China Growth May Slow at Worst Time for World Economy (Update1)

Jan. 14 -- China is starting to gain control of its turbocharged economy, just as a U.S. slowdown raises the risks of doing so.

A narrowing trade surplus and declining money-supply growth are among the first signs that the world's fourth-largest economy is pulling back from its fastest expansion in 13 years. The government has raised interest rates six times in a year, restricted credit, frozen some prices and let the currency appreciate to damp growth and inflation.

The risk is that, with months of effort to cool off China finally taking hold when the U.S. is already flirting with recession, both main engines driving the global economy may power down at the same time.

``As foreign demand deteriorates, China may overdo its tightening of policy and cause a sharp economic slowdown,'' says Frank Gong, Hong Kong-based chief China economist at JPMorgan Chase & Co. ``If the central bank raised interest rates too much, it would damp domestic demand and increase the danger of economic downturn.''

China is still on a tear. Its economy expanded 11.5 percent last year, according to a government estimate, and it contributed 17 percent to global growth, the same as the U.S. With prices rising at the fastest pace in 11 years, the ruling Politburo and the central bank are trying to engineer a cooling of growth that doesn't also throw millions of China's 1.3 billion people out of work.

`More Determined'

The tougher policies may be starting to pay off, data showed on Jan. 11. Last month's trade surplus shrank to $22.7 billion from $26.2 billion in November, and the broadest measure of money supply rose by the least in seven months.

``The efforts of the Chinese government to slow the economy have long been half-hearted, but now they are looking more determined,'' says Phil Suttle, director of global macroeconomics at the Institute of International Finance in Washington. ``There is some evidence that this policy package is starting to have an effect.''

Vice Finance Minister Li Yong said in Beijing yesterday that China plans to better coordinate fiscal and monetary policies in 2008 to further cut the trade surplus and mop up excessive liquidity. Yi Gang, a vice governor of the People's Bank of China, said the central bank ``will decisively fight against inflation and implement tight monetary policies.''

Recession Forecasts

Meanwhile, Goldman Sachs Group Inc. last week joined Morgan Stanley and Merrill Lynch & Co. in forecasting that the U.S., the world's biggest economy, will slip into recession this year for the first time since 2001 amid fallout from the subprime mortgage crisis. Today, Goldman cut its 2008 growth forecast for China to 10 percent from 10.3 percent.

The two economies are closely linked. The U.S. buys about 19 percent of China's exports. A cooling U.S. economy could magnify the impact of China's anti-inflation measures, says Qu Hongbin, chief China economist at HSBC Holdings Plc in Hong Kong.

``A U.S. recession would cause a major disruption to the Chinese economy,'' says Qu. ``Aggressive tightening could prove overkill.''

A 1 percentage point slowdown in the U.S. would trim China's export growth by 4 percentage points and reduce GDP by 0.5 percentage point, according to Ma Jun, chief China economist at Deutsche Bank AG in Hong Kong. Exports rose 21.7 percent in December to $114.4 billion.

`Heightened Risks'

Sun Mingchun, an economist at Lehman Brothers Holdings Inc. in Hong Kong, says China faces ``heightened risks'' because of its rapidly expanding manufacturing investment. Its 24 percent growth last year has created overcapacity and made the country vulnerable to a decline in exports and falling prices. Sun predicts economic growth will slide this year below 10 percent for the first time since 2002 and inflation may fall below 3 percent in the second half.

If China does want to reduce its reliance on exports, it needs to let the yuan gain faster so Chinese products are more expensive overseas, says Nicholas Lardy, a senior fellow at the Peterson Institute for International Economics in Washington. The current policy to restrain the currency forces the central bank to sell it to banks in return for foreign cash.

``The No. 1 problem for China is controlling money supply in an environment where the currency is so undervalued,'' says Lardy, who has written several books on China. ``If you want to have growth driven by domestic demand, rather than exports, you have to let the currency appreciate.''

Simultaneous Slowdown

A simultaneous slowdown in the U.S. and China would be ``bad news,'' says Nariman Behravesh, chief economist at Global Insight Inc. in Lexington, Massachusetts. China's trade with the rest of the world has been growing three times as fast as the global average since it joined the World Trade Organization in 2001.

``A combination of U.S. consumer spending and Chinese imports has pulled the world economy along,'' says Behravesh. ``The combination of a U.S. recession and hard landing in China could push the global economy into recession.''

Still, if Chinese leaders want to whip inflation, they may have no option but to keep raising interest rates and constraining credit and hope that any U.S. downturn is short- lived. Consumer prices accelerated by 6.9 percent in November from a year earlier, while producer prices rose at the fastest in more than two years.

``We expect rate hikes to continue, even with a global slowdown underway, to keep up with rising inflation,'' says Kathleen Stephansen, director of global economics at Credit Suisse Holdings in New York.

Paulson's Prediction

Binit Patel, an international economist at Goldman Sachs in London, says the likelihood of China suffering an abrupt reversal remains ``small.'' While Goldman Sachs's financial- conditions index for the economy is now at its highest level since 2004, it still is ``accommodative'' and the economies of China's trading partners in Asia are still robust, he says.

``I'm not predicting an economic slowdown in China right now,'' U.S. Treasury Secretary Henry Paulson said in an interview on Bloomberg Television's ``Political Capital with Al Hunt'' in Washington. ``If that were to occur, that wouldn't be good for us.''

A Chinese economy that has inflation under control would allow foreign central banks to try to boost their economies by cutting interest rates more deeply. Prices of U.S. imports from China increased just 0.1 percent in December from a month earlier, the smallest gain since April and down from 0.4 percent in August, the U.S. Labor Department reported last week.

The dilemma, says HSBC's Qu, is that China can't afford to wait to discover the fate of the U.S. economy. Policy makers need to make a bet on whether domestic inflation or falling overseas demand is the biggest risk, he says.

``By the time the global picture becomes clear, Beijing may have missed the opportunity to either control inflation or prevent a sharp slowdown,'' he says.