Editor's Note: After 20 years of rapid growth, China's economy remains one of the most vigorous and robust economies in the world. The strong rise has not only benefited China by transforming the country from a poor country into a regional power; but has also brought dynamic economic development to the region as a whole by turning China into one of the most attractive destinations for exports produced by neighbouring economies. On a different tack than other analysts, with their cool and cautious projections for the world's economy in 2004, Stephen Roach, chief economist with Morgan Stanley, believes that China will continue to see robust development in the coming new year. Follow the details of his argument below.

An elderly woman walks past tricycle drivers waiting for foreign tourists outside traditional alleyways, or hutong, in an old area of Beijing. China must successfully tackle many problematic issues, including unemployment, in order to promote the nation's healthy economic development. [newsphoto.com.cn/file]

The world has discovered China. And with good reason: I continue to believe that China is the greatest economic development story of the 21st century.

But no economy is perfect. There are often bumps on the road to prosperity - some minor and some serious - that pose important challenges to any growth strategy. China is no exception, and in fact is facing just such a challenge today.

The Chinese authorities are in the process of tempering some of the economy's recent excesses. This suggests that the next China growth surprise is likely to be on the downside, a development that could have important implications for the global economy and world financial markets.

There are two ingredients to the China slowdown story: a credit bubble and inflation. Beginning in late 2002, Chinese bank lending accelerated dramatically; in the 12 months ending November 2003, the outstanding volume of total loans was up 21.4 per cent - nearly double the average gains of 11.9 per cent over the period from 1997 to 2002.

It quickly became evident that the acceleration was concentrated in the four State banks, whose primary focus is to provide funding for China's vast network of State-owned enterprises (SOEs).

Unfortunately, this segment of the Chinese economy is still the shakiest. With excess lending flowing into SOEs, there was a growing risk of a new wave of non-performing bank loans, very much at odds with the basic thrust of Chinese financial-sector reforms. At the same time, there was mounting evidence of a real estate bubble, especially in the Shanghai area, but also in other pockets of the relatively wealthy coastal region.

This, too, appears to have been largely a by-product of excessive bank lending that was funding increasingly speculative property development projects.

There have also been indications of excess spending on infrastructure.

Meanwhile, there has been an important shift in the Chinese inflation dynamic: After 15 months of deflation, China moved back into positive inflation territory at the start of 2003.

And slowly but surely, the rate of inflation has begun to accelerate. The just-released inflation report for November 2003 is worrisome - a 3.0 per cent year-on-year increase, which represents the sharpest rise in nearly seven years.

The mix of Chinese inflation is important, but not for the reasons we stress in the industrial world.

The recent surge is concentrated in food prices, where annualized inflation is now running at an 8.1 per cent rate.

Weather-related or not, this is a big deal in a nation where about two-thirds of the population still lives in poverty. Unlike the West, where we strip out food in an effort to come up with "core" inflation, the Chinese have no such luxury. At the same time, there are indications of price acceleration elsewhere in the Chinese economy - especially for consumer essentials such as utilities (4.6 per cent), medical care (8.1 per cent), and education (3.9 per cent).

The same can be said of the property sector, where inflation in housing rents hit 3.7 per cent in November; this fits all too well with sharply rising prices in many construction materials such as steel and cement - a development that has caught the attention of China's central bank.

Has the Chinese economy overheated? The answer is no - at least, not at the present moment.

But it certainly could if the authorities stood by and did nothing. Precisely for that reason, China's central bank has taken preemptive action to stem the excesses of this credit-induced inflation. As announced in late August and implemented in late September, the People's Bank of China raised reserve requirements on bank deposits from 6 per cent to 7 per cent.

This action has since been followed by an early December reduction in interest rates paid on excess reserves - more of a technical regulatory adjustment than a reversal of the earlier tightening. Notwithstanding these policy moves, it should be stressed that China does not yet have a robust instrument-based monetary transmission mechanism as we know it in the West. In this still centrally controlled economy, banks - especially the four dominant State-owned institutions - take their cue more from the rhetoric of policy pronouncements. Largely for that reason, the medicine appears to be working. Bank loan growth averaged just 80 billion yuan (US$9.66 billion) in October and November, down sharply from average monthly gains of 275 billion yuan (US$33.13 billion) in the first three quarters of this year.

This turn in the Chinese credit cycle could have important global implications. The rest of Asia is especially vulnerable to a China slowdown. That's because Chinese imports have become an important source of external demand elsewhere in the region.

In the first nine months of 2003, China accounted for 66 per cent of Japan's total export growth; for South Korea the figure was 40 per cent and for China's Taiwan, an astonishing 97 per cent.

For the smaller and more diversified ASEAN (Association of Southeast Asian Nations) economies, China's share of this year's export growth is in the 20-30 per cent range.

A worker installs red lanterns for the Lunar New Year outside a shopping mall in Shanghai to celebrate the coming Spring Festival. China has witnessed a rapid economic upswing during 2003 despite some negative barriers, including the SARS outbreak, and the economy is expected to maintain a robust growth in 2004. [newsphoto.com.cn/file]

Nor is Asia alone in drawing sustenance from Chinese demand.

China accounted for fully 56 per cent of Germany's total export growth in the first eight months of 2003 and 21 per cent of that in the United States. Should China's economy now slow down, as we suspect, the rest of Asia, along with Europe and the United States, will suffer collateral damage.

Interestingly enough, early warning signs of a slowing in Chinese import demand are now evident: The November trade statistics revealed a sharp deceleration of import growth to 28.4 per cent year-on-year - still vigorous, to be sure, but well below the 40 per cent pace over the first 10 months of the year.

This could be the first hard indication of the coming slowdown in Chinese domestic demand. With China now qualifying as an important engine of growth in a still-sluggish world, a slowdown in the Chinese economy underscores the risk of a global growth disappointment in the first half of 2004.

As is all too often the case with respect to China, the West just doesn't get it.

Missing from the world's assessment of China, in my view, is the perspective from the inside - the overarching imperative for China to stay the course of reforms without disturbing social stability. Reforms in China are proceeding at a pace that is almost impossible to fathom from outside.

Critical to this process is the unrelenting restructuring of China's vast network of SOEs, resulting in the annual elimination of 7 to 9 million State-funded jobs.

China's reforms are all about creating a market-based alternative to its antiquated SOE sector, and are sustaining a vigorous growth climate that is capable of absorbing the concomitant increase in displaced workers.

Given this, China cannot afford a "growth accident" that might destabilize this process. The bigger the Chinese economy gets and the further it goes down the road to reform, the more severe the consequences of any growth accident, or upset. To the extent that recent developments on the credit and inflation fronts raise the risks of a hard landing, there is great incentive for Chinese authorities to take preemptive action to engineer a soft landing. And that's exactly what they have done.

True to form, the Western consensus is likely to go from one extreme to another in assessing the prospects for the Chinese economy, with euphoria over the boom quickly giving way to fears of the coming bust.

None other than US Fed Chairman Alan Greenspan recently warned of the latter possibility in voicing concerns over China's currency peg - stressing the risk of recession that stems from defending a currency regime through excessive domestic liquidity creation. Greenspan's view only adds to the growing chorus in the West calling on China to revalue the renminbi currency. The arguments in most cases are thinly veiled efforts to get China to temper pressures that are building elsewhere in the world. Japan and Europe want China to share the burden of the dollar's inevitable adjustment, a stance that I would argue is steeped in hypocrisy: Two of the wealthiest regions of the world that remain reluctant to reform are demanding assistance from a poor nation that has been aggressive in embracing reforms.

And, of course, there's the political angle, increasingly shaped by a bipartisan coalition of protectionist US politicians who are eager to see China cave on the currency issue.

A soft landing is likely. In the perception of the West, a hard landing in China is always the risk. Yet time and again, China has proved the doubters wrong. That was the case during the 1997 Asian financial crisis, when worries about a Chinese currency devaluation were rampant.

China was also feared to be at great risk in the recession of 2001.

And similar concerns are being voiced today. Yet China is dealing with its growth excesses on its own terms - not on terms that would be politically expedient for the West. A currency-driven solution works best in a market-based economy.

For a command economy like China's, credit allocation is far more effective in helping set the stage for a soft landing.

While this juncture could prove to be an important test for China's new leadership, it is a test that I believe will be managed successfully.

I wish I could say the same for the rest of the world.

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