Swedbank Asia Analysis No.

13 y 16 March 2011

Europe and Sweden

need a forward-looking China strategy
• The National People’s Congress in Beijing has approved China’s
development strategy for 2011-2015. It will be difficult to reach the goals of
more balanced growth, less income inequality and higher quality in
production within this timeframe, but there is little doubt about the direction.

• China is probably growing faster than the administration would like. The
goal is GDP growth of 8% this year and 7% over the entire five-year period.
Our forecast is for GDP growth of nearly 9% in 2011 and 8.5% in 2012. This
is an upward revision compared with our January forecast due to stronger
growth outside the country. Compared with other analysts, we remain
cautious, not least because the need for austerity is growing due to
persistent inflation problems and imbalances in the real estate sector. It is
also difficult to assess the effects of the catastrophe in Japan, China's most
important trading partner.

• China can pass the US within a few years to become the world's largest
economy in terms of purchasing power parity. This is the result of more
comprehensive pricing data, according to World Penn Tables. In dollar
terms it will take longer, but if China can avoid major setbacks it could
happen in the next decade.

• This analysis argues that the EU and Sweden need a more forward-looking,
holistic China strategy. There is every reason to more closely analyse the
effects of China’s new development strategy and our approach to China in
the years ahead.

Cecilia Hermansson
Contents Page
China’s global importance is growing quickly 2
China means more to Sweden and Europe 3
China has already impacted the world in various ways 4
What does China’s new development strategy mean? 5
Will the development strategy be realised? 7
How will China affect the world going forward? 8
Economic outlook in the short term 9
US- and EU-Sino relations differ 10
Europe and Sweden lack a China strategy 11
What should a China strategy contain? 11

Ekonomiska sekretariatet, Swedbank AB (publ), 105 34 Stockholm, tfn 08-5859 1000

E-post: ek.sekr@swedbank.se Internet: www.swedbank.se Ansvarig utgivare: Cecilia Hermansson, 08-5859 7720.
Magnus Alvesson, 08-5859 3341, Jörgen Kennemar, 08-5859 7730, ISSN 1103-4897
China’s global importance is growing quickly
China’s high rate of growth has been surprising experts since the
late 1970s, when the country opened up to the world. On average
GDP growth is nearly 10% a year. The economy is now twenty
times larger in real terms, and China has become the world's
largest goods exporter, steel producer and auto consumer. It is
also becoming a leader in many other areas.

GDP growth between 1978 and 2009 and average for the period (%)
2750 16
2500 A n n u a l G D P g ro w th (% ) 15
2250 14
2000 13
1750 12
M e a n g ro w th
1500 1 9 7 9 -2 0 0 9 (% ) 11

Percent
1250 10
Index

1000 9
750 8
500 7
250 6
0 5
G D P le v e l
-2 5 0 4
-5 0 0 3
80 85 90 95 00 05
S o u r c e : R e u t e r s E c o W in

Though an economic, political and military superpower, China is China is a superpower

also an unstable dictatorship, and it isn't a full-scale market – but stands apart in
economy, either. The financial market, in particular, has room to several respects
develop and open up. Besides interest and exchange rates, many
prices are set administratively rather than by the market. The state
exerts a huge influence over every level of the business sector.

Within a few years China will become the world's largest economy,
according to the Conference Board. In terms of purchasing power
parity, the US share of global production is expected to fall from
about 18% last year to 15% by 2020, while China's share is rising
from 16% to 24%. This compares with 2% of the global economy
when the country opened up.

The Conference Board, which used the World Penn Tables and
carefully studied pricing data in a larger number of Chinese cities,
predicts that China will pass the US in purchasing power parity
within a couple of years.

Obviously there are risks along the way: overheating and various Growth never follows a
asset bubbles that could burst, political turbulence, etc. But in our smooth curve
main scenario China will continue to grow quickly regardless of the
administration's desire to slow the growth rate.

2 Swedbank Asia Analysis No. 13 • 16 March 2011

Various countries/regions as a share of the global economy
between 2010 and 2020
Share of global output
2010 2020
Advanced economies 49.8 39.4
US 18.3 14.8
EU-15 17.7 13.4
Japan 5.6 4.2
Other advanced econom ies 8.2 7.0
Emerging markets 50.2 60.6
China 16.3 24.1
India 5.3 8.0
Other Asia 5.1 5.7
Latin Am erica 8.0 7.7
Middle East 4.2 4.4
Africa 2.9 3.1
Central adn Eastern Europé 4.1 3.7
Russia and form er Soviet Union 4.4 3.9

Source: The Conference Board with data based on the World Penn Tables (6.3)

According to the International Monetary Fund, IMF, which still uses

older data with less detailed pricing, it will take China longer to
pass the US, i.e., until the second half of the decade. In 2015 the
IMF predicts that China will represent 17% of the global economy,
compared with 13% last year, with the US shrinking to about 18%
from over 20%. When it reviews its data, the IMF will probably
have to account for the World Penn Tables and revise China’s
importance to the global economy upward.

In dollar terms it will take longer for China to become the world's In dollar terms it will
largest economy. Today it is about 40% of the size of the US in take longer for China
dollar terms, according to the IMF. This figure is expected to rise to to pass the US
55% in 2015. This means that it wouldn't be until next decade that
China surpasses the US.

If you study GDP per capita, it will take even longer, i.e., several
decades, to pass other richer nations. But it could happen faster
than we think. Since 1990 alone, GDP per capita increased fivefold.

China means more to Sweden and Europe

The EU is China's most important export market, while China
correspondingly is the third largest for the EU. The EU still exports
more to the US and Switzerland. China is the EU's most important
import market, however, ahead of the US and Russia.

China is Sweden’s tenth largest export market and its ninth largest
import market.

Exports accounted for 3.1% of Sweden’s total exports last year, After the US, China
while imports accounted for 4.1% of total imports. This means that is Sweden’s most
China is now a more important market for Sweden than Japan, important non-
Russia and Poland, for example, and other than the US is the only European export
non-European country among its top ten export markets. While market
imports from China have grown eightfold in value since 1998,
exports to China have tripled.

Swedbank Asia Analysis No. 13 • 16 March 2011 3

Trade between China and Sweden in current prices
900

800
Im p o rts fro m
C h in a
700

600
Index 1998 = 100

500

400
E x p o rts
300 t ill C h in a

200

100 T o ta l
im p o r t s
T o ta l e x p o rts
0
98 99 00 01 02 03 04 05 06 07 08 09 10
S o u r c e : R e u t e r s E c o W in

Relations between the EU/Sweden and China shouldn’t be Relations with China
measured strictly based on trade flows. You also have to consider involve more than just
other factors such as direct investments, which are now going in trade
both directions, as exemplified by Geely’s purchase of Volvo. In
education, students are studying in each other's regions and
research alliances are increasing. Moreover, tourism has grown in
recent years.

China has already impacted the world in

various ways
In recent decades China’s entrance into the global economy has Increased competition
held wages, consumer prices and interest rates in check in the from China has meant
West. Several hundred million Chinese have joined the global lower consumer prices
workforce, which has slowed wage growth, especially for low-cost and interest rates
producers in the West. Other emerging countries have also been
impacted by competition from China. Thanks to cheap exports of
apparel, toys and shoes that have reached the US and Europe,
consumer prices have stayed low. Many other products have been
impacted by price competition. Low inflation has allowed central
banks to cut benchmark rates. Interest rates have also been kept
in check because China has invested its steadily growing currency
reserves in US and European sovereign debt.

At the same time commodity prices have risen substantially as China’s impact on
China has pursued its goal to transition from a low income country commodity markets is
to a middle income country. Infrastructure is in need of huge
improvement, and China has responded by spending at an
accelerating pace. Export industry, for its part, needs raw
materials, including energy and various types of metals. China’s
development has had a significant impact on a number of
commodity prices in recent decades.

China’s growth has also created greater savings imbalances in the Savings imbalances
global economy. Because of its large savings and trade surpluses, between China and the
China's currency reserves have grown substantially at the same US remain a problem
time that the US current account deficit has risen as savings there
have failed to keep pace with consumption and investments. The

4 Swedbank Asia Analysis No. 13 • 16 March 2011

imbalances are now increasing as the US current account deficit
again begins to grow after financial crisis.

US current account balance and China’s currency reserves

4 .0 100

3 .5 0

3 .0 -1 0 0

2 .5 -2 0 0
USD (thousand billions)

2 .0 -3 0 0

USD (billions)
1 .5 -4 0 0
U S c u rre n t a c c o u n t
1 .0 (rh s ) -5 0 0

0 .5 -6 0 0

0 .0 -7 0 0

-0 .5 C h i n a 's c u r r e n c y -8 0 0
r e s e r v e s ( lh s )
-1 .0 -9 0 0
90 92 94 96 98 00 02 04 06 08 10
S o u r c e : R e u t e r s E c o W in

Global stock markets have also risen as new business Every foreign company
opportunities in China have helped many companies to improve isn't making money in
their profits. At the same time not every company that has invested China
in China has seen its earnings improve, due to strong competition
from other foreign companies as well as new Chinese businesses
that have been quick to copy their production methods.

China has become an increasingly important player in the global

economy, from sales to manufacturing and through its participation
in globalised financial and labour markets. Research and
development have been globalised lately as well, with China's
investments adding to the competition and creating new
opportunities.

China’s sovereign wealth funds have focused on funding strategic China has gradually
investments in companies, commodities and unique know-how. moved up the value
Through investments at home and abroad, China's export sector chain
has shifted from low to higher value production, which has meant
that competition for Western countries has increased.

What does China’s new development strategy

mean?
The 12th five-year plan has just been approved by the National
People's Congress in Beijing. It focuses on resolving a number of
fundamental problems in the economy, which requires a new
growth strategy. Back in as 2007 Prime Minister Wen Jiabao said,
“The biggest problem with China’s economy is that the growth is
unstable, unbalanced, uncoordinated, and unsustainable.”

The problems boil down to the fact that China’s economy is

unstable and risks overheating, unbalanced between urban and
rural as well as Eastern and Western China, uncoordinated
between the central and regional level as well as in the sense that

Swedbank Asia Analysis No. 13 • 16 March 2011 5

growth has been led very little by consumption and much more so
by export investments, and, lastly, unsustainable in that income
distribution is askew and the environment is being damaged.

Components in China’s supply balance as a share of GDP

0 .8

0 .7

0 .6
P riv 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 rts
- 0 .1
60 65 70 75 80 85 90 95 00 05
S o u rc e : R e u te rs E c o W in

The key is to achieve more balanced growth by levelling the The goal is to achieve
income gap, stimulating domestic consumption, giving poor more balanced growth
households greater financial stability and improving the social with more quality
welfare system. This means that the growth strategy has to shift
from investments and exports to household consumption. Wages
have to rise and opportunities in rural areas have to improve.

Income distribution based on the so-called Gini coefficient

(0 means total income equality and 1 means total income inequality)

0.45
Mid 1980's
0.40
Mid 2000's
0.35

0.30

0.25

0.20

0.15

0.10

0.05

0.00
China USA India UK Japan Germany Sweden

What is also needed is a greater focus on the environment and

climate, the quality of growth, technological innovations and value-
added production. China has decided to reduce its GDP growth
target to 7% and to continue to open up the country by
implementing reforms.

6 Swedbank Asia Analysis No. 13 • 16 March 2011

Will the development strategy be realised?
In the five-year plan for 2006-2010 the GDP growth target was Central goals aren’t
7.5%, but GDP actually grew by an average of 11.3%. Even always the same as
though the government wants to slow down growth at a central regional goals
level, regional and local power brokers are resisting. GDP is likely
to grow faster than targeted in 2011-2015 as well. It could be
difficult, but not impossible, to reach the goal of 8% in 2011. It is
more likely that growth will be higher this year, which will require
an even bigger slowdown in 2012-2015, when the average is set at
7%.

There has been criticism that the development strategy until now Not easy to transition
has prioritised quantity over quality. The question is how quickly from quantity to quality
the opposite can gain traction, so that China puts more emphasis
on quality in its manufacturing. Raising value-added takes time. A
research budget at 2.2% of GDP until 2015 is one way to achieve
this goal.

Similarly, many are worried about the lack of a common set of Without democracy,
values worthy of the name that isn't based simply on economic what values is Chinese
progress. A big challenge will be to permit greater pluralisation and society being built on?
democratisation at a local level within the current political system.
One goal is to reduce corruption, but this too was set earlier and
won’t be easy to meet. Expropriation of land by local governments
is the main reason for people’s demonstrations and uprisings.

The rapid increase in real estate prices is also a reason for the
increasing gap in wealth and income. The winners are those in the
upper middle class and the rich who were fortunate to build their
wealth early on, while students and recent urban immigrants are
the losers who are having a hard time affording housing.

Change in real estate prices in China’s major cities since year-and 2005 (%)

0 10 20 30 40 50

Beijing

Tianjin

Shenzhen

Hangzhou

Shenyang

Chongqing

Wuhan

Guangzhou

Nanjing

Source: Haver Economics

Swedbank Asia Analysis No. 13 • 16 March 2011 7

Obviously there are major social costs to modernising as quickly The real estate sector
as China is now doing. When local construction contractors and generates large social
power brokers confiscate land – usually without compensating costs when the country
residents – it breeds discontent, which could potentially threaten has to modernise
the current political system. The way to reduce this tension is to
charge property tax to squeeze local powers and reduce the
pressure on them to seek financing by selling land to construction
contractors.

There is plenty of reason to take the development strategy

seriously, but the challenges to achieving more balanced growth Wage increases could
with smaller income gaps and better environmental stewardship raise inflation even
are daunting. One of the biggest issues will be to keep inflation in more
check while wages and prices increase at the same time that
growth has to slow, which is never an easy thing to do. The
direction has now been staked out, but it is likely to take
considerably longer – if it's at all possible in some cases – to meet
the goals of the strategy.

How will China affect the world going forward?

Shifting the development strategy to more consumer led growth Higher prices and
with higher value-added in production could lead to higher prices interest rates in the
and interest rates outside China. This is because wages will have West?
to rise faster, which would mean greater price pressures and more
expensive exports to the rest of the world. As production becomes
more capital intensive (rather than labour intensive), China has to
retain more capital within the country to avoid downward pressure
on interest rates, as has happened in the West.

When wages and prices rise faster in China than the rest of the The yuan will
world, the Chinese currency, the yuan, appreciates in real terms. It appreciate, but mainly
is likely that China to some extent will accept a faster nominal in real terms
appreciation, which would ease inflation pressures, although real
appreciation will be the main focus.

Nominal and real exchange rates and spot prices vs. US dollar
130 8 .7 5
R e a l e f f e c t iv e e x c h a n g e r a t e
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 t iv 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
S o u r c e : R e u t e r s E c o W in

8 Swedbank Asia Analysis No. 13 • 16 March 2011

Competition in knowledge-based economies will increase as a
result of China’s strategy. It will also mean greater opportunities for
multinationals to outsource production to China. Less value-added
products can be moved farther west in China, where wages are
lower than along the coast, and to other emerging countries such
as Vietnam and Bangladesh.

To date China’s consumer and service markets have not been the The consumer and
main reason for trade and investment, but this will change as service markets will
millions of Chinese see their incomes grow in the years ahead. At increase in importance
the same time competition is increasing from domestic companies
that in many cases better understand their customers’ needs.
Adapting products – both goods and services – to customers and
being innovative enough to create new products will be important
to players in the market. Foreign companies could benefit
competitively from their better understanding of environmental
thinking, sustainability and corporate social responsibility (CSR),
all of which are having an increasing impact on demand.

Moreover, China continues to increase its investments abroad, The Chinese business
especially in Africa, where the emphasis is on commodities. The model is difficult to
question is still China’s business model. Often there are factors understand
involved that go beyond the purely economic, whether it is
maximising production, obtaining access to raw materials and land,
obtaining technological and commercial expertise, or securing
access to foreign markets. There is a more even exchange when
China invests abroad, but outsiders can still expect a lack of
openness in the future, which will continue to complicate
relationships between the decentralised, multifaceted private
business sector in the West and more centralised state-run China.

Economic outlook in the short-term

Last year GDP growth fell between the first and the last quarter.
During the first half of 2010 growth was 11.1% on an annual basis
and during the second half it was 9.7%. As a result, GDP growth
was 10.3%, compared with our January estimate of 10.1%.

In January we predicted that China’s GDP growth would slow to Lower growth in the
8.5% in 2011 and 8.1% in 2012. The main reasons for this were rest of the world and
slower growth in the rest of the world and economic austerity austerity measures will
policies in China to reduce the risk of overheating. slow growth compared
with 2010
These arguments still hold, but slightly faster growth in the US is
boosting activity in China as well, which increases the need for
austerity at home but doesn't always have the desired effect on
growth. Faster Chinese growth at the end of last year is pushing
growth higher in 2011, so there is good reason to expect slightly
stronger growth than in the January forecast.

On the other hand, Japan's catastrophic situation will reduce Japan is an important
growth globally for a while, until the recovery eventually leads to trading partner for
higher growth again. Japan is China’s most important trading China
partner, accounting for 13 percent of China's imports last year.
Chinese manufacturers could suffer a setback when input goods
produced in Japan are not available. It could also mean less

Swedbank Asia Analysis No. 13 • 16 March 2011 9

activity in consumer markets when shortages of Japanese capital
goods start to appear. After a while companies will switch to other
suppliers, and the effects will subside.

Leading indicators in China currently point to a slightly calmer Negative real

growth rate. Real interest rates are now negative, which raises interest rates
expectations of higher inflation and increases the risk that asset create imbalances
bubbles in the real estate market will burst. Attempts to mitigate
price increases have not taken hold, so we can expect even tighter
administrative controls in 2011.

Investments have driven growth in recent years, but as the impact The rate of investment
of stimulus measures fades and refinancing costs rise, the rate of is beginning to slow …
investment will decline. The appreciation of the yuan, especially in
real terms, is also making conditions tougher for exporters. In
February a trade deficit was reported. Imports increased by 19.4%
at an annual rate, while exports rose only 2.4%.

The rate of consumption instead increases as wages rise, but at … while the rate of
the same time is held back by higher inflation, which exceeds 4% consumption is rising
according to official statistics but is even higher for ordinary
people, since energy and food have risen even more and account
for larger share of their spending. We expect the real estate sector
to gradually contribute less to growth as authorities try to lessen
the risk of overheating

In summary, we expect China’s GDP to grow by 8.8% this year

and 8.4% next year, which is an upward revision of 0.3 percentage
points for both years.

There is a risk that authorities will not succeed in tightening The risk is that
economic policy, which would raise the prospects of both growth austerity will have
and inflation. For one thing, higher cash requirements and little impact
benchmark interest rates rarely stop state companies from
investing. Secondly, consumption can rise faster when wages
improve. In a scenario where lending rates remain high, bad loans
will increase as well, which would create the need to recapitalise
the banking system in the medium term. The lending rate has
slowed lately, however, but with negative real interest rates there
is risk of another upswing.

US- and EU-Sino relations differ

The relationship between the US and China is often debated,
especially by the U.S. Congress and various think tanks. There is
much less discussion, in contrast, about the relationship between
the EU and China.

After all is said and done the EU is China’s most important export The EU is seen as
market. The region takes a backseat, however, when the rest of a lightweight and
Asia, America and Africa are more important to China's interests. fractured when it
China regards the EU as an economic rather than a political union, comes to foreign policy
which makes it hard to find right spokespeople and access to the
organisation. The EU is split based on national interests and
therefore carries little weight when it comes to foreign policy. It is
easy for China to play EU member states against each other and

10 Swedbank Asia Analysis No. 13 • 16 March 2011

enter into bilateral agreements, which also happens to be in
China’s interest.

The EU has taken a hands-off approach on several fronts.

Although it too is affected, the EU is playing fairly little role in the
discussions on currency policies between the US and China.
Considering the EU's position on the environment, this is an issue
it could pursue more aggressively with China.

There is also the question of how China will be integrated into the
global economy. Will it be with the current world order, with the US
in the driver’s seat, or with a world order more suited to China’s
growing importance? This is also an area where the EU should
have a say.

The EU seems to have its hands full with its own agenda, i.e., the The EU is busy with its
debt crisis in the euro zone, including the competitive disparity internal agenda
between countries, expansion and the Lisbon Strategy. It was only
recently that the EU appointed a foreign policy spokesman in the
person of Catherine Ashton, but it doesn’t seem that she has a
mandate yet to more aggressively address the relationship with
China.

Europe and Sweden lack a China strategy

Europe and Sweden are lacking a China strategy. The last one The EU's China
formulated in 2006. Since then it seems like Europe has turned strategy is five years
inward and lost ground strategically compared with the rest of the old
world. The EU runs the risk of failing to keep pace with China’s
rapid development.

To date the EU and Sweden have focused on aid: transferring

values on human rights, the environment and social development.
These are important areas, but a more comprehensive strategy is
needed based on China’s development going forward and how the
rest of the world is affected according to our reasoning above.

What should a China strategy contain?

A forward looking strategy has to understand China’s new It is important that the
development strategy and how it could affect the rest of the world, strategy is both
including the financial, labour, commodity and product markets. It forward looking and
has to be holistic, based not only on the macro economy but also holistic
other areas such as political science, sociology, psychology,
technology and natural science.

An important question is how China is going to implement the

development strategy it has adopted when it lacks the tools at a
central level to change conditions regionally and at the micro level.
One example is China’s difficulties in relieving the overheated
property market, which should interest the EU considering the risks
to the global economy.

What is happening with China’s activities in Eastern Europe, a What is driving China
market it has shown great interest in? It has also shown increasing to invest in Europe
interest in financing the budget deficits in the PIIGS countries, and Africa?

Swedbank Asia Analysis No. 13 • 16 March 2011 11

 which should help it diversify away from investments in US
treasuries and counteract the euro's depreciation and declines in
the important European export market, but could also have other,
more political effects in the longer term. The EU has tried to work
with China on Africa, but without seriously analysing China’s
motivation and approach.

A more fundamental question is whether the current world order Should the world order
with the US in the driver’s seat has to change as China (as well as be adapted more to
India and other emerging countries) gain ground, and what role China and other
Europe wants to play in its development? emerging countries?

How will the new leadership (probably Xi and Li) that takes over
within a few years change China? When it is the world's largest
economy, not only in purchasing power but also in dollar terms,
which will happen within two decades, will power shift to where the
monetary resources are.

Last year the EU's Commissioner for Industry and

Entrepreneurship, Antonio Tajani, wanted to limit China’s
European investments and reduce opportunities for deals like
Geely’s acquisition of Volvo Cars. There is a risk that the EU could
adopt a more protectionist stance that would hardly benefit Europe.

What we need instead is an analysis of what Europe can do best to

promote trade and investment with China. The key is to understand
the playing field and promote fair competition.

China is investing in European technology, but this could also

result in production being shut down and research and
development moved to China. The strategy therefore has to
include China's knowledge explosion. How can we benefit from the
increased competition from China with regard to research and
development?

Cecilia Hermansson

Ekonomiska sekretariatet
105 34 Stockholm Swedbank AsienAnalys ges ut som en service till våra kunder. Vi tror oss ha använt
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12 Swedbank Asia Analysis No. 13 • 16 March 2011