For years, the Chinese dragon has grown stronger by riding America’s bull markets. Americans consumed, Chinese manufacturers prospered, and the country’s export-focused economy grew steadily year after year.


Now, the global economic crisis threatens to disrupt that trend, as American consumers scale back, export factories shut down and 20 million Chinese factory workers find themselves out of a job. Although the Chinese economy is still expanding despite the global contraction, growth fell to 6.8% in the fourth quarter of 2008, a seven-year low. The government has pledged a stimulus of 4 trillion yuan (US$585 billion) to keep the Chinese economy moving, but it remains to be seen whether China will hit its 8% growth target this year.


China will need to keep growing its economy to maintain social stability, whether through exports or domestic consumption, said a group of China experts at the 2009 Wharton China Business Forum. Organized by the Wharton China Business Society, a student organization, the conference explored a range of topics on China, from consumerism to capital markets.


The economic downturn was not the focus of every speaker at the forum. “I don’t put the economy up there as a key challenge today,” said Emma Walmsley, vice president of L’Oreal in China and head of the company’s consumer products division, during a panel discussion on the Chinese consumer. “Our markets haven’t been directly impacted.”


Walmsley said her company has so far experienced the “lipstick effect,” a reference to the theory that in bad economic times, people will substitute expensive indulgences for simple luxuries like cosmetics, driving sales up.


Others painted a bleaker picture of China’s economic future. Marshall Meyer, a professor of management Wharton, said the economic problems of the United States and other industrialized nations threaten to hit China hard. “China is faced with a huge ‘bullwhip effect,’” Meyer explained. “A small perturbation upstream can lead to a very strong snap downstream. As consumption goes down in the West, this ripples through China.”


If China does not spend its $4 trillion stimulus towards solving long-term economic problems, the government risks social instability, Meyer said. China has witnessed what may be the largest mass migration in human history over the past 20 years, as 130 million peasants have moved from the countryside to build China’s massive modern cities and man its export factories. With many of those factories now in trouble, the country must decide where to put its resources: Should it work to further beef up its export machine, or develop a new market for its goods within its own borders?


“The question is whether [China is] able to urbanize, develop industry in the interior and free up a domestic trading system that’s been pretty sticky for many years,” Meyer said. In the short run, the government could spend enough money to keep workers employed and the economy moving, but “make-work” jobs wouldn’t increase Chinese consumption in the long-term, he added. “In the long run, why won’t people spend in China? Because they must save for retirement, they must save for medical care, they must save for education.” Directing the stimulus towards social security, education and medical care would spur more future consumption than spending on bridges, highways and other construction projects, Meyer noted. “Investment in ‘soft services’ is probably the best long-term solution for consumer spending.”


Extending Credit


To be sure, China’s rapidly-growing economy has a strong consumer base.

“Forty percent of GDP is accounted for by domestic consumption,” said Z. John Zhang, a Wharton marketing professor. In 2008, China boasted 20 billionaires, 414,900 millionaires, and between 60 and 100 million middle-class consumers, Zhang said.


Given that the Chinese government holds $2 trillion in foreign reserves, the government has enough money to spend to keep the economy going if exports fall, Zhang said. In fact, the real economy could contract to a 5% growth rate and the government could still meet its growth target through stimulus spending. But given today’s economic climate, it is not clear whether China can maintain past growth rates, which averaged 9.6% per year for the last 30 years.


“Before the economic crisis, it seemed that everybody agreed that the growth [of China’s economy] could last for another 10 years,” Zhang said. With the current economic crisis, however, “it’s not so clear whether this forecast is still true.”


China will not only have to spend its stimulus dollars but will need to modernize its financial system to meet the economic challenges ahead, several of the forum’s speakers noted. Until consumer credit becomes more accessible, Chinese consumers will continue to spend carefully, said Milton Kotler, president of Kotler Marketing Group, which assists multinational companies with their marketing strategies in the China. The company is headquartered in Washington, D.C., with offices in Shenzhen and Beijing.


“The Chinese will not spend their savings on consumables,” said Kotler. “They will save money to buy a house that has an appreciable asset value. But they are not going to spend their savings on perishable consumer items.”

China will have to extend consumer credit to private retail channels to spur more consumer demand, Kotler noted. His advice for the Chinese government would be to promote a new campaign: “It is glorious to spend!”


“There are a hundred million credit cards in China,” Kotler said. “So, young people are using their credit card, but not enough. Instead of having one credit card, they need five cards…. The [spending] behavior will change as the cards multiply.”


Financial Innovations


Several experts said that the Chinese government would need to loosen its hold on the country’s financial system and open it up to innovation to fuel further long-term economic growth. Simon Jin, managing director of UBS in Beijing, said China needed to develop its corporate bond markets to alleviate pressure on its banking system. Having a more developed corporate bond market would make it easier for companies in China to finance their operations, because it would provide them an alternative to taking out loans or issuing stock.


Growing the markets for corporate bonds would also help Chinese investors, who have few places to put their money, aside from depositing it in the bank or investing in the stock market, Jin added. “There are very few [options] in between that,” he said. As more of China’s population reaches retirement age, the demand for fixed-income investments is growing, he noted. “Investors are clearly needing more choices…. The government realizes it needs to grow the market.”


In a panel discussion on capital markets, Shi Chen, an associate at Deutsche Bank, took that idea a step further, suggesting that China could consider creating a regulated market for credit default swaps, derivative investments which are used to insure corporate debt. “The major financing option for companies is still to issue stock, but corporate bonds are another alternative,” Shi said. “Credit default swaps could be useful, but without an exchange, credit default swaps could bring the whole market down.”


According to Shi, China could heed lessons from America’s financial crisis as it introduces financial reforms. “At the current stage, the Chinese system is good for China. Does this mean that China should limit all financial innovations? Absolutely not. I think that China needs to find the right balance. Financial markets should serve the development of the real economy. When China introduces any type of financial innovation, they should see if the economy can sustain it. They should not just rush into it.”


Walter Hutchens, a professor at Whitworth University in Spokane, Wash., who studies China’s legal and financial systems, said he has long argued for financial reform in China. “The Chinese financial system is broken,” he said. “It does not efficiently allocate capital.”


China’s current system funnels money from workers into four government-run banks. These banks make policy-driven loans to state-owned enterprises, while the government has a heavy hand in deciding which companies issue stock. “In other words, both the banking industry and the stock markets do not allow people like you and me to get capital to generate enterprises for China’s growth,” Hutchens said. “And so, what we’ve said to the Chinese is, you’ve got to be more like [the U.S.].” In other words, he said, the Chinese need to have independent regulators, open up the financial system, be more innovative with financial products and use that to build the economy. Today, however, the current economic crisis has given him pause.


“All this advice to China has to be seen in the context of what’s happened lately outside of China. We are ourselves now moving sharply away from deregulation and increasing the role of government in the economy,” Hutchens noted. “It seems to me we could be talking about you meiguo tese de shihui zhuyi – Socialism with American Characteristics,” he said, twisting a common slogan the Chinese government uses to describe its economy, “Socialism with Chinese Characteristics.”

“While I still believe I could offer some useful comments on China’s capital markets,” Hutchens concluded, “a profound sense of humility, at the very least, is appropriate for foreign analysts — especially an American one — to give China advice about how to manage its financial system.”