The value of Chinese exports dropped 2.2% in November, the first year-on-year drop since the 2001 and the biggest since 1999. Since we are only at the beginning of what might be a long recession, there are likely further falls in line. As domestic demand is not picking up the slack, China may be in a precarious position internally.
China has moved millions of citizens to urban manufacturing centers in recent years and given them a taste of hard cash and buying power. If foreign demand keeps dropping, many of these are going to be out of work. The great fear of China's leaders is that they will lose control of domestic order. Having millions of people with no money, no jobs, and time on their hands is a recipe for social unrest, especially if the recession continues or worsens into the Summer of 2009. (Summer heat feeds anger.)
What can the leaders do about it? First, they could attempt to stimulate domestic demand in order to keep people working. This may drain a big chunk of their accumulated cash reserves, but this is a huge pile of cash we're talking about. They also have to be careful in how they encourage local consumption, as other nations will be watching for signs of protectionism and may retaliate, which could drop external demand further.
Second, they could "persuade" businesses, including banks that extend credit to those businesses, to run at a loss until the crisis passes. They have done this recently with oil refiners, who had to pay market prices for crude while being restricted to price limits in selling gas and fuel oil domestically. Businesses, however, will quietly cheat on other fronts, like dropping quality or selling into shortages in the gray market. The former will cause problems with exports, and the latter will fan the flames of consumers as it pushes them into higher prices in the gray market to compensate for shortages.
Third, they could pre-emptively crack down now on any signs of domestic unrest. This actually is a given. The country's cash reserves could easily compensate all the military and police needed to preserve order. This runs the risk, though, of strengthening the military's hand in internal politics, which in turn risks shifting the national priorities away from maximum employment and towards military build-up. In the long run, they may take their eye off the root of the domestic order problem.
Then again, this could all be wishful thinking if the presumed strength of the Chinese economy is what the business world says it is.