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Why the Fed has a wary eye on China's economy

Uncertainty about the global economy is making the Federal Reserve more cautious about raising U.S. interest rates. That was Fed Chair Janet Yellen's message in a speech to the Economic Club of New York last week. This uncertainty is reflected in the Fed's dialed-back forecast for rate increases this year. In December, the central bank signaled that rates would go up by 1 percent over the course of the year, but that projection dropped to a half-percent at the Fed's most recent meeting.

And when the topic is the health of the global economy, the discussion is largely about the performance of the Chinese economy. From 2002 through 2011, China's average growth rate was a remarkable 10.6 percent, according to International Monetary Fund data. But that has fallen steadily to 6.8 percent in 2015, and it's projected to slide further to 6 percent by 2017 then level off in subsequent years.

But this forecast itself has quite a bit of uncertainty. China faces several challenges that it must overcome to avoid an even lower growth rate -- and perhaps a "crash landing."

The country has experienced a loss of business competitiveness due primarily to rising labor costs and a heavy tax burden. Many sectors are also suffering from excess capacity due to government-directed overinvestment in manufacturing. A related concern is the quality of bank holdings of financial assets used to fund these investments.

Among the other problems are fiscal issues due to an imbalance between government spending and tax revenue, transitioning from an investment-led economy to one more dependent on domestic consumption and finding a way to provide sufficient liquidity to ensure this economic transition goes smoothly without exacerbating its bank asset problem. Finally, there's the problem of slow growth in the world economy, which is reducing demand for China's exports.

However, there's also reason for optimism. Although China's manufacturing sector has shown signs of weakness and growth has slowed, the service sector has expanded considerably and taken up the slack, and further growth is expected. This is a good sign for China's ability to transition to a "new normal." In addition, growth in the primary sector -- agriculture, fishing and mining -- has been stable and should remain so in the future.

Also, and this is key, the government recognizes the challenges China faces and seems prepared to do what's needed to overcome the country's problems. For example, it has proposed a "One Belt-One Road" initiative to develop emerging economies in the region that can provide a new market for its exports.

Plus, if the proposals for financial liberalization and fiscal and labor market reforms can be successfully implemented, improved resource allocation could provide a much-needed boost to productivity and growth.

Furthermore, China's development has been uneven. The coastal area has been growing rapidly in the past 35 years, but the interior region has lagged. As government policy begins to focus on interior development, growth in the less-developed regions should accelerate and help boost China's overall growth rate. The country has set the stage for this development with its investment in high-speed rail, airports and highways already built in the past few years.

Still, while the potential for continued robust Chinese growth exists, execution of the necessary government policies is another matter. It remains to be seen how successful Beijing will be in managing the many challenges it faces. For this reason, the Fed is right to be cautious about the uncertain global economy and about prematurely raising its target interest rate.

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