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China Hits the Brakes. Will Share Prices Slow Down Too?

It was the gasp heard around the world. Chinese Premier Wen Jiabao stunned China-watchers everywhere last Sunday when he declared that he would be lowering China's target growth rate.

With China serving as the locomotive of the world's economy, there could hardly be a more attention-getting statement. Last year China racked up an impressive growth rate of 10.3 percent. Wen's growth target for the coming year? A measly 7 percent!

Why only seven percent? Wouldn't that cause a crash in global commodity prices? And what would happen to countries dependent on Chinese exports?

If you missed Sunday's news flurry, you skipped a lot of needless hysteria. Markets opened Monday morning and commodities did not crash. Key indexes drifted aimlessly. The prospect of a Chinese slowdown had not caused a panic after all.

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In fact, the highly sensitive China ADR Index popped at the beginning of trading in New York, only to ease off slightly. It ended the day with a gain of more than half a percent.

So how do we reconcile Wen's decision to slow the economy with a rise in the markets? Smart traders looked at the details and found a lot to like.

Like Shifting Gears

In the first place, we should take official government targets with a grain of salt. Real GDP growth has exceeded official targets for decades. For the previous five year plan, the official growth target was 7.5 percent. Real growth was 11.1 percent.

Now Wen has put the target for the next five years at only 7 percent. But we know that won't happen either. In fact the last time China had a lowly 7 percent target, real economic growth came in at 9.8 percent over the years between 2001 and 2005 (just as the effects of the Asian financial crisis were wearing off).

So what is the point of setting a target that China will certainly overshoot? Premier Wen is signaling some important changes ahead in the direction of China's future expansion. Bureaucrats and regional governments are getting their marching orders.

With inflation running high and consumer dissatisfaction growing, Beijing has recognized that it must improve the standards of living for millions of Chinese. Instead of diverting billions to expand state-owned industries, China will be cutting taxes and raising wages.

Income taxes for China's poorest citizens will be eliminated entirely. Middle class Chinese will be encouraged to become more of a consumer society. Of course, that's exactly what the U.S. and other westerner trading partners are hoping for. Chronic trade deficits with China may be reduced as the Chinese purchase more abroad, and as they buy more of the goods they make for themselves.

What about commodities? If Wen plans to slow down the breakneck pace of building new steel mills and other heavy industry facilities, what will happen to demand? Not very much.

At the moment, spending on factories is heavy enough to create the risk of a bubble. So shifting China's buying power to consumers is a healthy move. It's a move that won't devastate China's industrial expansion because regional governments will still be striving to expand industry in their own territories. Meanwhile consumers will presumably be buying more finished goods.

Wen has signaled that he is willing to use China's vast foreign reserve stockpile to buy all the goods and commodities China needs to build a better life for the people without passing along inflation. That means China will continue buying cotton, food and fuel on world markets, but store prices may be controlled by Beijing, using a number of monetary tools.

Another major irritant to lower-income Chinese is the housing bubble. Prices for homes have been driven up by a speculative frenzy, leaving many behind, unable to afford the homes they need.

Again, Wen pledged to put the power of Beijing's big government apparatus to work. Speculators will come under even greater pressure in future. Meanwhile, Wen says he plans to build 36 million new "affordable homes" by 2015.

China's boom is not over. It is simply shifting gears.

We can expect demand patterns to shift and trade balances to change. State-owned industries (many of which are traded in New York as ADRs) may come under heavy pressure. Companies that serve consumers may find new opportunities as personal incomes rise.

As "people power" becomes a worldwide political reality, Beijing is pragmatically shifting direction. Instead of unlimited growth, the government has set new targets for itself and for balky regional governments. Citizens are receiving higher priority.

People's living standards, environmental protection and improved efficiency will be the "new evaluation criteria" for local governments according to the official Xinhua news agency.

Stay tuned as more big changes transform the country that has already transformed the global economy. For investors, change means opportunity.

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