Flanked by a larger-than-life statue of Julius Caesar on horseback, the seven-story faux-Roman sauna and massage parlor garishly lights up the Shanghai night. Ushering a small group of customers to one of the empty sofas scattered through the lobby, a greeter clad in a red qipao admits the global financial crisis has not left saunas untouched.
"We’ve seen some effects," said the greeter, who declined to give her name. "So far, it’s been limited. Service professions haven’t been as affected as much, but it’s worse outside Shanghai."
It seems nothing is safe from the crisis. As overseas demand faltered, China’s GDP growth slowed to 9% in the third quarter, from 10.1% in the second quarter. The purchasing managers’ index (PMI), an indicator of manufacturing activity, fell to an all-time low of 38.8 in November. Exports fell 2.2% the same month, the first contraction in seven years.
Big problem, big response
The government’s reaction indicates that it is well aware of the scope of the problem: At a Politburo meeting held at the end of November, President Hu Jintao went as far as warning that the economic downturn is a test of the Communist Party’s capacity to govern.
Earlier, on November 9, Beijing had unveiled its US$586 billion stimulus package. Details have been slow to emerge, but the consensus is that the package will provide short-term economic respite.
"The macro issue is: Can the government provide enough stimulus? The issue then is: enough for what?" said David Dollar, country director for China and Mongolia at the World Bank.
Dollar’s second question points to an issue of rising concern about the stimulus package’s long-term implications. In attempting to keep 2009 GDP growth at or above 8% – which is widely touted, though not universally accepted, as the minimum growth level necessary to absorb new labor into the workforce – Beijing may risk sacrificing more balanced, long-term growth for a short-term fix.
China employed fiscal spending to carry it through slowdowns in 1997-1998 and 2001-2002. Roughly equivalent to 15% of GDP, the current stimulus program is considerably bigger than programs that have come before it.
Futher differences are apparent in its structure. While the National Development and Reform Commission (NDRC) has said infrastructure will get much of the money, the plan also includes spending on social programs like health and education, noted the World Bank’s Dollar.
Despite the package’s strengths, however, there are limits to the government’s ability to support the economy. Differing expectations of the private sector response to the package have given rise to a wide range of forecasts for the next year.
"The key will be stimulating additional private activity," said Logan Wright, an analyst with economics research firm Stone & McCarthy in Beijing.
That is nothing new. Andy Rothman, China macro strategist with CLSA, notes that even during heavy fiscal spending in 1998, government spending peaked at 7% of total fixed-asset investment.
Filling a hole
The need for private money today is illustrated clearly in quake-hit Sichuan province. The NDRC has pledged US$145 billion for reconstruction but Wei Hong, Sichuan’s executive vice governor, estimates this is US$98 billion short of the province’s required total. He hopes the hole can be filled by private investors.
Some companies are heeding the call. South West China Cement, which recently closed US$40 million in financing from Merrill Lynch and Lunar Capital, a private equity fund, is using the money to rebuild facilities destroyed in the quake and invest in new production lines.
Cement produced by the plants will be used in hydropower and other infrastructure projects, providing some of the estimated 370 million tons of cement needed for rebuilding.
"Reconstruction needs both government funding and private investment to complete," said Michael Ng, partner at Lunar Capital and director of South West China Cement. "The private investment environment in Sichuan will still be very strong because of reconstruction plus the government stimulus package."
Evidence, however, suggests South West China Cement is in a minority. In an uncertain economic climate, investors are keeping their money to themselves. A falling PMI is just one sign of skittishness: Foreign direct investment dropped more than 36% in November from the previous year, and a recent Duke University-CFO Magazine survey of domestic CFOs showed firms plan to cut capital expenditure by an average of 4% this year.
"Obviously, the corporate sector is a little bit reluctant. A lot of the investment in infrastructure will be financed by local governments," said Glenn Maguire, chief Asia-Pacific economist at Société Générale in Hong Kong.
Obstacle to reform
A funding gap is only part of the problem. Even if private investors can be convinced to put money into projects, this investment may delay, rather than eliminate, problems, as the government abandons some attempts at structural reform.
"In the next year, 8% or even 9% [GDP growth] is possible," said Zhang Jun, director of the China Center for Economic Studies at Fudan University. "I don’t worry about this. Why I worry is that China has structural problems. [The government] needs to tackle those first … but now they’ve had to give up."
The concern is that by placing an emphasis on investment-led growth, China risks maintaining an unsustainable model of growth. Exports have long been a foundation for economic development, but Beijing has repeatedly expressed its desire to shift the balance toward domestic consumption, a more reliable long-term driver. Recent increases in tax rebates on a range of exports, however, have sparked fears that Beijing will once again fall back on exports to weather the storm.
"It’s impossible for China’s exports to grow at 10% and above," says the World Bank’s Dollar. "For a long stretch, China’s exports have been growing at more than 20% per year. That’s been great, but it just can’t continue now that China’s such a big player in the world market."
As overseas demand has fallen, the importance of stimulating domestic consumption has become ever more apparent. According to Société Générale’s Maguire, Beijing is well aware of this. He sees plenty of scope within the stimulus package for supporting income formation and paying higher prices for agricultural commodities. Even some infrastructure projects, such as passenger rail, can potentially drive consumption.
The ongoing construction of a social safety net, through investment in areas such as health care and pensions could also help to convince Chinese to save less and consume more.
Furthermore, at the close of the annual Central Economic Work Conference on December 10, leaders issued a statement calling for expansion of domestic demand and strengthening of areas of the economy not specifically tied to exports.
Predicting the future
These are encouraging signs, but it will be some time before the effectiveness of both government statements and stimulus become effective.
"We’re looking at bad data pretty much baked into the cake for Q4  and Q1 of this year," said Wright at Stone & McCarthy. "There’s a lot to watch … it’s very difficult to forecast."
Even more difficult to forecast is the effect the stimulus package and short-term changes in government priorities will have beyond 2009. But despite the difficulties, it is too early to discount Beijing’s ability to meet them, said Lu Ting, an economist with Merrill Lynch.
"Many people have underestimated China’s resolve and capability. That will be a mistake," he said.