EASING INFLATION: A farmers' association in Paris sells 60 tons of fruits and vegetables below retail prices to help combat inflation

The U.S. financial market turmoil, stirred by the meltdown of several major investment banks, has exerted an enormous impact on Chinese markets and directly caused a slowdown in Chinese exports this year. Looking ahead, China's economic growth could be further dragged down by 0.7 of a percentage point by the slackening European economy and the weakening euro, according to Ma Jun, chief economist at Deutsche Bank AG, whose commentary on the subject appeared in a recent edition of the 21st Century Business Herald.

This year, the weakening U.S. economy is the biggest trigger for shrinking Chinese exports. But next year, we believe that the European economic slowdown will become the biggest threat to Chinese exports.

Economists at Deutsche Bank's European branches recently slashed the euro zone's GDP growth for 2009. They expect a 1.2-percent and a 0.1-percent GDP growth in 2008 and 2009, respectively, much lower than their previous forecasts of 1.7 percent and 0.8 percent. They also argue that the exchange rate of the euro against the U.S. dollar will fall to 1.35 or less by the end of 2009.

Therefore, considering the circumstances of a 0.1-percent GDP growth in Europe and the euro's depreciation of about 10 percent versus the renminbi next year, we estimate that China's exports to Europe will fall to zero growth from the current 26-percent growth rate.

The new challenge for China's exports and the investment growth slowdown caused by falling housing prices demand that the Chinese Government readjust its macrocontrol policies, and in particular loosen its monetary and fiscal policies.

We cite several reasons for Deutsche Bank slashing the economic outlook: the shrinking external demand for European products, investment decreases caused by credit constringency, the negative impact on consumption due to high commodity prices, and more bank deposits due to falling property prices.

In the short term, the euro zone might fall into recession in the second and third quarter of this year, and its economic growth might fall on a month-on-month basis. We therefore estimate that the euro will continue to depreciate against the U.S. dollar during the second half of this year. If we assume the U.S. dollar will maintain its exchange rate to the renminbi, then we expect that the euro might depreciate 15 percent against the renminbi from this July to the end of next year.

We attribute the euro's weakening to the following three reasons:

First, the risks of economic recession in the euro zone are accumulating, while inflationary pressure is being relieved. Hence, the European Central Bank (ECB) is likely to start cutting rates as of the first quarter of next year. We estimate that the ECB might cut 100 basic points during 2009. Across the Atlantic Ocean, the U.S. Federal Reserve (Fed) will likely maintain the benchmark rates, but interest rate hikes are possible. As a result, the interest rate difference between the euro zone and the United States will prop up the U.S. dollar.

Second, judging by the economic performances of Europe and the United States, international investment capital will probably favor the latter more, which will boost the dollar's value. When the U.S. recession started early last year, the Fed cut rates to stimulate growth. The United States will pick up growth momentum in 2010. However, when America was cutting rates, Europe kept raising interest rates and was reluctant to lower them. Therefore, the European economy will fall behind the U.S. economy.

Third, the euro is currently overvalued if we take into consideration European economic performance. Our research shows that in the long-term the euro should stand at 1.20 against the U.S. dollar, lower than the current exchange rate.

Exports to Europe

China's exports to Europe might undergo a zero-growth period next year from a 26-percent year-on-year growth this year. Our research shows that two factors will determine China's exports to Europe-Europe's economic growth and euro/renminbi exchange rate.

Each 1-percentage-point slowdown in European economic growth will result in a 7-percentage-point slowdown in China's export growth to Europe. In addition, with each 10-percent appreciation of the renminbi against the euro, China's export growth to Europe will drop 3 percentage points. This also applies to China's exports to Britain.

If we assume the euro zone's GDP growth will drop to 0.1 percent in 2009 from 1.2 percent in 2008; if the euro's exchange rate against the U.S. dollar drops to 1.35 by the end of next year from 1.59 this July; and if the renminbi/U.S. dollar exchange rate remains the same (a very conservative assumption), we estimate that China's export growth to Europe will fall to 6 percent next year from 16 percent growth this year, if goods are calculated in euros.

If goods are calculated in the U.S. dollar, according to the common practice of international trade, China's export growth to Europe will drop to around 1 percent in 2009 from 26 percent this year.

China's GDP growth

The European economic slowdown and weakening euro might lead to a 0.7-percentage-point decrease in China's GDP growth rate.

The euro zone together with Britain absorbs 20 percent of China's exports. We expect that the growth rate of China's overall exports, calculated in the renminbi, will fall 2 percentage points, as a result of economic slowdowns in Europe and Britain.

Moreover, the European economic slowdown might spread to other countries, which in turn will export fewer goods to the euro zone. As a result, those countries also will have less demand for Chinese products. The direct and indirect impacts will lead to an export growth rate drop of 4 percentage points, which will drag down China's GDP growth by 0.7 of a percentage point.

Sluggish international demand and the investment slowdown caused by decreasing home prices are the reasons why the Chinese Government should adjust its fiscal and monetary policies. China might further loosen its stringent monetary policy.

The biggest victims of the growth slowdown of China's exports to Europe are the mainland's electric and textile industries, which are the two major exporters to Europe. In particular, electrical products, including home appliances, office stationery, and telecommunications equipment and spare parts accounted for more than one third of China's exports to Europe last year, while textiles and clothing accounted for 29 percent of the country's total exports to Europe. Obviously, these two industries will suffer the most from a European economic slowdown and the weakening euro.