A Fork in the Road for China

China's economic slowdown promises to help push the country's leadership into a tough choice: whether to resume its prerecession push to liberalize the economy or to adopt more-nationalistic policies in an effort to temper mounting domestic political unrest. The implications for the U.S. are significant.

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If party leaders opt for further market-oriented economic reforms, it will mean more opportunities for American exporters and for U.S. corporations that do business in China, says Derek Scissors, an Asia expert at the Heritage Foundation. It also could help spur more domestic demand in China, boosting hiring, income and spending, and, hopefully, leaving the Chinese poised to buy more U.S. products and services.

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But if Beijing moves toward a more China-first posture it will mean sharp increases in subsidies to Chinese exporters and state-owned companies, stiffer regulations and constraints on foreign firms, and increased economic and geopolitical tensions with the U.S. and other major industrial countries. It also could dim prospects for increasing U.S. exports to China over the medium-term.

Christian Murck, a longtime China-watcher now president of the American Chamber of Commerce in China, says Beijing is coming under increased pressure from its major trading partners to take the reformist route -- a step recommended most recently by its own government think tank, the Development Research Center of the State Council, in a report called China 2030, produced jointly with the World Bank.

The U.S., Europe, the International Monetary Fund and World Bank, and some emerging market countries such as Brazil all want China to ease import restrictions on foreign-owned patents and companies, privatize state-owned companies or at least reduce their subsidies, and remove capital controls. All are within the realm of possibility, as are eliminating rationing of credit, allowing foreign companies to float bonds and permitting foreign ownership of domestic banks. The new U.S.-led Trans-Pacific Partnership (TPP) is expected to pressure Beijing to move in that direction.

If Beijing does go that route, however, it's likely to be for its own self-interest. Liberalizing the Chinese economy would be most likely to help the country's fast-emerging middle class and leave the government in a better position to cope with the aging of its population, which is expected to become an increased burden over the next several years.

By most standards, China is still growing at a comfortable pace. But the growth rate is visibly slower than the country has been used to, and it's becoming a worry for China's political leaders. Economists now forecast a growth rate of 7.5% to 7.9% this year, down from the 8% to 8.5% considered likely just a few months ago. By comparison, the country's economy expanded by a robust 9.2% in 2011 and 10.4% in 2010.

The sluggish performance is beginning to have an impact on China's jobs picture. Unemployment rose in June, particularly in exporting industries -- which have been hit hard by slumps in Europe and Asia -- and in Chinese companies that have been hurt by the nation's cooling real estate market.

Although the slowdown is spreading rapidly and lasting longer than expected, the country's leadership has been reluctant to launch a new stimulus package. And China's central bank doesn't want to relax monetary policy for fear of reviving last year's inflation-threatening property price bubble.

Decisions on both the stimulus package and medium-term reform are being stalled by the country's unexpected political turmoil. With scandals sowing uncertainty over China's once-in-a-decade leadership transition, decisionmakers are frozen, raising the odds that the government will seek to export its way out of the slowdown by increasing subsidies and impeding foreign competition. There are growing doubts whether the country's incoming leaders will have enough political power to make real economic reforms.

Despite the hand-wringing in the U.S. about the drag on U.S. growth from China's slowed growth, the slump itself isn't likely to weigh heavily on the recovery here. Although China is one of America's fastest-growing export markets, and U.S. shipments to China have continued to rise during the latest slowdown, the total is still relatively small.

Some U.S. exporters of coal, aircraft, capital goods and heavy earthmoving and mining equipment may find their orders from China falling off a bit if the slowdown worsens. But new orders require so much lead time that cutbacks aren't likely to affect U.S. production levels for months. Few U.S. firms rely on China for much of their growth."Europe is still a bigger worry for us," says Heritage's Scissors.