Swedbank Asia Analysis, No. !2

Swedbank Asia Analysis No. 12 26 November 2010

The Middle Kingdom is gradually transitioning to a new growth model –
it’s important to analyze the effects on China and the rest of the world
• China’s GDP is growing by slightly over 10% this year, a slight upward revision
of our previous forecast. A slowdown has already begun, however. We expect
GDP growth to decline to 8.5% in 2011 and 8% in 2012.

• China’s stimulus policy has increased imbalances. Higher inflation should be
seen in light of shortages in food production, however, which won’t be fixed by
tighter monetary policy. The supply problems will eventually subside, with or
without administrative action. Despite regulation of the housing and credit
markets, housing prices are again on the rise, with the risk that the tools that
have been used so far to slow down the economy have been insufficient. We
expect that banks will have to increase their reserves, that savings and lending
rates will rise, and that greater control will be exerted at the local level to
ensure that lending volumes are actually reduced.

• China’s 12th five-year plan (2011-2015) includes a growth model with greater
emphasis on household consumption as well as higher value-added production
and quality. This will probably mean a lower growth rate of around 7-8%, higher
wage growth and a slight nominal appreciation – but more of a real appreciation
– of the yuan. The middle class would grow faster, environmental conditions
and income distribution would improve, and relationships with other countries
would strengthen compared with today, when China’s trade surplus and
currency reserves continue to escalate. If the plan is put into action, China will
have achieved some progress in ten years to meeting its new goal of “inclusive
growth”. On the other hand, we also paint a less favourable scenario, where
economic imbalances increase and result in political revolt and instability.

• The effects on Swedish and other foreign companies with higher quality
products would clearly be positive, with increased sales opportunities if the new
growth model is adopted. Competition will increase as well. A gradually more
consumer-led growth model in China would probably also raise global prices
and interest rates.

Contents Page
High growth – but imbalances are growing as well 2
What has to be done? Why isn't it being done? 8
Short term: High but slowing growth 10
Slightly longer term: A new growth model 12
How does China affect the rest of the world? 13
How does rest of the world affect China? 15
The EU-China relationship has been pushed aside 15
Effects on Sweden and Swedish companies 17

Economic Research Department, Swedbank AB (publ), SE-105 34 Stockholm, tel +46 (0)8-5859 7740
e-mail: ek.sekr@swedbank.com Internet: www.swedbank.com Responsible publisher: Cecilia Hermansson +46 (0)8-5859 7720.
Magnus Alvesson +46 (0)8-5859 3341, Jörgen Kennemar +46 (0)8-5859 7730 ISSN 1103-4897

High growth – but imbalances are growing as well
Impressive development...
China has produced the most impressive economic growth in modern China has had three
times. Its GDP has risen by an average of nearly 10% a year since decades of high
1979. With such rapid growth, it has passed Japan as the world's growth
second largest economy in dollar terms. Considering that growth has
been concentrated in investments in state-owned or subsidised
export companies, China has already passed Germany as the world's
largest goods exporter.

GDP growth between 1979 and 2009 and average for the period (%)
16
15
14
13
12
11
10
Percent

9
8
7
6
5
4
3
2
1
0
80 82 84 86 88 90 92 94 96 98 00 02 04 06 08
S o u r c e : R e u te r s E c o W in

China is currently the world's largest consumer of a number of
minerals such as copper, nickel and zinc. It is also the world's largest
steel producer and consumer. It is China’s importance to the rate of
increase in commodity consumption that should be the focus,
however. No other country is more important to driving demand, and
thus commodity prices.

China’s share of global GDP has increased substantially since the The country's GDP per
late 1970s, when the country opened up, from 2% in PPP terms in capita has risen
1980 to 11.5% in 2008 (and from 2.6% to 7.3% in USD). At the same fivefold since 1990
time China’s share of global trade has increased by a factor of eight
to slightly over 8%. Obviously the country's size is important, with a
population of over 1.3 billion, but since the early 1990s China's GDP
per capita has risen fivefold.

Poverty has been reduced significantly and the middle class is
growing. Nearly half the population now lives in cities, and that
number will continue to rise. Urbanites earn and consume about three
times more than the rural population per household.

Last year China's auto sales passed those of the US, making it the
world's biggest passenger car market, at 13 million units, compared
with just over 10 million in the US. Within five years the Chinese will
be buying 20 million cars per year. That would mean a total increase
of 55 000 cars per day, mainly in the country's cities.

2 Swedbank Asia Analysis No. 12 • 26 November 2010

... but the growth model is cracking
You can't equate the last three decades with the ones to come. There
are several reasons why China's current growth model won’t last.

First, it is based on huge, and gradually rising, investments and It’s hard to expect a
exports, which between 2001 and 2008 accounted for 60% of GDP, bigger contribution
vs. 30% in the euro zone. To stay the course, China will have to from exports and
capture market share by cutting prices on its products, e.g., through investments
higher productivity, lower profits or even higher industrial subsidies.
Although this is by no means impossible, it will become harder to do
as the years go by, and eventually (maybe in a couple of decades)
we may reach a limit how large a share of global trade any one
country can have.

Consumption, investments and net exports as a share of GDP
0 .8

0 .7

0 .6
P r iv a te C o n s u m p tio n
0 .5

0 .4
Share

In v e s tm e n ts
0 .3

0 .2 P u b lic C o n s u m p tio n

0 .1

0 .0
E x p o r ts
- 0 .1
60 65 70 75 80 85 90 95 00 05

Secondly, demand is declining from developed countries, which have Weak development in
to consolidate their finances, raise their saving rates and slash debt. the West is
As a result, China’s key export markets won’t be enough to meet its accelerating the
growth targets in the next decade. Other emerging countries will have transition to a new
to take over, but in the short term they will hardly be able to growth model
compensate for loss of demand from developed countries.

Thirdly, a number of imbalances are incorporated into the current China cannot continue
growth model. China’s government is aware of this. At a press to build its growth on
conference following the Communist Party's national congress in imbalances
March 2007, Premier Wen Jiabao uttered the now famous words:
“The biggest problem with China’s economy is that the growth is
unstable, unbalanced, uncoordinated, and unsustainable.”

The premier’s statement has to be analyzed word for word:

i) By “unstable” he meant the overheating that was becoming
apparent as a result of high investment growth, surplus liquidity
and a rapidly rising trade surplus. Equity and real estate prices
were escalating and inflation was beginning to reach
uncomfortable levels, peaking at 8.5% in mid-2008.

Swedbank Asia Analysis No. 12 • 26 November 2010
3

ii) By “unbalanced” he was referring to the differences between
wealthy eastern China and the poorer west, as well as similar
differences between urban and rural areas.

iii) By “uncoordinated” he meant the difficulties the central
government was having controlling the regions and with macro-
oriented policies, as well as the emphasis on export- and
investment-oriented manufacturing ahead of the domestic
service sector and consumption.

iv) Lastly, “unsustainable” growth referred to the increasing income
gap and environmental concerns. Today China ranks high in
income inequality, with a so-called Gini coefficient of 0.49. (The
higher the number, the bigger the inequality. Sweden’s is about
0.32.) Green accounts for 2004-2005 indicated that GDP
growth would have been about 3 percentage points lower if
excessive natural resource consumption and environmental
damage were included in China’s national accounts.
Sustainably meeting the country's energy needs and handling
all those new cars are significant environmental challenges.

At about the same time, in the spring of 2007, a period of austerity Last time China had to
was launched to reduce inflation and the risk of overheating. It act aggressively to
succeeded with the help of increases in bank reserve requirements reduce overheating
19 times over a two-year period and in the benchmark interest rate 6
times in one year. Economic policies were also aided by the global
financial crisis and recession. Imbalances were therefore reduced
because of both China’s own economic policies and the global
recession.

Now the imbalances have grown again after a pause during the The problem of
financial crisis, when the Chinese government instead focused on imbalances has again
stimulating the economy out of the crisis. This included a major fiscal resurfaced
stimulus to increase investment and to a lesser extent to support
consumption. In addition, lending rose and expansive monetary
policies were adopted. After the yuan was allowed to rise between
2005 and 2008, it again was pegged to the US dollar.

As a whole, the measures succeeded in helping China to avoid a
recession and led to faster than expected economic growth during the
second quarter of 2009. GDP growth is now some 10% this year, and
the imbalances are growing. Inflation, the trade balance, currency
reserves, the credit expansion and asset prices are the biggest
concerns.

An annual inflation rate of 4.4% in October surprised many analysts.
The official target is below 3%. Are the inflation fears of the
government and the financial markets overblown?


Inflation rate
9

8

7

6

5
Percent

4
O ffic ia l ta rg e t
3

2

1

0

-1

-2
00 01 02 03 04 05 06 07 08 09 10
S o u rc e : R e u te rs E c o W in

On the contrary, the official measure underestimates actual inflation Inflation for “normal
for many people. Inflation is a bigger threat to less wealthy urbanites people” is higher than
than the numbers show. Food prices in some cases have tripled in official statistics
one year. Clothing has risen as well due to higher cotton prices. indicate
Inflation is nearly 10% for these groups, which spend a higher
percentage of their incomes on food. Household confidence has
declined of late, which is also a sign that their personal prospects
have worsened.

To truly answer the question whether these fears are overblown, you Food prices are being
have to analyse what is driving China’s inflation right now. Food driven higher by supply
prices are being driven by supply shortages domestically and to some problems
extent by higher global food prices. Another few months of rising
prices are expected. One uncertainty is whether China will resort to
price controls to slow the increase. In that case inflation would decline
faster, but it is more likely that the problem will be pushed aside for
now and that price increases will return when the controls are
removed. Supply problems could be exacerbated as well.

Underlying inflation – or core inflation excluding food and energy – is Underlying inflation is
mainly being driven by foreign demand, global commodity prices and being driven more by
to a lesser extent by the domestic production gap and other domestic the rest of the world
prices. Slower demand from the rest of the world should ease and should ease
pressure on commodity prices somewhat. One uncertainty is capital
inflows, which are raising China’s asset prices. The stimulus enacted
during the crisis, which is now fading, has not had its full impact yet,
either. Higher inflation can be expected, but not to a level of around
8% we saw during the last crisis. Monetary policies and credit spigots
will be tightened to avoid a rapid rise in prices. It is in the interest of
the party and the government to protect (price) stability.

5

Current account balance and currency reserves
500 2 .5 0

450 < -- C u rre n t A c c o u n t 2 .2 5

400 2 .0 0

USD (thousand billions)
350 1 .7 5
USD (billions)

300 1 .5 0

250 1 .2 5

200 1 .0 0

150 0 .7 5
F o re x R e s e rv e s -->
100 0 .5 0

50 0 .2 5

0 0 .0 0
00 01 02 03 04 05 06 07 08 09

The trade surplus shrunk in 2009, but this year – especially in the The trade surplus is
second quarter, when it grew by 35% at an annual rate – exports again growing and
have again exceeded imports. Currency reserves rose to USD 2.65 currency reserves are
billion in September, which means they have risen by USD 1 trillion, rising to new heights
including changes in value, in less than three years. Large capital
inflows (through export revenues, foreign direct investment and hot
money) are strengthening the yuan, which China is countering by
buying US securities to add to its currency reserves.

Credit expansion, reserves requirements and interest rates
30

25
C re d it G ro w th

20
Percent

15

a n d in
10 la rg e b a n k s
R e s e rv e re q u ire m e n ts in s m a ll

5
L e n d in g ra te 6 m o n th s

D e p o s it ra te 6 m o n th s
0
98 99 00 01 02 03 04 05 06 07 08 09 10
S o u rc e : R e u te rs E c o W in

During the global financial crisis the economy was stimulated by a Lending volume will
credit expansion through the banks. Benchmark rates and reserve exceed China’s target
requirements were reduced slightly. The stimulus gave a boost to this year
asset prices, especially housing, while equities didn’t perform as well.
Credit growth has now declined, but the 2010 target of less than 7.5
trillion yuan won’t be reached even if the government gets banks to
hold onto their money. Next year's target of 6 trillion yuan is even
tougher, but still corresponds to 15% of GDP (compared with the
2007 target of 14%).


To slow housing prices, lending has been more tightly regulated, Housing prices are
especially for second and third homes. This had its intended during again rising, if we are
the spring and summer. These rules can be circumvented at the local to believe the data
level, however, and in September and October price increases
returned. More modest housing price developments are not yet
assured.

Annual growth in housing prices (Beijing) and stock prices (Shanghai)
2 5 .0 13000
S h a n g h a i s to c k
2 2 .5 exchange, 180 12000
in d e x - - > < -- H o u s e
2 0 .0 p r ic e g r o w t h 11000
B e ijin g
1 7 .5 10000

1 5 .0 9000
Percent

1 2 .5 8000

Index
1 0 .0 7000

7 .5 6000

5 .0 5000

2 .5 4000

0 .0 3000

-2 .5 2000
05 06 07 08 09 10
S o u r c e : R e u t e r s E c o W in

There are several reasons why China’s growth is being accompanied
by large, growing imbalances. We discuss them here from a political
and economic perspective:

i) The Communist Party's legitimacy is based on strong growth.
Weak economic development, high unemployment or high
inflation could increase the risk of upheaval, especially in rural
areas. Threats to the party’s stability affect every economic
decision. In the late 1970s Deng said, “Let some get rich first,”
which made a widening income gap an accepted part of China's
growth model, at least to a certain extent. In the same way
there was initially a lack of understanding of growth’s impact on
the environment.

ii) To maintain high growth, the focus increasingly shifted to an
expanded export sector and manufacturing industry with the
help of large subsidies to state-owned companies. At the same
time the importance of the domestic sector gradually declined.

iii) The export industry’s expansion was mainly based on the
manufacture of low-value goods, often with low quality and little
consideration to sustainability. Because of the lack of emphasis
on quality, environment concerns were brushed aside.

iv) China has developed a market economy on the consumption
end but not the production end, which is still driven by subsidies
and questionable pricing of land, natural resources,
environmental impacts, interest rates and exchange rates. This

7

is leading to excessive investment and unsustainable
production.

v) Most investment decisions are made locally, which reduces the
influence of the central government. The lack of effective
economic policy tools means that imbalances can arise more
easily.

vi) The stimulus during the financial crisis helped China to avoid a
recession but at the same time helped imbalances to continue
to grow.

vii) An undeveloped financial sector is one reason why credit is
allocated more for political reasons than market considerations.
This increases the risk of overcapacity and that capital is being
incorrectly allocated.

viii) The yuan’s peg to the dollar is hindering a more market-driven
transition from exports to domestic demand. The currency peg
also means that China is importing an overly expansive
monetary policy.

ix) Growing currency reserves are contributing to liquidity in the
domestic economy and creating imbalances in assets markets.

x) Expectations of a stronger yuan are driving short-term capital
inflows (hot money), which is increasing liquidity in the economy
and creating the risk of new bubbles. The quantitative easing in
the US is increasing capital flows to emerging economies,
including China.

In summary, imbalances have grown again and new measures are
needed to reduce the risk of a major correction, which would greatly
impact growth, employment and stability.

1. What can be done? Why isn't it being done?
On the one hand, income levels are rising quickly in China. On the China is both
other, the government is trying to ease off the gas in a number of accelerating and
areas where the West would prefer to see faster development. braking

What took 50 years to achieve in the West could take 10 years in
China. This applies to the development of export companies,
infrastructure and technology in certain sectors. At the same time the
financial sector is still undeveloped, the exchange rate is pegged to
the dollar and production is heavily subsidized.

Liberalising the currency regime and the financial sector and adopting The measures that are
free-market principles are important. Other measures include creating needed will have a
a better social insurance system that allows household to have to long-term impact
save less.


The yuan’s spot rate vs. the dollar, nominal and real effective exchange rates
130 8 .7 5
R e a l e f fe c t iv e e x c h a n g e r a te
125 8 .5 0
U S D /C N Y
120 8 .2 5
115 8 .0 0
110 7 .7 5

USD/CNY
Index

105 7 .5 0
100 7 .2 5
95 7 .0 0
90 6 .7 5
85 N o m in a l e f f e c tiv e e x c h a n g e r a t e 6 .5 0
80 6 .2 5
96 98 00 02 04 06 08 10

Why is China’s leadership taking a slower approach in some areas National sovereignty
where Western countries would prefer to see faster reforms? First, comes first
national sovereignty always comes first for the Chinese, and domestic
stability can never be at risk. There is a feeling among officials and
some Chinese economists that allowing the currency to appreciate
too quickly would lead to slower growth and higher unemployment.
This, they feel, would in turn affect the global economy as well. Many
foreign and some Chinese economists feel it was a mistake to
prevent the currency from further appreciating in 2008, however,
since it delayed the transition to a new growth model and contributed
to domestic and global imbalances.

Secondly, China's government is afraid of repeating Japan's mistake, Japan's mistake must
since it feels that the yen's appreciation led to Japan's long-term be avoided at all costs
stagnation. You could also look at it another way and say that China
is making a mistake by waiting too long to let its currency appreciate,
allowing bubbles to form in asset markets and increasing the risk of
serious deflationary problems and stagnation when the bubbles
eventually burst. The yuan has appreciated against the dollar since
last June, but fairly slowly, so that China has been able to diversify its
currency portfolio before the dollar falls in value and losses are
avoided.

Thirdly, China is not receptive to pressure from the West. Instead, it is Outside pressure is
increasingly finding that it has to go its own way. counterproductive

Fourthly, its size and structure make it difficult to create effective Economic policies are
economic policy instruments. This is why China is working with a lot rarely totally effective,
of pilot projects, e.g., in the pension system, social insurance system, and reforms have to be
the hukou system of residency permits, and in the internationalisation tested
of the currency. Testing policies in a few select regions means that
measures taken up in the five-year plan will not reach full scale until
the following five-year period, or the one after that.

9

Fifthly, the growing complexity of the financial system is making the The financial crisis has
Chinese leadership more cautious. The global financial crisis has delayed deregulation
probably delayed a liberalisation. Chinese economists in the know of China's financial
also note that government officials still have a lot to learn about sector
financial markets. Furthermore, there are many examples of how
deregulation of the financial sector in country after country has led to
imbalances and financial crises. As far as possible, the Chinese are
trying to mitigate this risk, which would have a huge impact on China
and the rest of the world considering the country's size.

Lastly, economic restructuring always generates winners and losers There is always going
in an economy. The big losers in a transition to higher domestic to be resistance
demand are state-owned companies and, in the longer term, local among those hurt by
politicians who currently benefit from subsidies and the capital reforms
allocated through the banking system. It is likely that they will do their
utmost to block the central administration.

The last (11th) five-year plan (2006-2010) stressed the need to The targets of the last
stabilise the economy. The government recommended a growth rate five-year plan have not
of 8% per year and higher quality growth. Things didn't work out that been met
way. The global financial crisis global made the government worried
about a major economic slowdown, which resulted in a big stimulus
and a significantly higher growth rate than it intended.

The new (12th) five-year plan for 2011-2015 was discussed at the The new plan focuses
fifth plenary session of the 17th CPC Central Committee in Beijing on even more on
October 15-18. For the first time greater emphasis is now being put domestic consumption
on domestic consumption. There is also more focus on modernisation
outside urban areas and aide to farmers. The previous emphasis on
harmony has now incorporated the Asian Development Bank's term
“inclusive growth,” which has become the Chinese administration’s
new mantra. This encompasses a vision of more balanced economic,
social and environmental development.

There is little doubt that the Chinese are interested in correcting There is a willingness
imbalances by reducing income inequalities and improving the to change at the
environment. The question is how economic policy will contribute. central level, but what
Urbanisation, investment in inland regions, a higher minimum wage, about locally, and are
new housing that people – especially migrant workers – can afford, enough tools
environmental taxes, higher standards that contribute to a better available?
environment and higher quality, and not least research and
development in environmental areas are all being discussed. If
political stability were threatened, the Chinese administration would
undoubtedly try again to stimulate growth and maintain employment.
This could delay the transition to “inclusive growth”.

2. In the short term: High but slowing growth
The upward revision of GDP growth from 9.8% to 10.1% this year
was due to stronger than expected growth numbers, especially in the
third quarter. While it may seem that focusing on a few tenths of a
percentage point is misguided considering the reliability of Chinese
economic data, our upward revision signals that China still has its foot
on the gas thanks to the earlier stimulus and continued recovery in
the global economy, despite concerns to the contrary. The purchasing


managers indexes from HSBC and NBS both indicate that industrial
production has continued to increase.

GDP growth in industrial production (annual rate)
2 0 .0
In d u s tr ia l p r o d u c tio n
1 7 .5

1 5 .0

1 2 .5
G D P - g r o w th
Percent

1 0 .0

7 .5

5 .0

2 .5

0 .0
00 01 02 03 04 05 06 07 08 09 10
S o u r c e : R e u te rs E c o W in

The growth rate has already begun to slow, however, and this trend is GDP growth has been
expected to continue at even greater intensity. Several factors point in higher than expected
this direction. First, the impact of the stimulus is subsiding and this year, but is now
lending is not growing as quickly. beginning to slow

Secondly, exit strategies have been replaced by monetary tightening,
i.e., higher – though still modest – reserve requirements and savings
and lending rates. More will have to be done to slow inflation,
however. We also expect the yuan to gradually continue to
appreciate.

Thirdly, inflation means shrinking household pocketbooks in real
terms, which will reduce consumption.

Fourthly, the austerity measures have been felt in the construction
sector and in housing prices, which have fallen due to the tighter rules
on new mortgages and housing purchases introduced by authorities.

As a result, we expect GDP growth to slow to 8.5% next year before
falling further in 2012. If the prospects of global growth seem
reasonable, China will be more willing to accept the growth rate
around 8% recommended in the five-year plan.

Right now the Chinese are worried about the US and Europe. They China has great
are both far its most important export markets. A new downturn in concerns about
these economies would seriously threaten China's development and another slowdown in
necessitate a new wave of stimulus measures to avoid higher the West
unemployment.

3. In the longer term: A new growth model
An interesting question is where China will be in its development in
ten years. To answer that, we offer a number of suppositions based
on our main scenario as well as a less favourable version where the
risks of economic and political instability are realised.

11

We begin with our main scenario ...
In ten years China will have achieved some progress in its transition Domestic consumption
to stronger domestic growth, mainly to increased public and private and the private sector
consumption. For example, studies show that every yuan invested in will be in a stronger
the public health sector adds three yuan to GDP through higher position in ten years
consumer spending. Educational investments are also made to
increase productivity and make people more employable. The
emphasis is on the quality of the workforce, and due to demographic
challenges the one-child policy has been abandoned. The importance
of state-owned companies has decreased after all the hype during the
financial crisis, and instead private companies are growing.

At the same time China's share of global trade continues to rise China has also gained
toward 15%. China has passed the US as the world's largest market share
economy in PPP terms, but still has another decade to go in dollar
terms.

The emphasis on stronger consumption markets has required Urbanisation has
investments in the service sector and better logistics. Infrastructure continued, which has
has been further modernised. To increase efficiencies and reduce benefitted the
environmental impacts, urbanisation has continued and the country environment and the
has made progress in increasing its urban population from nearly middle class
50% to a target of around 70%. This has led to huge investments in
midsize cities around existing mega centres. The middle class has
grown by an additional 10 percentage points to slightly over one third
of the population. Instead of letting a few become rich first, the goal
has been to create a “moderately affluent society” (Xiaokang). Wages
have increased annually by 10-20% for several years. At the same
time the government has managed to keep inflation in check.

The yuan has been allowed to appreciate nominally by 4% per year, A stronger yuan – but
and appreciate in real terms through higher wage growth and input not completely
prices. The financial sector has not yet been fully liberalised and liberalised
opened up to international players. The yuan is traded abroad, but
does not command the importance you would expect from a country
of China's size. However, efforts to change China’s growth model
have led to better trade relations with the US, Europe and emerging
economies in particular, which now see China as an increasingly
important export market.

Geopolitically, China has continued to stress that it isn’t trying to National interests drive
threaten other countries and wants good international relationships. China's foreign policy
The military has grown, so that China can measure itself against the
US, which has been an important goal in itself. China has begun to
take greater responsibility for global development issues such as
poverty, the environment and climate change through international
institutions, although national sovereignty still overshadows global
coordination.

Xi Jinping and Li Keqiang have succeeded Hu Jintao and Wen Jiabao Xi and Li have
as president and premier, respectively. They (Xi and LI) have preserved the party's
protected the party’s stability over an eight-year period while monopoly on power,
cautiously continuing political reforms. This has required changing but have to find a new
values through various types of reforms designed to increase local set of values
pluralisation and democratisation in an orderly fashion while
maintaining monopoly power. The key has been to avoid chaos but


still open society up to change and more meaningful values, like
Western democracy but from a Chinese perspective. Measures to
strengthen civil society have precedence. The Internet has been used
strategically to allow opposing opinions, particularly on the legal
system and local government power. Democracy in a Western sense,
with popularly elected representatives, multiple parties, democratic
rights (in the legal system, media and public debate) and
transparency, is still lacking.

... and continue with a less favourable scenario
This scenario assumes that imbalances have continued to grow and Imbalances could lead
that China hasn't succeeded in changing its growth model. Instead it to economic collapse,
has continued to pour money into state-owned companies, the export increasing the risk of a
sector and unbalanced growth. The income gap has widened and political revolt
environmental problems have become more serious. Trade relations
are now so strained that other countries have adopted tough
protectionist measures. Chinese trade decreases. Growth falls.
Bubbles in asset markets burst and GDP growth drops to 1-2%. The
economic climate leads to rebellion among farmers. The Communist
Party’s monopoly on power is threatened. Chaos spreads to urban
areas. Foreign companies leave the country. The new leadership tries
to find a scapegoat such as Taiwan or Japan. Regional stability is
threatened and the country risks breaking apart.

While this alternative scenario may seem unlikely, the point is that
many actors on the financial markets have assumed that China’s
growth rate in recent decades will simply continue in the decade
ahead. Considering that imbalances continue to grow, there is an
increasing likelihood, as low as it may be, of an economic collapse
followed by political revolt.

4. How does China affect the rest of the world?
China’s strong economic development has impacted the global China’s economic
balance of power. This is evident at G20 summits and international growth is not reflected
institutions such as the WTO and also in the International Monetary in its international
Fund, IMF, where China has gained greater power. All in all, it has influence
not yet exercised this stronger power position. At the Copenhagen
climate conference and on environmental issues, for example, China
has maintained a low, cautious profile.

Despite changing its growth model, China will continue to gain market
share in global goods and services. Since it wants to move higher up
the value chain (value-added production is now some 25-27%,
compared with 35-40% in many other countries), it will face greater
competition in markets with higher knowledge content. This applies to
high technology, research and development. It would also increase
the chances that Western companies shift more high-tech production
to China. Production with lower knowledge content will move to
Vietnam, Bangladesh, Africa and eventually North Korea – all
countries that will increasingly export input goods to China.

13

China’s growing consumer markets will initially have the most impact An increased standard
on Western companies and growth. Production will also increase to of living is helping
meet domestic demand, with some production handled by Western growing companies to
companies. China will take over more of its own production, too, improve their sales,
requiring foreign companies to continue to innovate and offer higher but China will also
quality and ingenuity. China’s innovative capabilities are growing want to produce itself!
quickly, even though Western multinationals still maintain an
advantage (but not much longer).

As China changes its growth model, it will want to buy fewer US Higher wages and
securities, which will probably raise interest rates in the West. Wages prices – and more
are rising in Chinese industry, which means that there is no longer the domestic growth –
same price pressure downward, and if anything, global inflation could should push global
receive a push. Commodity prices continue to rise as a result of interest rates upward
China’s expansion, though eventually this will slow. Competition for
some raw materials is growing and could pose a problem for
Western-oriented companies. One example is China’s recent trade
restrictions on rare metals. We expect to see more of this in the year
ahead.

If the less favourable scenario proves accurate, China’s overcapacity
and overinvestment will contribute to global deflation. In addition, the
slowdown would create greater turbulence in global financial markets,
which have increasingly seen China as a guarantor for the global
recovery. As was the case in 1989, when many businesses
abandoned China, political instability would lead to several years of
shrinking foreign capital.

Our main scenario, however, assumes a soft landing and transition to China continues to
higher domestic demand. As the yuan gradually appreciates, China diversify its currency
will try to increase its investments abroad. portfolio

The question is what kind of business model China will provide the The search for
rest of the world after mergers and acquisitions? It often weighs Chinese business
factors that aren't strictly economical, such as how to maximise models has just begun
production, gain access to materials and land, build up technological
and commercial expertise, and obtain entry into foreign markets.
Budget limits are often soft, leaving plenty of access to capital.
Politicians negotiate for the Chinese, so it can be hard to know who
makes the decisions in a Chinese organisation. Volvo, for example,
may build factories in two Chinese regions after its takeover by Geely
due to the influence exerted by local politicians, even though this may
not be the most effective solution given current economic
considerations.

China’s foreign investments have increased substantially in the last
five years, and will continue to do so. Access to raw materials in
Africa or Latin America is a priority, as are opportunities to access
European markets by taking over companies in Eastern Europe and
providing “aide” to Portugal and Greece during their financial crises.


5. How does the rest of the world affect China?
China is concerned about developments in the US and Europe, since The West is slowing
weaker demand reduces Chinese growth and will force it to more China’s development
quickly transition to a new growth model.

China is feeling pressure from G20 countries to take greater When it suits them, the
responsibility for the environment and climate change, financial Chinese still act like a
stability, high savings rates, poverty and trade issues. To date it has developing country
maintained a low, cautious profile, which has served them well. On
some issues, like the environment, China still claims it is a developing
economy, while on others it flexes its muscle as one of the world's
biggest economies. Which happens to apply depends on what suits
the Chinese at the moment. China has seen how the current global
economic model has developed in the West, with a market economy
focused on democracy and human rights. It would prefer to develop
its own model that also commands world wide respect.

Although China is still strongly dependent on the West in many areas, Intra-Asian trade is
it is expanding its collaborations with other emerging countries in Asia growing, but China is
and elsewhere. Eventually China will also realize that a market still dependent on the
economy, political stability, transparency and openness in countries West
where it operates are in its interest as well. This in turn would benefit
the domestic culture.

6. The China-Europe relationship has been pushed
aside
China and the EU seem to have a fairly good relationship at this
point. Europe has not as frequently or fervently criticised China’s
currency regime.

Despite all the rhetoric between the US and China and the fact that China seems to have
their relationship sometimes seems to be splitting at the seams, greater respect for the
China has greater respect for the US than the EU. China can more US than the EU
easily manipulate a divided Europe. Even though China values
Europe's welfare and social systems, especially with respect to the
environment, the American dream remains an ideal for many Chinese
and to them represents Western success.

Of late, however European businessmen and the European Union Businessmen from EU
Chamber of Commerce in China have expressed their displeasure countries have begun
with how China protects its industries and casually violates European to show their
copyrights and patent protection. One example is the indignation displeasure
expressed by Peter Löscher from Siemens and Jurgen Hambrecht
from BASF in their meeting with China’s Premier Wen Jiabao in July.
The figure below provides an idea of the extensive government
controls that Chinese and foreign companies both face. However, it is
easier for domestic companies to form relationships that help them
better understand the rules and make it easier to circumvent them.

15

Market regulation in various regions in 2008, from 0 (least restrictive) to 6
(most restrictive)

Barriers to Trade and FDI
US
Barriers to entrepreneurship
State control
Euro area Overall Indicator

OECD

Russia

China

0 1 2 3 4 5

Source: Wall Street Journal, 17 November 2010

The EU has been slow in developing a strategy for its relationship The EU still has to
with China. As China’s self-confidence has grown of late, this strategy improve its strategy
will have to assume a future China with a new growth model and vis-à-vis China
even greater financial muscle, which it will increasingly flex in
emerging countries and in the West. It is also important that the EU
understands the Chinese system as it develops, including the
possibility of a new set of priorities and with a greater focus on what
China calls “inclusive growth” and “a moderately affluent society.”

China is concerned about that the euro could collapse and is offering There are several
support to Greece and Portugal partly for this reason, but also reasons for
because of the opportunity to increase its presence in European China’s support of
markets. First and foremost China wants to see a normalised Europe Greece
where structural reforms strengthen the region, so that its biggest
trade partner again increases its appetite for Chinese products.

In the longer term Europe will have to shoulder the role of the The EU's collaboration
innovator, since China’s growth model assumes increased with China has to be
cooperation on high-tech development. It is up to the EU to build on based more on
this cooperation in a constructive manner. This applies, for example, innovation, R&D
to green investments in environmental and energy technology,
nanotechnology, robotics, biotechnology and social development.
China's growing consumer markets dream of Europe, and Europe's
extensive experience in research and development in these strategic
areas is of interest to China. Developing climate-smart products, for
example, is a mutual interest of both regions. As China's service
sector develops, it will also want to take advantage of Europe’s
experience. At the same time China has to develop its financial sector
and allow foreigners in.

European consumer markets will become increasingly attractive to
Chinese companies as they become more active in their marketing,
sales and goods purchases for the European market. Eastern and
Western Europe differ in terms of market expectations as well as
production costs. Western Europe's costs are considerably higher


than China's. The Baltic countries, for example, are in between
Western Europe and China, but compete more and more with
manufacturing similar to China’s and at the same time are trying to
increase value-added in their production, just like China.

7. Effects on Sweden and Swedish companies
The most important consequence of China's new growth model, with Swedish products
its increased emphasis on quality, is that it will benefit Swedish should benefit from
industry. Swedish products already maintain a high quality content. China’s new growth
As China adopts higher sustainability and quality standards, which model
will happen slowly but undeniably, demand will increase for products
that last longer and improve efficiency in production or the supply
chain.

Rather than trying to shift production to the lower quality that China It's important to
produces today (B market), Swedish companies should continue to maintain a focus on
offer higher quality products (A market), which China will slowly but quality, which will
surely demand more of. China’s C market will instead move to remain in demand
markets with even lower wages and value-added such as
Bangladesh, Vietnam, certain African countries and eventually even
North Korea, when geopolitical conditions allow.

In terms of sourcing, Chinese companies are facing increasing In sourcing, CSR
pressure to maintain high CSR standards. This means that Swedish issues will grow in
subcontractors that follow larger companies to China have to realise importance
that the same high CSR requirements apply to working conditions,
the environment, etc. If they don't meet the same requirements as in
the West, it will mean considerably higher production costs in the long
run. Carefully choosing a local supplier to work with, also means
taking CSR factors into consideration.

Bigger consumer markets and a higher standard of living for millions The key is to consider
of Chinese will mean greater sales opportunities for Swedish both threats and
companies that do their homework. At the same time competition is opportunities
growing significantly in higher value-added production. Those that
manufacture in China can expect costs to rise and profit margins to
shrink. New labour laws are contributing to higher wages, which is
also desirable, since it will speed up the transition to the new growth
model.

Because of its one-child policy, China will gradually face a labour
shortage. Raising the quality of teachers and students will be
necessary to fill demand at the university level as well – which is
lacking today. It is still cheaper to hire an engineer in Shanghai than
in Stockholm, but the difference is gradually diminishing. In a not too
distant future competition for educated Swedes may increase in part
due to Chinese demand. The key is to keep up, because as usual
things change quickly, provided the Chinese want them to.

Cecilia Hermansson

17

Economic Research
Department
SE-105 34 Stockholm Swedbank Asia Analysis is published as a service to our customers. We
Telephone +46-08-5859 1000 believe that we have used reliable sources and methods in the
ek.sekr@swedbank.se
www.swedbank.se
preparation of the analyses reported in this publication. However, we cannot
guarantee the accuracy or completeness of the report and cannot be held
Legally responsible publishers responsible for any error or omission in the underlying material or its use.
Cecilia Hermansson,
Readers are encouraged to base any (investment) decisions on other
+46-8-5859 7720
material as well. Neither Swedbank nor its employees may be held
responsible for losses or damages, direct or indirect, owing to any errors or
Magnus Alvesson, +46-8-5859 3341 omissions in Swedbank Asia Analysis.
Jörgen Kennemar, +46-8-5859 7730
ISSN 1103-4897


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