China on the Boil (Part 2 of 3)

The Dark Side

Deng Xiaoping kicked off China’s economic reforms with a refutation of Mao Zedong: “Learn truth from fact,” Deng said in 1978. In our first segment we saw the rosier side of China’s economy. But we have to seek the truth from its darker side.

China faces a perfect storm of challenges that have broad implications for its economy and, given its authoritarian system, its politics. The dark side looks like this:

Sluggish industrial production. In 2008 it grew by only 5.8 percent, down from the 18 percent in 2007.

A projected growth rate of 6 percent for 2009. This is a hard landing for China, according to the Economist Intelligence Unit.

An inflexible currency policy that undercuts long-term economic stability. China is forced to assume large amounts of U.S. Dollars to keep the currency value within targeted levels. This causes over-production and non-performing loans held by banks.

But China is in a vicious circle. The more dollars China holds, the less likely it will float the currency as the value of dollars would depreciate. A free-floating Renminbi (Chinese currency) would likely settle at five per U.S. dollar. It is currently at 6.84 per dollar.

The burden of government owned enterprises. About one-third of China’s industrial production comes from them, and half are losing money. Ending government subsidies and allowing state-owned companies to go out of business creates great unemployment, a clear political problem for a fragile government.

An inefficient banking system that provides government subsidies to state-owned enterprises. Chinese loans are often made on the basis of politics rather than economic profitability. China has yet to open its banking sector to foreign banks because its own could not compete.

A horribly degraded environment along with a growing water shortage. This poses serious risks to public health and to China’s economic well-being.

The facts are staggering. Twenty of the world’s 30 most polluted cities are in China. Three hundred million rural residents are drinking unsafe water. China has now surpassed the U.S. as the world’s largest contributor of CO2. The rates of various cancers and lung diseases are on the rise.

Though strict environmental laws are on the books, they go unenforced at the local level in a trade-off of economic growth for environmental health.

The high cost of pollution -- estimates have it as high as 12 percent of GDP -- in terms of illness, factory shutdowns, and remediation (cleanup) projects.

Fallout from the global financial crisis. China’s exports shrank in the last several months, and Chinese officials expect no growth in exports in 2009.

Half of China’s GDP growth in the last 30 years is attributed to exports and government consumption. Domestic consumption is a weak link given the Chinese penchant for saving.

Thousands of shuttered factories in Guangdong Province. Five million jobs have been lost. Half of China’s toymakers and one-third of its shoe manufacturers have disappeared.

Supply chain contagion. Foreign manufacturers rely on Chinese-made parts and accessories to finish their own products. Foreign companies using Chinese supplies will suffer too.

Consumer confidence has plunged. In November the Chinese government issued its own stimulus package of $586 billion.

Moving away from an export-led model requires increasing government-funded social security such as health care, pensions, and education to dampen the Chinese penchant for saving.

Production would need to be reoriented to the domestic market, which in turn requires labor retraining. Replacing the foreign investment garnered with the current economic model requires financial institutions that can raise capital and are not risk averse.

A widening income gap between rural and urban residents. In 2007 it was 3.33 to 1 (urban to rural). This January it was 3.36 to 1. Peasants account for about 65 percent of the population.

Growing public unrest. There were 87,000 reported protests (many violent) in 2005 over issues of pollution, government corruption, land seizures, forced relocation, and unemployment. Estimates of protests for 2008 are at the same levels.

Already insecure because of communist government collapses in Eastern Europe and the Soviet Union in 1989 and 1991, the Chinese government feels boxed in by economic woes. The future is not as bright as the façade appears.

NEXT: The Five Woes (Part 3 of 3).