CHINA: Strong underpinnings mitigate overheating fears

Analysis

First-quarter GDP growth of 9.7% year-on-year shows that the economy continues to expand rapidly, but there are signs that the modest credit tightening initiated by the government in the fourth quarter of last year is beginning to take effect, and will restrain growth in the second half of this year. The first-quarter figure was slightly lower than the 9.9% rate registered in the fourth quarter of 2003. The narrow measure of industrial production, which counts only enterprises above a certain size, was 17.7% -- slightly higher than the figure for 2003 as a whole (17.0%) and the comparable year-earlier period (17.2%). However, the broader measure of total industrial value-added showed growth of 11.6%, compared to 12.5% for the full year 2003.

Solid foundations. The slowdown is likely to be quite gentle as the government continues to reject the notion that the economy as a whole is overheating, arguing instead that a handful of sectors suffer from over-investment. GDP growth for 2004 is likely to be between 9.0% and 9.5%, further fuelling concern of overheating (see CHINA: Growth strategy changes gear - March 8, 2004, and see CHINA: Growth sustainable but revaluation likely - February 6, 2004). While these concerns are valid, it is also important to recognise that the foundations of growth are quite solid:

1. Housing demand. Over-investment in real estate is a serious problem in some parts of China. However, unlike the previous real-estate boom in the mid-1990s, which was built on unrealistic expectations of the need for commercial office space, this boom is driven largely by demand for private housing. With China's cities expected to welcome up to 200 million new residents in the next 20 years, this demand is a sustainable source of growth.
2. Export growth. China recorded a trade deficit of 8.4 billion dollars in the first quarter. This reflected not weakness in exports -- which grew by 34.1% year-on-year -- but strong demand for imports, which grew by 42.3%. Traditionally, China's trade balance is weakest in the first quarter and strongest in the last quarter, so full-year merchandise trade should be in rough balance in 2004. While this means that net exports will not make much direct contribution to GDP, it also means that a relatively high investment rate predicated on export demand will be sustainable.
3. Consumer demand. Retail sales grew by 9.2% year-on-year in the first quarter, in constant-price terms. There has been a steady increase in the rate of retail sales growth since the beginning of 2002, interrupted only by last year's SARS epidemic (see CHINA: Room for cautious optimism on SARS - April 30, 2003). The strength of retail markets is mostly confined to the cities (which account for two-thirds of retail sales), but again the underpinnings of this growth are very strong: rapidly rising incomes are permitting increased expenditure on housing, home furnishings and autos.

Risks. Two significant risks cloud this generally strong outlook:

1. Inflation dangers. Additions to foreign exchange reserves in the first quarter were 36.5 billion dollars -- well below the 64.4 billion added in the fourth quarter of 2003. However, this does not mean that capital inflows are slowing; the difference is mainly the result of the trade cycle. Net of trade and foreign direct investment, capital inflows were 30.8 billion dollars in the first quarter, only slightly lower that the 34.7 billion dollars in the previous quarter, and far higher than the 17.3 billion recorded a year earlier. This means that China continues to draw short-term capital ('speculative' or otherwise) at a very rapid rate, and this inflow, if allowed to pour directly into the domestic money supply, creates inflationary risk.

   

   Zoom

   So far that risk has been neutralised by generally successful sterilisation measures by the People's Bank of China (PBoC). Since last November, consumer price inflation has remained at roughly 3%, and was 3% again in March despite the partial failure of some of the PBoC's sterilisation-bill auctions (see CHINA: Disappointing bond auctions signal RMB limits - March 26, 2004). It is now apparent that the PBoC is targeting consumer-price inflation at 3%. Five percent probably represents the upper level of government inflation tolerance, beyond which it would have no choice but to impose draconian credit controls or raise interest rates, neither of which it wishes to do.

   However, it also has little interest in pushing inflation below 3%: sustained modest price inflation should eventually lessen the upward pressure on the currency. Eventually this inflation should also feed through to higher prices for manufactured goods, which remain in a vicious cycle of overcapacity and falling prices. Meanwhile, the likelihood of a much smaller trade surplus (or even a small deficit) and the prospect of a rise in US interest rates in the second half of the year could mitigate the inflationary impact of capital inflows.

2. Fixed-asset investment. The year-on-year fixed-asset investment growth rate for the first quarter was 43% -- a pace last seen in the bubble year of 1993. Then, over-investment generated double-digit inflation (peaking at nearly 25% in 1994) and was only ended by a severe credit crunch which ultimately -- aided by the 1997-98 East Asian financial crisis -- brought on several years of deflation. This scenario of inflationary boom followed by deflationary bust is repeatable. Loan and money-supply growth remain very high, and overcapacity plagues many manufacturing industries.

However, there are important differences between now and the early 1990s:

• The basic structures of production and demand are far healthier now than then. In the early 1990s, China had no export economy to speak of, but last year it was the world's fourth-largest exporter, behind Germany, the United States and Japan, and exports play a far larger role in China than they do in those economies (the export-to-GDP ratio in the first quarter was 35%).
• In the early 1990s, most real estate investment was wasted. Today, there is built-in high demand for real estate thanks to housing privatisation.
• Overcapacity is a severe problem now, but was far worse in the early 1990s. Additions to inventories accounted for 9.3% of GDP in 1990 and averaged 6.1% of GDP in the 1990-97 period. Inventory build-up accounted for just 0.2% of GDP in 2002, the most recent year for which figures are available.

Outlook. The significance of the 43% investment growth figure is not clear, since beginning in January the basis for calculating this series was changed to include more non-state activity. The National Bureau of Statistics says it has recalculated the year-earlier figures so that growth rates are reliable, but the figures must still be treated cautiously. Trend year-to-date growth figures, released each month, are more important, and so far show a decline (from 53% in January to February to 43% in January to March), but there is not yet enough data to allow a firm conclusion as to whether investment growth is really slowing.