Testing the China growth story

China has moved into a difficult social and economic phase in recent years, with the global recession severely affecting its export-oriented economy and its products increasingly uncompetitive due to inflation.

And the challenges will continue for the country and the East Asian region at large as we head into 2012.

We expect three things to shape events in East Asia in the coming year: China's response to the economic crisis and possible social turmoil amid a leadership transition; the European Union's debt crisis and economic slowdown sapping demand for East Asia's exports; and regional interaction with the US re-engagement in the Asia-Pacific region.

The 2008 financial crisis exposed the inherent weaknesses of the Chinese economy, which, like its East Asian powerhouse predecessors, largely was based on a growth model driven by exports and government-led investment. While Beijing had been aware for some time of the need to shift toward a more balanced economic model, the continued slump in Europe and fears of another global slowdown have forced the government to face the challenges of economic restructuring now, rather than constantly staving them off. Even in the best of times, the redirection of an economy the size of China's would be difficult, but the pressure for change comes amid a leadership transition, when Beijing is particularly sensitive to any disruptions. With the politburo lineup changing in October and the new state leaders taking office in early 2013, the Communist Party of China (CPC) is focussed on maintaining social stability to preserve the legacy of the outgoing leadership and solidify the legitimacy of the incoming leadership.

A rapid drop in economic growth poses a serious threat to China in 2012; a modest slowdown is widely expected this year due to the weakening export sector, a slump in the real estate market and investment, and risks to the banking system. Beijing is betting the decline will remain at a manageable level – at least for a year of transition. The sharp drop in demand from Europe will harm the export sector in particular, with growth likely reduced to single digits. This declining external demand will threaten the already weakened export-oriented manufacturing industry, which has experienced rising costs in labour, raw materials and utilities as well as appreciating currency on top of its already thin-to-nonexistent profit margins. China will seek to compensate in part by refocussing on exports to the United States and expanding in emerging markets in Southeast Asia, Latin America or Africa, though this will not fully make up for the drop-off from Europe. Moreover, growing trade protectionism because of the economic downturn and political considerations – especially the upcoming US election season – will likely put Chinese manufacturers at the centre of trade frictions, making their position even more vulnerable. Beijing will employ traditional tools including targeted credit, tax reductions and direct subsidies to mitigate the risks of rising unemployment and bankruptcy in the financially strained manufacturing sector.

While Beijing knows that rolling out another massive fiscal stimulus and bank loans as it did in 2008-2009 is unsustainable and would put the economy at risk, it sees few other short-term options and thus will use government-led investment to sustain growth in 2012. Beijing will resume and launch a number of large infrastructure projects even at the expense of overcapacity and lack of productivity. However, accounting for around 10 per cent of gross domestic product and a quarter of fixed investment, the decline in the real estate sector due to Beijing's tightening measures since 2010 represents one of the largest threats to Beijing's effort to stabilise growth. With affordable housing projects – Beijing's plan to offset the negative consequences from falling real estate prices and weakening investment – unlikely to reach their designated goal, Beijing may have to selectively relax its real estate tightening policy in 2012 while trying to avoid overcompensating by causing a sharp market rebound or property price inflation. The ruling Communist Party had promised it would bring these issues under control; its failure to do so could undermine the party's credibility.

The continued high-level credit boom combined with the need to work out nonperforming loans (NPL) from the 2008-2009 stimulus will bring China into heightened NPL risk. The actual NPL ratio may rise as high as 8-12 per cent in the next few years. At least 4.6 trillion yuan ($A720 billion) out of a government-estimated local debt of 10.7 trillion yuan is set to mature within two years, and Beijing expects 2.5 trillion to 3 trillion yuan of the total risk to turn sour. The NPL risk, the 2.1 trillion-yuan debt from investment in the railway system and the massive informal lending from the shadow banking system that grew significantly during Beijing's credit tightening pose a systemic risk to the banking sector. Beijing may have to take some pre-emptive actions, such as refinancing measures or capital injections, in 2012 to ensure Chinese banks are able to maintain confidence in China's financial system. China's leaders, faced with near-term stabilising options and long-term deep reforms, will choose the former, postponing the crisis but amplifying it when it becomes unavoidable in the future.

Given the economic uncertainty and political sensitivity surrounding the leadership transition, political elites in Beijing will attempt consensus at the highest levels. As it learned from the Tiananmen Square incident, CPC factional infighting exploited at a sensitive time is a serious risk, and we expect to see measures to ensure ideological and cultural control throughout the Party and down through the rest of society. Meanwhile, the priority to ensure a smooth transition means Beijing will be much less tolerant of actions that could spread instability, though Beijing is also cultivating pre-emptive methods for social control, such as community-level management or providing carefully controlled outlets for expressing grievances to better manage the country's social frustration, which will likely be exacerbated by the deteriorating economic situation.

Internationally, China will continue to accelerate its resource acquisition and outward investment strategy. As domestic problems mount, China may use external disputes to ease public dissatisfaction. Anticipating US economic and trade pressure due to the electoral season and strategic encroachment in China's periphery, Beijing will focus its attention on reducing miscalculation and stressing interdependence in its relations with Washington while clarifying its response to the US engagement. Meanwhile, China will balance nationalistic initiatives with maintaining neighbourly relations – particularly with the South China Sea claimant countries, India and Japan – and countering perceived moves by the United States to constrain China's economic influence in the region and lines of supply. The South China Sea claimant countries, including Malaysia, the Philippines and Vietnam, will respond by accelerating their military purchases, taking advantage of the US re-engagement efforts to hedge against China.

Most Asian countries – which showed a strong economic recovery throughout 2010 and early 2011 – will experience reduced growth amid the global economic slowdown. As the most important economic partner to many countries, China will increase its economic assistance and trade to the Association of Southeast Asian Nations countries to leverage its influence. Beijing hopes to again project economic power in the region through aid, the import of consumer goods, currency swaps and regional trade agreements, but Beijing's role may also face challenges by renewed interest from other nations – for example, the United States and Japan.

* This is an edited version of an article that first appeared on Stratfor.com and is the first part in a series on Stratfor's political and economic forecasts for 2012. The second article – on Stratfor's European outlook – will be published on Friday night (January 13).Reprinted with permission of STRATFOR.