China: Is the Reward Worth the Risk?

Some market pros remain optimistic about Chinese stocks, despite interest rate-hike jitters and periodic bouts of volatility.

Any lingering doubts about China's global clout were laid to rest when fears that the government would have to raise interest rates caused a brief panic on Apr. 19 in Asian and European markets. News that China's economy had grown at an annualized rate of 11.1% surpassed expectations, and investors feared China would have to hike rates to stave off inflation and rein in overheated growth. But analysts remain sanguine despite the Middle Kingdom's periodic bouts of volatility, good news for investors in Europe and the U.S.

Though it's far more volatile than markets in the U.S. and Europe, the Chinese stock market has also displayed impressive resilience. After the Shanghai composite index plunged more than 9% on Feb. 27, it quickly rebounded to new highs. Likewise, on Apr. 19, when the market benchmark saw a large slump on interest-rate worries, it recovered most of the losses by the next day.

Some equity players in China and elsewhere appear to be rethinking their initial rate-hike worries. Peter Cardillo, chief market economist at investment firm Avalon Partners, says that even if China does raise rates, "I'm not sure how hard they're going to hit those brakes." Cardillo figures policymakers would be cautious because tightening would hit development in the country's rural interior, which has seen fewer benefits from China's rise than glittering cities such as Shanghai and Beijing. The prospect of rate hikes, he believes, was mainly a catalyst for high-priced stocks to pull back a bit.

Exporting Deflation

China will raise rates if central bankers become concerned about inflation, says Shigeki Makino, managing director at Putnam Investments' global core equities unit. But that may not be as much of a threat as investors think. Sure, overheating remains a concern in rapidly expanding countries like Brazil, Russia, India, and China—a quartet sometimes called "BRIC"—but Makino says China has a built-in venting system.

How so? Makino says that as the country begins to depend on more sophisticated businesses instead of the mass manufacturing of inexpensive goods, it is able to export deflation to smaller up-and-coming economies like Vietnam and Bangladesh that are inheriting China's manufacturing base.

Markets appear to have some confidence in Beijing's ability to keep things on an even keel despite the occasional dustup. Year to date, the Chinese benchmark is up about a third. This is even more remarkable considering that last year it more than doubled, ending the year at an all-time high.

Hike Fears Factored In

Apprehension that China would raise rates had a greater effect on markets in Europe than in the U.S. But after declines Apr. 19, continental indexes seemed to shake off their concern, paring losses before gains on Apr. 20. Their stateside counterparts likewise appeared to brush off the news: The Dow Jones industrial average approached 13,000 for the first time on Apr. 20.

Todd Salamone, senior vice-president at Schaeffer's Research, says the prospect of China raising interest rates is "one more worry built in" to market conditions. But taken as a whole, he sees that fear actually being a positive for investors, especially with strong performances from U.S. markets. "From a contrarian perspective, it's bullish when prices contradict worries," he says. "You'd rather have a market that has low expectations because it makes it easier to surprise on the upside."

This is good news for U.S. investors looking to latch onto the China story, and they have several options. Among several China-oriented exchange-traded funds, iShares offers one that tracks the FTSE/Xinhua China 25 index (FXI), a basket heavily weighted to large companies especially in the financial and utilities sectors. It includes many of the individual stocks available to U.S. investors as American depositary receipts like well-established outfits China Mobile (CHL), PetroChina ( PTR), CNOOC (CEO), and China Life Insurance ( LFC). None of these are startups. In fact, they are among the largest and most liquid Chinese outfits. Still, Salamone holds that because of the high risks, U.S. stocks are a stronger bet than emerging markets including China.

Nonetheless, the ability of Chinese equities to withstand the occasional storm—and of the Middle Kingdom's economy to sustain its rapid pace of growth—offers encouragement to those investors brave enough to play the emerging-market stalwart.

Halperin is a reporter for BusinessWeek.com in New York.

China Carmakers Go Upscale in Shanghai

At the Shanghai Auto Show, local manufacturers are putting their own stamp on higher-end vehicles
There are the leggy models, the concept cars, and the hordes of automotive journalists. There are the latest vehicular offerings from General Motors (GM), Toyota ( TM), DaimlerChrysler (DCX), and Rolls-Royce. So, just another auto show, like the annual confabs of Detroit, Geneva, and Tokyo? Not quite.

Instead, at the Shanghai Auto Show, which opened Apr. 22 and will run for one week, much of the attention is focused on an unprecedented lineup of higher-end Chinese-branded autos. Xian-based BYD Auto, which got its start as a cell-phone battery maker, showed off its F6, a 2.4-liter-engine luxury sedan. Geely had its Mybo sports car as well as its MVP 2.4-liter, Shanghai-manufactured version of a London black cab, which it is producing with Manganese Bronze Holdings.

Shanghai-based local champion SAIC Motor is showing off eight vehicles, including its Roewe W2 concept car, complete with models attired as English dressage-style equestrians. That W2 showcases the design and style of the next Roewe model, to be released at the end of this year. SAIC also showcased a fuel-cell car called the "Shanghai," resurrecting a brand it first launched in 1964 but then shuttered 16 years ago.

Plenty of Potholes Ahead

Meanwhile, China's most successful domestic brand, Chery (which beat out GM in March, coming in first place in domestic sales with 44,000 vehicles), showed an astonishing 40 models, including the A6 Coupe (designed with Italian company Bertone), the Shooting Sport recreational roadster, the Tiggo6 sport-utility vehicle, and several concept cars in its sprawling 2,200-square-meter booth.

Chinese-branded high-end cars? Hard to believe, but they have arrived, albeit perhaps with plenty of potholes on the road ahead. To date, Chinese carmakers have found their niche either by helping the big brands from abroad make their cars, or producing ultra-low-cost cars like Chery's QQ and Geely's Haoqing. Those cheap vehicles, aimed to appeal to lower-income first-time buyers outside China's first-tier cities of Beijing, Shanghai, Guangzhou, and Shenzhen, have been known as much for their low quality and shoddy design as for their rock-bottom price. Nevertheless, that focus has worked well so far, with Chinese self-branded autos holding close to 30% of the domestic market today, compared to 10% five years ago, say auto market watchers. (The overall sedan market grew 30%, to 5.18 million vehicles last year.)

Now that's changing, particularly as Chinese makers face new competition from the likes of GM's Chevrolet brand, including the $6,500 Spark, Volkswagen's Golf, and Hyundai's Elantra, all vying for the low end of the China market. "Foreign automakers are starting to produce low-price cars, which is a very dangerous signal for the Chinese auto industry, and is driving the move towards higher end," says Beijing-based auto analyst Jia Xinguang. So "Chinese automakers are experiencing an upward trend on pricing. Geely used to produce cars priced from $2,600 to $3,900, while now they enjoy producing cars from $5,200 to $6,500. The same trend can also be seen in Chery."

From Imitation to Innovation

Geely knows all about managing on razor-thin margins. It has outsourced services like its company cafeterias to cut costs. And it has founded three universities, including Geely University in Beijing, which together enroll 30,000 students and provide the company both income from tuition and a ready source of affordable and well-trained graduates to staff its engineering, design and marketing ranks. But with average auto prices declining some 7% a year in China, moving up the quality ladder is another important way to protect margins.

"When most Chinese companies start, whether in service or manufacturing, they tend to copy. That is the easy way to start. But if you stay with this strategy, sooner or later you will die," says Lawrence Ang, executive director of Zhejiang Geely Holding.

Big Numbers Give Baidu a Bump

Impressive earnings are sending the stock of China's leading search engine into orbit. Google and Yahoo need to move fast to share the space.

Can anything stop Robin Li? A lot of people in China are probably asking themselves that question today, following news that Baidu.com (BIDU), the country's No. 1 search engine, reported impressive earnings growth for the first quarter. Li, Baidu's founder and chairman, predicted more good times to come, helping to fuel a 23% rise in the company's stock price.

Baidu's good news comes at a time when its two main rivals, the Chinese versions of Google (GOOG) and Yahoo ( YHOO), are struggling to keep up with their high-powered local competition. Baidu commands over half (57%) of the Chinese search market, with Google controlling 18.7% and Yahoo 13.6%.

That dominance helped Baidu increase its profit for the three months through March by 143%, to $11.1 million, compared with the same quarter in 2006. Quarterly revenue also grew well, doubling to $35.7 million.

China, the world's second-largest Internet market after the U.S., provides Li and his team with plenty more room to grow. While there are more than 130 million Chinese online, that's still only 10% of the country's population. In the U.S., Japan, and South Korea, about 60% to 70% of the people are online, says Richard Ji, an analyst in Hong Kong with Morgan Stanley (MS).

'Better in Chinese'

Even more promising for Baidu, the untapped pool of potential advertisers is deep. China has about 30 million small and midsized enterprises, but fewer than 0.5% of them are Baidu customers.

That number is likely to increase at the same time that the percentage of Chinese using the Internet rises. "If you combine these, it is not difficult to see enormous growth potential in the Chinese Internet market," says Ji, who estimates that the total market for online search last year amounted to $260 million and is likely to grow by 50% to 60% compounded annually over the next three years.

Numbers like that mean companies like Google and Yahoo have to find ways to make inroads into China, despite the clear advantage Li has. But Baidu has been able to maintain its big lead thanks to its well-established brand and superior search technology, says Duncan Clark, managing director of Beijing-based consulting firm BDA China. "Baidu is just better in Chinese," he says.

The company does face some big challenges. On Wednesday, for instance, Google announced it had reached a deal with state-owned operator China Telecom to share revenue from online ads. Last month, Google announced a similar partnership with China Mobile, the dominant cellular operator, to collaborate on mobile search.

Taking a Chance on Japan

Such deals provide some hope for Baidu's rivals that Li won't be able to gobble up the whole market. "There's still a lot of potential there," says Clark.

Adds Morgan Stanley's Ji: "If you look at the U.S. market, there are two or three other search players [besides Google]. In China, there is a chance for coexistence of two or three of the major search players."

Another concern is Baidu's recent expansion into the Japanese market, its first foray beyond China. Although Google and Yahoo Japan dominate the Japanese search market (with a combined market share of over 80%), Li has launched Baidu Japan. The idea is to provide a way for Chinese businesses to reach potential customers in Japan who are interested in purchasing lower-cost, made-in-China goods (see BusinessWeek.com, 2/16/07, "Baidu Thinks It Can Play Japan").

It won't be easy for Baidu to pull this off, cautions Ji. A big problem will be costs. "Japan is expensive," he says. "Labor costs are typically 10 times higher than in China." Still, as long as business keeps booming back in its home market, Baidu is reckoning it can afford to take a chance.

Einhorn is a correspondent in BusinessWeek's Hong Kong bureau .

China Tops U.S. as Japan Trade Partner

Though old differences remain, Japan is keen to continue its expansion by exporting to booming China, while Beijing wants more Japanese know-how

This decade hasn't been an especially cordial one for Asia's dominant powers. Japan has feared China's economic and military ascendance and clung more closely to the U.S. on national security matters, much to the irritation of Beijing. Chinese leaders have routinely stoked raw national anger directed at Japan over its perceived insensitivity, or outright historical amnesia, about its wartime behavior going back to the 1930s. Some of the Sino-Japanese diplomatic clashes over disputed natural gas assets in the East China Sea have been nasty.

Yet through it all the overall economic linkages have strengthened—even if the politics have been acrimonious. That reality was underscored by new data out on Apr. 25 showing that mainland China (excluding Hong Kong) has eclipsed the U.S. as Japan's biggest trading partner in the fiscal year that ended Mar. 31. Two-way trade between China and Japan shot up nearly 10% to $214 billion, according to new data from the Japanese Finance Ministry (see BusinessWeek Assistant Managing Editor Christopher Power discuss China's new clout with Japan, "Video View: Japan's New Trade Priorities").

None of this is going to completely reshape geopolitics in Asia. However China's economic clout and the diminished stature of the U.S. in Asia since the Iraq War could complicate the U.S. agenda in the region. Five years ago the Bush team could count on Tokyo to side with the U.S. when it came to pressuring Beijing to crack down on fake goods or make its military spending more transparent.

A Stage-Managed Visit

That may not be the case as the years roll on and the Chinese and Japanese economies integrate even more. In fact the growing trade and capital flows between these two giant economies—with a combined $7 trillion-plus in gross domestic product—do explain in part the thawing in relations between Tokyo and Beijing since Japanese Prime Minister Shinzo Abe came to power last fall.

Chinese Premier Wen Jiabao's visit to Japan in mid-April (the first by a Chinese leader in roughly seven years) was a stage-managed kiss-and-make-up session. The two signed a major environmental technology cooperation pact and Wen made a perfectly civil speech to members of the Japanese Diet. Abe visited Beijing back in October just weeks after taking over power from his predecessor Junichiro Koizumi, whose regular visits to a Tokyo Shinto shrine that honored Japan's war dead drove Chinese leaders to fits of anger.

Within the orbit of the conservative ruling Liberal Democratic Party in Japan, Abe is actually more hawkish than Koizumi ever was—but he is far from naive about current global economic realities. Sure, the U.S. economy still matters. Yet with the slowdown in the U.S., the Chinese are now making a more meaningful contribution to Japanese growth.

Growth Envy

This isn't a difficult point to grasp: China is likely to grow 10%-plus in 2007, while the U.S. is probably to going to come in at about 2.4%, many economists figure. In fact, Chinese demand for Japanese cars, construction equipment, and machine tools played a huge role in lifting Japan out of its decade-plus of stagnation a few years back. If you include Hong Kong, China became Japan's No. 1 trading partner back in 2004.

China wants Japanese know-how in making autos and high-end consumer electronics, and to absorb the secrets of how Japan has become one of the most energy-efficient economies on the planet.

Old historical enmities die hard, but right now the burst of mutual prosperity between these two economies seems to have trumped politics.

Bremner is Asia Regional Editor for BusinessWeek in Hong Kong.

Lenovo: Down So Long, It Looks Like Up

Integrating IBM's PC division continues to tax China's No. 1 computer maker, but growth is up, and more job cuts are cheering investors

The cost cutting continues at Lenovo (LNVGY), China's top PC company. As part of its effort to integrate the money-losing PC division of IBM ( IBM) that it acquired two years ago, Lenovo President and Chief Executive Officer William J. Amelio said yesterday that the company is cutting 5% of its work force. This follows a round of layoffs last year.

The cuts are just the latest in a long list of changes that Lenovo has gone through since it took over the old IBM division in 2005. There's been a major overhaul of management, with the departure of old IBMers like then-President Stephen Ward in late 2005 and the arrival of a team of former Dell (DELL) executives like Amelio. The company has also launched a new line of PCs in the U.S. in an attempt to win over consumers and small-business customers and promote awareness of the Lenovo brand name.

So far, Lenovo has not enjoyed much success from its global push. The stock price dropped 25% last year, and in September, Lenovo's falling market capitalization cost the company its place on the elite Hang Seng Index. The stock price is down about 12% so far this year. The company has not seen significant improvement in U.S. market share and has also struggled in Japan.

Promising a Payoff

Although the IBM deal catapulted Lenovo into the top tier of PC makers globally, the company has been losing market share. On Friday, market research firm International Data Corp. announced its numbers for the first quarter, showing that Taiwanese rival Acer had climbed into a tie with Lenovo at 6.7%.

The Taiwanese have the wind at their backs: While Lenovo's sales climbed 17.4%, Acer's jumped 41.4% (see BusinessWeek.com, 1/07, "Acer Closes in on Lenovo").

Still, Amelio promises the payoff is coming. Lenovo's first-quarter sales growth wasn't as sizzling as Acer's, but it still topped the 10.9% growth of the overall market and certainly outshone the 6.9% slide that Dell suffered. Moreover, the newest cutbacks will cost the company between $50 million and $60 million (to be charged this quarter), but management believes Lenovo will see $100 million in savings for the year.

Are there more cuts to come? Maybe, but Amelio says the shrinking at Lenovo might be over.

"We believe the 'tipping point' is within reach," the executive said in a statement released by the company as it announced the layoffs. "If we can combine optimal cost competitiveness and efficient delivery capabilities with innovative, best-engineered products, we can generate more profitable growth, gain market share, and make further reinvestments into the business, fueling more growth."

Moving Up in the World

Investors were cheered by the news of the layoffs. Lenovo's stock price rose 2.1% in Hong Kong trading on Friday. Some other good news for Lenovo came on Friday with the announcement by IDC that the company had expanded its lead in Asia Pacific (excluding Japan) in the first quarter.

While the market as a whole grew 17.6% year-on-year in the first three months of 2007, Lenovo enjoyed 24.3% growth. Lenovo is tops in the region, with 17.8% of the market, compared to No. 2 Hewlett Packard's (HPQ) 15.4%. And this progress came at a time when sales in China slumped because of the weeklong Chinese New Year holiday; that's a sign Lenovo is becoming more of a player in other countries around the region.

Talks to Follow

Kathy Sin, an analyst in Hong Kong with IDC, attributes the strong Asia-Pacific growth to Lenovo's push to build awareness of its brand among consumers. "They are targeting the retail market," she says. "In the past, the IBM ThinkPad was targeted at the commercial market only; they had limited presence [among consumers]."

Lenovo has not said where the cuts will fall, but positions in Europe are likely to be on the chopping block. The company's statement yesterday said: "In Europe, Lenovo will immediately launch the process of consultation with workforce representatives, as appropriate, regarding the plan's intended efficiency gains and cost structure reductions."

Einhorn is a correspondent in BusinessWeek's Hong Kong bureau .

Cautious Consumers

The Chinese are on a spending spree, right? Not really. In fact, they're so tightfisted, Beijing is worried.

Meet the XUs. This typical Chinese middle-class family of three shares a two-bedroom apartment in Beijing, purchased four years ago for $40,600. The father, 51-year-old Xu Zhibao, takes home $454 a month from his job as a teacher at Beijing Pharmaceutical College. His wife, Zhang Xiaoping, 50, earns $260 a month as a nurse at a local hospital. Their 25-year-old daughter, Xu Hong, is a student at People's University. A Whirlpool (WHR ) microwave oven and a Haier refrigerator command pride of place in the tiny kitchen. Among the family's other prized possessions are two Sony (SNE ) televisions and a Mitsubishi air conditioner.

But it isnt just the things the Xus have bought that make them representative of China's bourgeoisie; its also what they choose not to buy. Like most mainlanders, the family members sock away tons of cash, close to 40% of their earnings every month. The Xus hardly ever go to restaurants, a movie outing is a rare treat, and they have no plans to trade in their bicycles for a motorcycle or car. "Only if a product is discounted heavily and I think it's worth it will I consider buying it," says daughter Xu Hong.

Isn't China in the grip of a consumer frenzy? Well, sort of. Car sales shot up 30% last year, while retailers from Wal-Mart Stores Inc. (WMT ) to Carrefour are doing a brisk business as newly prosperous mainlanders stock their larders and living rooms. And not a day goes by without some big-name American company announcing a new China push. On Apr. 16, for instance, Hewlett-Packard Co. (HPQ )unveiled an energy- efficient computer aimed at the China market.

But look beyond the headlines and you'll find that China's 1.3 billion people are actually buying relatively little. Although the mainland's population is four times that of the U.S., Chinese consumers last year spent just 12% of what Americans did, figures investment bank UBS (UBS ). And private consumption as a share of gross domestic product in China is falling, to less than 40% today from about 48% in 2000.

Prying open the wallets of tightfisted folks like the Xus is emerging as the hottest political topic in Beijing. Although the economy is still expanding at 10%-plus annually, China's economic mandarins are concerned that the country's growth depends too much on its soaring exports and investment in ever more factories and luxury high-rises. Exports leave the Middle Kingdom vulnerable to potential downturns in the U.S. and Europe while causing trade tensions with Washington. And too much investment threatens overcapacity in industries from steel to autos. So Beijing has cut taxes and boosted some social outlays to spur Chinese to spend more at the mall. "We need to adjust the balance between investment and consumption," Premier Wen Jiabao warned at the annual meeting of the National People's Congress on Mar. 5.

NOT TRICKLING DOWN
When might the Chinese consumer help really drive the global economy? Analysts at Credit Suisse Group (CS ) have conjured a rosy scenario in which China becomes the world's second-largest consumer nation (after the U.S.) by 2020, up from No. 5 today. UBS is less upbeat, estimating that the middle class includes only about 25 million people—just 2% of China's population—hardly big enough to have much impact globally. And even Credit Suisse acknowledges that personal incomes, while climbing, aren't keeping pace with rising GDP. "If you think the purpose of rapid economic growth is to increase consumption and the general welfare, then China isn't doing a very good job," says Nicholas R. Lardy, senior fellow at the Peterson Institute for International Economics in Washington.

The problem is vexing not just for Beijing but also for the legions of global companies making big bets on China. With the more prosperous coastal areas already reaching saturation in everything from cellular phones to fried chicken outlets, foreign investors have to drive deeper into the interior in search of sales. "There are 900 million people in China" without mobile phones, says Michael Tatelman, president of Asia Pacific Mobile Devices at Motorola Inc. (MOT ) in Beijing. "We are looking at how to reach the unconnected." Getting to those people can be tough. Rural consumers "are a very dispersed crowd," says Jonathan Anderson, chief economist for Asia at UBS. To address that, the Commerce Ministry is working on a project—likely to include Procter & Gamble (PG ) Co.—that would seed the Chinese countryside with small retail outlets.

China used to approve foreign-owned factories only if most of the output would be exported. More recently, though, Beijing has shifted the emphasis to consumer goods for sale within China. Sony Corp. (SNE ), for instance, once sold the bulk of its Chinese production abroad, but today it's devoting more resources to developing televisions, MP3 players, and other gadgets specifically for sale to Chinese consumers.

Ultimately, if Beijing wants to unlock consumer spending, it must do more to make ordinary Chinese feel secure about the future. With the market reforms of the past three decades, the safety net of lifetime housing, free education, subsidized health care, and a pension—all courtesy of the state—has been largely dismantled. As a result, Chinese "want to save every penny," says Chen Zhiwu, a professor of finance at the Yale School of Management. "In case of sickness, job loss, an auto accident, or old age, they will have some way to support themselves."

A BREAK FOR FARMERS
The Xus would agree. "Our money is limited," says father Xu Zhibao. These days he pays $270 a month for his mortgage, something he didn't have to worry about when the family lived in an apartment provided free of charge by his father's employer, a printing factory. And throughout much of the past decade, falling food prices meant that city dwellers such as the Xus could easily afford eggs, meat, and other staples. Now they face rising food prices, which increased by 2.3% last year. This year, inflation for the first quarter alone probably jumped an additional 3%, largely because of a surge in the cost of food, estimates Merrill Lynch & Co (MER ).

To ease the burden, the government has been pumping more money into social initiatives. The national budget for education is slated to rise by 42% this year, while outlays for public health will nearly double—though government spending as a share of GDP continues to decline. Beijing also earmarked $3 billion for employment and worker-retraining programs. At the same time, in several provinces the government is trying out a new hybrid public-private pension system.

Beijing has also been tinkering with taxes. Last year, in a move aimed at kick-starting consumption, it doubled the income threshold at which citizens start getting taxed, to about $200 a month. And after years of being trampled on the road to progress, China's farmers are getting a break. Last year, Beijing abolished a 2,000-year-old agricultural tax and handed out billions of dollars in subsidies to grain farmers and schools. To spur creation of jobs in rural areas, and thus boost spending there, Chinese legislators in March left intact tax breaks for foreign companies that are investing in forestry, farming, and fisheries even as they did away with incentives in most other areas.

Economists have generally welcomed these steps. Yet many argue that China's leadership must move more aggressively to shift the economy toward higher- paying service industries and away from manufacturing. Services make up less than 40% of China's GDP, compared with 54% in India, with its thriving outsourcing sector. Despite regular hikes in legal minimum wages and efforts by Beijing to better enforce labor laws, salaries have declined from 53% of GDP in 1998 to only 41.4% in 2005, compared with 57% in the U.S. "If consumption is to go up, then the share of wages in economic growth will have to rise," says Bert Hofman, the World Bank's chief economist in Beijing.

Meanwhile, it's Saturday, and that usually means a Xu family shopping trip to the bustling Fangzhuang district Carrefour hypermarket, one of seven the French retailer operates in Beijing. The attraction? It's nearby and offers a wide range of goods, but just as important, Carrefour "has very low prices," says mom Zhang Xiaoping. Such words will surely strike both hope and fear into multinationals and Beijing policymakers alike as they attempt to persuade frugal families such as the Xus to dig deeper into their wallets.

Why Taming the China Dragon Is Tricky

Slowing down China's high-speed economy is devilishly hard to do, and may even be beyond Beijing's control

It's a problem a lot of developing countries would die for. Yet Beijing faces a policy quandary of the highest order. China's $2.6 trillion economy, which blew away market expectations and clocked 11.1% growth in the first quarter, is rushing along like some blisteringly fast, runaway maglev train. Chinese President Hu Jintao's economic team in Beijing has been trying to tap the brakes to avoid a reprise of the painful boom-and-bust scenario that hit the country in the mid-1990s, yet hasn't managed to do so despite three years of effort.

China's seemingly unstoppable surge was a big topic on the podiums and in the hallways at the 2007 Boao Forum for Asia, a gathering of regional leaders and executives held in the southern province and resort island of Hainan on Apr. 20-21. Another prime subject: the global economic risks of a China that might jump the rails.

While China's restrictive currency policy that has kept the yuan relatively cheap gets much of the blame, Beijing is having trouble wrestling with this economic beast for lots of reasons that cut to the basic structure of China's economy. Among them is a massive savings glut in the corporate sector, the globalization of manufacturing networks, and the still vast developmental needs of an economy that must generate 15 million-plus jobs annually to avoid widespread joblessness and social unrest. Here is a quick guide to some of the issues:

Just how strong is the Chinese economy right now?

The world has never seen such a sudden and sustained rise of an economy that was so desperately poor just three decades ago. China has averaged 9.6% growth rates for 30 years and is now the fourth-biggest economy in the world—and likely will overtake Germany as No. 3 in the next year or so. It's the third-biggest trading nation: Two-way trade between China and the rest of the world hit $1.76 trillion last year.

China's nearly $1.2 trillion stockpile of foreign currency is the biggest on the planet, a reflection of the mainland's role as the biggest creditor economy and massive capital power. Lured by cheap labor and a white-hot Chinese domestic economy, foreign companies pumped about $60 billion in direct investment last year, and the country's global trade surplus came in at a record $177 billion. "No nation has moved as fast as China in establishing a global footprint," marveled Pakistani Prime Minister Shaukat Aziz at the Boao gathering.

Sounds like party time. Why are Chinese leaders worried?

Lost in all the breathless talk about China's overall economic performance is the cold, hard reality that the country's per capita gross domestic product is only $2,000 per person. There are huge income imbalances between China's big-city and rural provinces, years of rapid development have ravaged the environment, and the pressure to create fresh jobs and provide adequate social welfare policies is awesome in a country that is home to 1.3 billion people, about one-fifth of humanity.

"China remains a developing economy that has a long way to go before it can achieve modernization," says Wu Bangguo, chairman of China's National People's Congress standing committee. A big runup in inflation or an economic bubble that bursts would be absolutely catastrophic for hundreds of millions of Chinese families barely making ends meet—not to mention for Hu and his comrades running the show in China's one-party Communist regime.

Why doesn't Beijing just ratchet up interest rates to cool things off?

China did so in March, when the People's Bank of China increased a key benchmark, the one-year interest rate, by 27 basis points, to 6.39%. The one-year deposit rate was nudged up by the same amount, to 2.79%. It was the third such interest-rate hike in the past 12 months—and one or two more credit tightening moves are likely in 2007.

Yet here's the thing: China needs to slow down investment in factories and public works projects, which drive 40% of overall gross domestic product growth.

Slowing down loan growth helps, but not in a country where all manner of state-owned companies (about 50% of the corporate sector) are enjoying double-digit profit growth and don't have to pay dividends like big publicly traded companies in the West. They are awash in cash and will keep investing into overcrowded sectors like autos, steel, cement, and construction.

China has an enormous pile of savings (the national savings rate is an awesome 50%), and the retained earnings the corporate sector is now generating is a big reason for this. Gang Fan, an economist and president of the Beijing-based National Economic Research Institute, points out that 5% to 10% of the national income the economy generates is now getting socked away by state-owned companies because the government doesn't require a dividend payment, which publicly traded foreign companies have to pay to shareholders. "It's quite a serious problem," he says, regarding the efforts by Beijing to slow things down.

What about throwing some ice water on the export sector by letting the yuan appreciate?

Beijing financial authorities probably could do more in this area, but it is not a magic bullet for two reasons: the weak consuming power of most individual Chinese consumers and the mainland's critical role as a final assembly platform for global companies. One big driver of China's rapidly expanding trade numbers is that ordinary Chinese families aren't spending enough on foreign goods.

True, there is plenty of conspicuous consumption in prosperous coastal cities such as Beijing, Shanghai, and Shenzhen, but there are also 700 million Chinese in the hinterland who don't buy Rolls-Royce Phantom sedans and Gucci handbags. China is reluctant to risk a major slowdown because these folks would get crushed. Beijing needs to keep the economy stoked in high-speed mode until China's vast income gap closes more. "The income disparity is behind the low consumption," figures Yifu Lin, a professor and director of the China Center for Economic Research at Beijing University (see BusinessWeek.com, 4/30/07, "China's Cautious Consumers").

Consider, too, that some of the biggest exporters out of China are actually foreign companies from Taiwan, Japan, the U.S., and Europe. There are some 600,000 overseas-funded companies operating in China. They import goods, assemble them on the mainland with cheap labor, slap on the "Made in China" label, and then ship mobile phones, desktop computers, and sedans to the rest of the world. These products get counted as Chinese exports but are really pieced together with components from around the world.

China can't really order Honda (HMC) or Nokia ( NOK) to export less out of China. And the kind of trade sanctions being contemplated by trade hawks in the U.S. would ultimately hurt foreign corporate interests in China, too. "This is a problem of economic globalization," not just Chinese policies, reckons Yongtu Long, a former Chinese trade negotiator and secretary general of the Boao Forum.

What's the way out of all of this?

Short term, China needs to boost private consumption by shifting tax breaks away from the cash-rich corporate sector and toward Chinese families. A stronger social safety net—more affordable health care and education and secure pensions—would give them more confidence in their futures and get them spending more.

Beijing also needs to crack down on banks and local governments that keep lending and spending, despite the risks to the entire country if the economy overheats. Phased-in liberalization of the yuan, interest rates, and capital flows is another needed reform. This would allow market forces to send price signals to policymakers and executives alike about when to slow down and speed up.

Yet this is going to take many years, if not a decade, to realize. Chinese authorities, naturally enough, are far more concerned about the living standards of their own people than those of the comfortable middle class in the U.S. They probably will do just enough to avert trade sanctions from the U.S. It would take a dramatic currency shift to really improve the trade balance with the U.S.—but that would risk destroying China's fragile social balance. From China's perspective, "it's about hundreds of millions of rural workers," says Chinese economist Fan.

Bremner is Asia Regional Editor for BusinessWeek in Hong Kong.

2006, China Top Six (Fortune 500)

Rank	Global 500 rank	Company	Country	Rev ($ mil)
2	23	Sinopec	China	98,785
5	32	State Grid	China	86,984
7	39	China National Petroleum	China	83,557
38	199	Industrial & Commercial Bank of China	China	29,167
39	202	China Mobile Communications	China	28,778
44	217	China Life Insurance	China	27,389
40	206	Hon Hai Precision Industry	Taiwan	28,350