from 11.4% in 2007 to between 8% and 9% this year, the slowest in seven years. And growth in the real per capita incomes of Chinese citizens is likely to slow from 10% to 8% a year.

While the western media is giving wide coverage to the worsening US economy, most Chinese will not detect much difference between an 8% or 11% growth rate. Even taking into account the negative impact from across the Pacific Ocean, the Chinese economy will still continue to be the fastest growing economy in the world in 2008.

But potential risks are still there. China ships 48% of its exports to the US, Japan, and Europe, which will probably all be in or near recession this year, or even in the next few months, with at most a 1% growth rate. From 2005 to 2007, 32% of China’s GDP growth was driven by its huge exports. It would not be surprising if a slowdown in these economies eroded the Chinese economy.

Consumer spending in China is also likely to slow as rapid food price hikes and greater caution prompt a shopping downturn. Capital spending is likely to slow as foreign investors become more cautious about their Chinese portfolio, including the fluctuating stock market. Chinese businessmen and private investors are sharing the mood and psychological pressures of their western counterparts.

The slowdown is likely to make the Chinese government reconsider its recently tightened monetary policy and the rapid appreciation of the currency since July 2005 when it scrapped the decade long peg against the greenback. China has been raising interest rates and reserve ratio requirements and imposing harsher bank loan quotas to rein in the hectic economy. But no measures have worked as expected. The RMB has been gaining on the US dollar more rapidly, with the intermediate rate breaching the 7.19 threshold a couple of days ago.

China is better off slowing its rising currency given its exports are also expected to slow down, especially after the worst winter storms in decades caused blackouts that in turn disrupted automobile and steel production and blocked transport lines.

As the US economy continues to deteriorate, anti-growth measures may no longer be favored. China’s top concern will be to continue to expand its economy by ensuring domestic demand plays a bigger part. So, the central government is likely to start loosening macroeconomic controls from the second quarter and moderating the appreciation of the yuan. Government expenditure will be scaled up to offset some of the decreased capital spending in the private sector.

In terms of inflation, the government may intervene more aggressively in the coming months. It is a bad idea for China to continue to use administrative price interventions rather than letting market forces keep inflation checked, but the world has to wake up to the fact that China, sticking to its own way, has chalked up the fastest economic expansion record over the past 25 years.

China has been working hard to become a full-fledged player in the international arena. Indeed, it has succeeded, at least to some extent. But the decision makers in the secretive Zhongnanhai compound, who consider control and stability as their top priority, will need to start worrying about the slower economic growth that has been anticipated by a number of Chinese economists.

This article originally appeared in Chinese in the China Securities News on January 31, 2008. The China Perspective takes no responsibility for the accuracy of the original article