China risk rising: a glass-is-half-empty scenario.

• Author: Lo, Chi

Things seem to be going too smoothly in China. Its stock market keeps going up and setting record highs, and its financial system complains about too much liquidity when the global markets are suffering from a liquidity crunch brought about the subprime crisis. Let's play devil's advocate and ask ourselves, what could go wrong in China that would end the bull run in the Chinese asset prices and wreak havoc the economy? When might these potential risks unfold and what are signs to watch out for?

External risk. The external risk to China is a sharp slowdown in external demand stemming from the U.S. subprime woes. China's exports are already vulnerable to slowing world demand growth even without the subprime crisis. The impact of China's self-imposed export restraint measures, like the cut in export tax rebates and the introduction of export tariffs and quotas for some products, will aggravate that vulnerability.

Since net export has been a major contributor to China's GDP growth in recent years, an export slowdown will hurt economic growth. However, there are offsetting forces from the domestic front limiting the negative trade impact on China's growth. First, the central government has room for fiscal expansion to boost economic growth, if needed. Beijing has been reducing its fiscal stimulus to the economy since 2002, when the fiscal deficit turned from 3 percent of GDP to a surplus of over 1 percent recently. With an improved fiscal balance, Beijing can afford to restore fiscal stimulus by raising spending, especially on much-needed social programs such as medical, pension, and education initiatives.

Second, domestic consumption growth has been steady, and it is going to continue to trend up due to Beijing's effort in boosting private consumption's contribution to GDP growth, rising income growth, accelerating urbanization, and improving social security coverage. Third, domestic capital spending will remain strong, and this will offset some of the negative impact of slowing exports on manufacturing capacity expansion. Fast income growth and urbanization will create demand for housing and, hence, property investment. The central and western regions of the country will continue to enjoy an investment boom under the central government's policy of equitable income distribution. Hence, a growth slump due to external factors is unlikely.

Domestic risk, A more serious risk stems from domestic policy. The authorities' efforts to cool investment...