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Will Global Economic Downturn Hit China Too?

Not so long ago, conventional wisdom held that China would emerge unscathed from the global financial crisis, mainly because its banks had virtually no exposure to the toxic assets poisoning the Western financial system. Some still hope China will help fuel a broad recovery.

But warning signs have begun to emerge, as the Chinese economy slows and thousands of its manufacturers close their doors. Might the financial crisis inflict enough damage to pose serious risks for China's stability? The threat is real, but it's not imminent.

Why is China vulnerable? Much of its growth continues to depend on the supply of manufactured goods to the United States and European Union, where recession has sharply reduced consumer demand. China's government reported GDP growth of 9 percent in 2008 -- a healthy number, though not on par with figures of the past several years. Despite a sharp slowdown in recent months, Chinese officials say publicly that they expect 8 percent growth in 2009, though some privately concede that 7 percent is more likely. Some analysts warn it could fall to 5 percent.

Yet, despite the slowdown, the Chinese leadership is unlikely to face a dangerous public challenge this year. A $586 billion stimulus package announced in November will help limit job losses by targeting funds at enormous infrastructure projects that create work for millions of migrant workers moving between China's countryside and its booming eastern cities. The Chinese government will also spend to buoy the export sector, slowing the hemorrhaging of manufacturing jobs. Aware of the risk of social unrest, the Chinese leadership has publicly acknowledged the need for security troops to remain loyal and on alert.

For the moment, the risks the central government face are limited.

Several years of double-digit economic growth and the opportunities it creates for hundreds of millions to join a growing middle class have helped the Communist Party leadership build its domestic political capital. And if Chinese blogs and Web sites are any guide, many appear to blame the slowdown almost entirely on the United States and the Western free-market system.

Over the longer term, however, the global financial crisis will harm the Chinese economy and threaten the country's stability by delaying much-needed reform. If the leadership is to continue to create millions of new jobs each year -- essential for social order -- it knows it must shift its economy from export-driven growth toward a model that relies on spending from increasingly wealthy Chinese consumers. Officials hoped to manage that transition over a period of 10 to 15 years, but the severity of the economic crisis has persuaded some within the leadership that they won't have nearly that long if they are to avoid the risk that an extended slowdown will trigger dangerous levels of civil unrest.

Even if the Chinese bureaucracy has the means to avert a near-term crisis, there are several factors worth watching that will contribute to longer-term problems. First, there is China's reliance on state-managed capitalism. The details of Beijing's current stimulus package suggest the leadership will continue for the next several years to rely on the state to manage China's economy. As the global recession discredits those within the leadership who favor go-go growth based mainly on trade and foreign investment, the government will strengthen and protect "national champions" at the expense of foreign competitors. This will add to growing trade tensions with the United States and European Union, both of which may well speed efforts to protect domestic industries of their own. Protectionist tit for tat will slow the recovery everywhere -- including China.

In addition, there is the ongoing issue of environmental degradation. The country's dirty air and a shortage of clan water have become well known, and the government has directed resources in recent years toward serious efforts to address the growing problem. But the economic slowdown has shifted priorities, and the ministry of environmental protection is now green-lighting construction projects at a faster rate and with fewer rejections than at any time in several years. The risks of both environmental accidents (from chemical spills to the poisoning of groundwater) and the public anger they provoke are on the rise.

Further, as Beijing authorizes the disbursal of billions, the risk is higher than ever that local officials will pocket unprecedented amounts of money. Corruption is yet another problem that drives citizens into the streets, and it will undermine investor confidence at a moment when foreign direct investment might help generate jobs. Enormous state spending will also create bureaucratic problems as various agencies and ministries compete for turf and control of the cash, creating confusion and policy paralysis.

Then there are the more direct lasting effects of the economic slowdown. Over time, as expectations of wage growth diminish and more manufacturing jobs are lost despite the spike in state spending, it will become more difficult for Chinese and foreign companies to satisfy the demands of local workers. Protests over wage arrears, which began last year, will increase in frequency and intensity.

Chinese officials feared that 2009 might prove a volatile year. In March, Tibetan activists and their supporters around the world will mark the 50th anniversary of the Dalai Lama's flight into exile. In June, China faces the 20th anniversary of the bloodshed in Tiananmen Square.

But the real risk remains just behind the horizon, as the Chinese government's response to a short-term slowdown creates longer-term problems it might prove unable to manage.

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