January 1, 2005


The Chinese economy is devouring the world—commodities as well as finished goods. But when the dragon is full, what becomes of global markets? And what if this dragon is, in fact, insatiable?

It is hard to read news about China's fast-growing economy without a twinge of envy, a measure of awe and, if one happens to be in a business that must compete against the Chinese dynamo, some fear and anger. Surely the factories that power China's economic revival can't consistently boost their output, cut their prices and undercut rivals.

China's roaring success sharply contrasts with the news about American manufacturing over the last three years, when factories have been shuttered, often to move overseas. Is China's status as a super-competitor the natural result of market forces, or is there something fundamentally unfair about the way the country, and its producers, go about business?

According to the World Bank's recent East Asia Update, 2004 was the strongest ever for the economies of the 11 countries and self-governing territories it counts as East Asia. Growth in the region topped 7%. The economy of the entire world grew at 4%, a lower but still robust pace. Yet, the world's true miracle economy in 2004, as in nearly all of the previous 20 years, was China's. It grew 9.2%, a rate that is both astonishing, and now, for China, commonplace.

Since economic reforms began to revolutionize China's moribund economy in the 1980s, the country's gross domestic product (GDP) has doubled and doubled again. Where China once meant little to the world economy, it is now one of its chief drivers. China is today the world's fourth largest trading country, the biggest consumer and manufacturer of steel, the greatest producer of consumer electronics, builder of ships, consumer of cement and the second largest consumer of petroleum. “China alone accounts for 40% of all the world's growth in oil consumption since 2000,” notes Daniel Yergin, chairman of Cambridge Energy Associates, a consulting firm that analyzes oil trends worldwide for governments and international business client.

The hunger for raw materials and industrial machinery to build the country's infrastructure, satisfy its domestic consumers and feed its ever-expanding base of export industries has helped pull up Asia's developing economies and lift Japan out of its long doldrums. The World Bank report is unambiguous: The great strength of East Asia's economies in 2004, and the strong performance of the world, including the United States, owes much to China's boom.

And yet, it also offers a warning. China's appetites, which pushed up the prices of nearly every important commodity in 2004, also can squeeze the world economy pressed to pay dramatically higher prices for raw materials and energy. China's economy also may falter, sending global prices of commodities sharply down and cutting the imports into China that have helped spread China's prosperity.


For North American companies, China's economic designs and fortunes will play an increasingly influential role. As impressive as China's economic development has been in recent years, the country still is at the beginning of a long climb up. China's entire economy is about the size of the U.S. manufacturing sector alone. Average per capita income in China, at about $1,000 annually, is still only around one-fortieth that of the United States. Or, using the more generous measure of purchasing power parity (PPP), one-fifth, as calculated in the 2004 CIA country study of China. PPP measures different currencies' relative purchasing power by comparing the price of the same goods in different countries with that price converted by the foreign exchange rate of that country's currency against a base currency, normally the U.S. dollar.

China's population, officially counted at about 1.3 billion people, means, however, that even relatively modest gains in incomes in China can rock the world economy. John Mearsheimer, a political theorist at the University of Chicago, warns that China's growth could make it a superpower that is both rich and poor at the same time, a fact that not only is economically important, but also could determine the country's geo political ambitions. If incomes in China double (using PPP), the country's economy would be equal in size to the United States, where GDP is nearly $11 trillion annually.

China is heading in that direction. President Hu Jintao predicted in 2003 that China's GDP would grow four-fold again to more than $4 trillion by the year 2020. As it does, China's demand for the world's resources and manufactured goods will grow, too.

Consider that China is now in the midst of the greatest wave of human migration in history. Hundreds of millions of Chinese have picked up and moved, leaving farms and moribund inland cities, to take up places in China's booming industrial economy. Today, an estimated 150 million migrant workers traverse the job markets of China's east coast. In 2003, Shanghai added 3 million migrants to its official population count, most of whom fill menial factory and service jobs.

But migrants also play a big role in another of China's booms, the phenomenal growth of the entrepreneurial economy. According to a study of business executives in Shanghai conducted by researchers at the Shanghai Academy of Social Sciences, the vast majority of the city's entrepreneurs are from other regions of the country, while executives who are native to Shanghai tend to work for multinational companies. Kellee S. Tsai, a political scientist at Johns Hopkins University, calculates that over the first 20 years of reform, from 1978 to 1998, the Chinese started 30 million new private businesses. On top of that, there were tens of millions more businesses that fit into the broad category of public/private hybrids of many varieties that could, given the evolution of reform, only exist in China. Some of China's new businesses now are big enough to challenge giant multinationals.

These businesses, domestic and foreign alike, help create a string of megacities. China's most prosperous cities also have civic infrastructures—new roads, subways, telecommunication links, ports—that are among the most advanced in the world. Some grow by a million people a year, a fact that amazes until one considers that China still has a disproportionately large rural population even when compared to other developing nations, and that hundreds of millions of Chinese are expected yet to leave the farm.

To accommodate the new urban population, China must build out and power up the equivalent of a new Philadelphia or Houston every month. When Robert Ivy, the editor of Architectural Record, America's premiere architecture magazine, visited Beijing, he had to readjust his sense of the possible. “The numbers are mind-boggling. Millions of square feet of new construction render Beijing the busiest construction zone on the planet,” Ivy reported. “Two thousand high-rise buildings are under way, in one form or another, in a concatenation of architecture, urban design and construction that makes Berlin look like an opening act.”


China's massive, rapid urbanization and industrialization drive the world markets for raw materials and energy. Investments in factories, roads and other fixed assets still make up a huge slice of China's economy. Growth in fixed-asset investment accounts for about half of China's GDP, according to the financial news service Bloomberg. In the first two months of 2004, fixed asset investments grew at a remarkable 53%, but by September had slowed to an average growth of 28%, a pace still strong enough to warrant caution against an overheating economy. Michael Kurtz, an associate director at Bear Stearns in Hong Kong, anticipates that the Chinese government will have to rein in fixed asset investment in an effort to trim the country's growing industrial overcapacity, the result of such rapid investment. “China's fixed asset investment ought to get back to its long-term mean of 15% growth by 2005,” Kurtz says.

Coming on top of such high recent levels, even the lower numbers look very robust. Record prices for metals, oil and gas in 2004 were the result largely of the increase in demand for resources by China's burgeoning industrial cities. Both the cities and the demand they create will continue to grow.

What's more, inland cities that have been passed over by China's development boom will begin to resemble the prosperous eastern metropolises. Today, the country has more than 100 cities with populations greater than 1 million (the United States has nine, Canada four), a number that changes rapidly as medium-sized cities grow into goliaths and new cities of a million or more mushroom where only tiny villages existed before.

Expect a shift in China's economic growth from the industrial sector toward the consumer. Kurtz points out that China's industries are now caught in a price squeeze. The victims of China's own industrial demand, consumers are stuck paying higher prices for basic materials such as metals and plastics, while at the same time struggling with falling consumer prices that result from the overcapacity created by the rush to invest.

Even with People's Bank of China's late 2004 interest rate hike of 25 basis points—the first hike in years—real lending rates in China still hover around minus 3%, making money free to companies that choose to expand. Kurtz expects China's central bank to raise interest rates by another 125 basis points by the end of 2005 to retard overbuilding. That will restrict the rate of fixed asset investment growth, but China will still grow nonetheless, mainly because China's growing consumer population will continue to increase spending.

China's middle-class, estimated at 100 million people, comprises the group that eventually will make China the largest customer of nearly every consumer good one can mention. The Chinese already buy one-third as many cars as Americans, and by 2040 they will almost certainly buy more. “The last time China engineered a slow down in 1993 and 1994,” Kurtz says, “real year-over-year growth in the rate of fixed asset investment dropped from 30% to 11% in 3 years, but there was almost no change in the real growth rate of household consumption.”


While many analysts forecast sharp reductions in the growth of demand in China for raw materials, big corporate players remain extremely upbeat. Recently Nippon Steel Corp. and Luxembourg's Arcelor SA made strongly positive statements about their expectations of China's growing demand for steel. BHP Billiton, the supplier of nearly a third of the world's coking coal exports and the world's biggest supplier of coal for steelmaking, said in November that it may raise its contract prices by a huge 79%. That would translate to coal prices at near $100 a ton, compared with $56 a ton in 2004. The company estimates that global trade in coking coal will climb 50% over the next five years.

All economies are vulnerable to sudden reversals, and China has more than its share of uncertainties. Jeffrey Garten, dean of the Yale School of Management, told an audience at the World Economic Forum China Business Summit 2004 in September that while he thought China was headed toward becoming a global superpower in the long run, it would most likely suffer a formidable economic reversal in the next five years.

One scenario: China's big state-owned banks might collapse. Standard & Poor's complained late in 2003 that China's banks show a decreasing willingness to reduce their burden of half a trillion dollars in bad debts, or 35% of all money loaned. China lately has been beset by civil unrest as China's farmers protest against state corruption.

Taiwan or North Korea might goad China into armed conflict. The United States, wearied by a flood of Chinese goods sold at prices American manufacturers cannot match, may kick off a nasty trade war. How those shocks might hit American shores depends on how they take shape. American industry might suffer while consumers profit. China's export industries, which feed the United States' $150 billion trade deficit with the country, would continue to pump goods into the U.S. market, most likely at even lower prices (if past financial crises in Asia and Latin America are any guide). Fixed asset investment would dry up.


The most public dispute between the United States and China is the controversy over the exchange rate between the two countries. Every high-level meeting between U.S. and Chinese officials—and Chinese officials and members of the European Union, as well—concludes with the lodging of a complaint against China's policy of fixing its exchange rate at 8.3 yuan (or Renminbi) to the dollar. There is almost universal agreement that the rate makes China's currency cheaper against the dollar than it would be if it were traded openly in the world's currency markets.

China is the only big player that maintains a fixed exchange rate. Gary Hufbauer of the Institute for International Economics in Washington, D.C., explains that the Chinese regard foreign exchange, especially dollars, as “super valuable.” Dollars in China, he says, fill the role formerly played by gold in the United States and other countries once on a gold standard. By the end of 2004, China's total foreign exchange reserves topped $514 billion, giving it a huge war chest in the world's financial markets.

For a long time, few complained about China's monetary policies. China's economy was not prosperous enough or big enough to warrant concern. And when an Asian financial crisis struck in the late 1990s and the currencies of North Korea, Indonesia and Thailand collapsed, China, which could have devalued its currency, stuck by its dollar peg and was lauded for bringing stability to a most volatile situation.

The Institute for International Economics claims the yuan is 15% to 25% lower than it would be if it traded freely. U.S. manufacturer groups contend that China artificially depresses the value of its currency against the dollar by as much as 40%. Certainly, if the 40% figure is credible, nearly everything China sells the world comes at a steep discount, while everything North American companies seek to sell to China comes at an equally steep premium. Even a 15% discount puts American manufacturers at a severe disadvantage—provided, that is, they have not taken steps to move their production to Chinese factories.

Although China may move to adjust its currency peg slightly in the coming year, it has strong reasons to keep the rate fixed where it is. A higher yuan, for instance, would force Chinese food prices down as foreign crops flood the market. China is already struggling with ways to improve the lots of hundreds of millions of desperately poor farmers, and lower crop prices would work against one of the government's top priorities.

A discounted currency also is seen as vital to China's industrialization, since it makes it easier for Chinese companies to seize market share against foreign competition. Indeed, Nicholas Lardy of the Institute for International Economics has argued that the vast bulk of China's exports to the United States do not so much compete against American manufacturers making the same goods, but against other low-income countries that China has displaced.

China, however, is not the only country that depends on a low yuan. In an ironic twist of geopolitical and economic fortune, the United States has developed a peculiar addiction to China's currency regime. That, in turn, has made much of the world dependent on the pegged yuan as well.

China buys so much of the U.S. bond market that it actually pushes up the price not only of U.S. currency, but also of American debt overall. And because any change in the yield on a debt instrument usually moves in the opposite direction of any change to its value, China's heavy buying of U.S. Treasury bills and other forms of public and private debt serves to push down the U.S. interest rate, and thus the interest rate of the world. Jeffrey Frankel of the Kennedy School of Government at Harvard University suggests that where America's economy as a whole is concerned, the benefits of a revalued yuan may be met by the disadvantages of higher interest rates that would pinch industry and consumers alike.

China's new economic power changes everything.

Ted C. Fishman's new book China Inc.: How the Rise of the Next Superpower Challenges America and the World will be published February 2005 by Scribner.


Scenario 1. China's Economy Collapses

30% chance of a significant reversal in the next five years
A collapse in the Chinese economy could be spurred by severe weaknesses in the national banking system and a possible withdrawal of foreign investors should China face political strife or the fall of the red-hot real estate market. On the plus side, exports out of China may drop in price for American buyers. China's ambitious industrial development may leave many otherwise valuable firms listing, providing buyout opportunities for foreigners with deep pockets. American companies that sell to China, on the other hand, are likely to see their market there dry up quickly. Commodity prices, which have skyrocketed under the pressure of Chinese demand, would likely plunge, and China's metals manufacturing sector, rated at 220 million tons annually for steel alone, likely would seek new markets globally.

Scenario 2. China's Economy Grows

95%. Barring global calamity, China is certain to grow in the long run, becoming the world's largest economy within two generations.
A richer China does not mean a poorer United States. The emergence of Japan and Europe following World War II helped the United States prosper. China's economic power, however, will limit the ability of the United States to set the world's economic agenda and rules. One can expect, for example, the patents, trademarks and copyright will no longer provide corporations with the same protections, and that speed to market and rapid innovation will become increasingly important.

Scenario 3. The United States and China Enter a Trade War

70%. There is growing political pressure in the United States to address the problems of China's vast trade surplus and the loss of American manufacturing jobs. So far, the Bush administration has been reluctant to use adjustment mechanisms allowed by the World Trade Organization to protect American industries that face sudden and severe competitive pressure from China. This will change.
A trade war with China would hamper the ability of American companies to compete in the China market against companies from other countries. The Chinese government has vast economic powers at it disposal to reward nations it regards as friendly and to punish the businesses of countries it expects more from.

On the other hand, trade sanctions are really the only weapon America has to persuade China to adhere to international rules that forbid hidden subsidies, guarantee open markets and encourage the rule of law. In the long run, a strong U.S. stance could create a more balanced economic relationship. In the short run, consumer prices likely would increase.


The U.S./China trade balance shows China's growing economic strength, but in terms of the United States growing as an economy, the trade imbalance doesn't necessarily matter as much as the big picture. Currently, China takes away the most business from other Southeast Asian countries, Mexico and Japan.

Trade Balance
with China
(Thousands of dollars)
All Merchandise Total
Iron and Steel Total
Aluminum and Aluminum Articles Total
6,181,164 123,166 15,824
10,416,555 5,498 10,349
12,688,965 14,012 42,233
18,205,936 20,632 35,765
22,767,730 65,170 27,695
29,494,383 2,252 37,487
33,806,985 56,791 91,883
39,517,356 140,511 104,719
49,746,518 140,294 103,398
56,897,908 160,642 12,765
68,668,252 84,642 33,243
83,809,929 124,998 131,521
83,045,656 265,096 85,156
103,115,207 251,191 91,132
123,960,742 879,766 121,084
Source: Office of Trade and Economic Analysis (OTEA), Trade Development, International Trade Administration, U.S. Department of Commerce
Sources: West Texas Oil: Economagic and McCoy, Scott & Co.; Producer Price Indexes: U.S. Bureau of Labor Statistics through November 2004 and McCoy, Scott & Co. estimates for December 2004