China’s economy is heating up – fast. Warning bells rang loudly in April, when the economy hit 11.1% growth year-on-year – more than most had expected – and inflation, at 3.3%, breached the central bank’s target for the year.
Markets, still edgy after March’s rout (triggered then by fears of a Chinese crash), spun briefly into turmoil. This time, it was on fears of the likely impact of further monetary tightening, especially on the profit positions of China’s domestic banks and bloated enterprises. (For a detailed look at the banking sector in China see Managing China's credit deluge)
The recent upsurge prompted premier Wen Jiabao to stress that the government will take steps to curb lending and investment and rein in the record trade surplus. “We need to prevent the economy from shifting from relatively fast growth to a state of overheating, and to prevent big ups and downs,” Wen said.
China has grown consistently by more than 10% for the past four years, and many economists now say full-year growth this year of more than 10% is fairly certain, despite many projections last year of moderation.
“China’s economy is not landing,” says Stephen Green, senior economist at Standard Chartered in Hong Kong. “It has refuelled mid flight and is flying higher again.” The danger is that China allows the economy to move too rapidly for too long and, in the absence of effective, market-based policy instruments, is then forced to slam on the brakes – and a hard landing ensues.
For some, the risks of breakneck growth are inevitable, given China’s economic constraints. “The idea that they’re going to have stable growth at 10% is just nonsense,” former IMF chief economist Ken Rogoff tells Emerging Markets. “China, for all its successes and achievements, is still very much an emerging market.” He adds: “China is going to have its accidents.”
No hard landing
China’s central bank governor Zhou Xiaochuan is confident China can avoid a hard landing. In a wide-ranging interview with Emerging Markets in late March, the central banker argued that there is a “high probability that we can avoid [a hard landing].” His comments came on the same day that China raised interest rates for the third time in 11 months – a move that underscored Zhou’s priority to curb inflation and the boom/bust cycle in asset prices.
The People’s Bank raised interest rates, he said, “to give a very clear signal that the central bank will fight inflation.” The authorities will “not tolerate” a further uptick in consumer prices, he added.
Their recent rise in inflation, however, is not indicative of “a medium-term trend of rising inflation.” The main explanation for the anomalous rise, says Zhou, is food prices. “In recent years, Chinese inflation has been relatively low, but in the last 4 months CPI has started to rise.”
In March, the People’s Bank raised a key benchmark, the one-year interest rate, by 27 basis points, to 6.39%. At the time, Zhou would not say whether another interest rate rise would be necessary this year, though most analysts believe one or two more tightening moves are now likely in 2007.
“China is clearly not overheating,” says Jonathan Anderson, chief economist at UBS Asia. “We’ve already seen signs that the government has mopped up liquidity. We should be back on track by the second quarter.” Anderson does not believe there will be a “serious jump” in interest rates or a crackdown on credit this year.
Cooling off
The critical question remains whether the central government can actually rein in the parts of the economy that it believes are overheating, without causing broader economic damage. Investment – in everything from factories, real estate and infrastructure – remains the primary motor of domestic demand, driven by a mixture of retained earnings by firms and bank loans. (For a detailed look at the growing popularity of asset management funds in China see Chinese retail investors: the next frontier) Fixed asset investment in core economic sectors has been rising at an annual rate of 25-30%. The recent monetary tightening measures have yet to slow investment. Calls to cool lending have not stopped factories and plants proliferating.
Xu Xiaonian, professor of economics and finance at China Europe International Business School, puts it bluntly: “The danger of investment-driven growth is well known. If you continue to increase the input of capital to support economic growth, the law of diminishing returns will eventually take effect,” he says. “When that happens, the miracle will start falling apart.”
But rate rises are unlikely to impact much on state enterprises and local government investment behaviour. Attempts to slow down loan growth have so far been unsuccessful. In all likelihood, further administrative measures, such as public-sector investment cutbacks and tighter management of bank credit, are forthcoming.
Currency
Zhou does not rule out a further appreciation of the yuan, but maintains that exchange rate flexibility will depend on the economy’s ability to tolerate the effect. “When we observe that the Chinese economy can absorb the impact of exchange rate flexibility, then we will enlarge it,” he says. “The major policy consideration is that, along with enlarging [exchange rate] flexibility, we are going to be more dependent on the supply/ demand relationship.”
The yuan has risen 5% since it was revalued by 2.1% against the dollar in July 2005 and untied from a dollar peg to float within managed bands. Economist Barry Eichengreen tells Emerging Markets that a more flexible exchange rate regime is critical for balancing China’s growth, but says that “there’s a willingness to acknowledge the importance of this agenda but an unwillingness to act on it.” Many observers expect some appreciation of the yuan this year, with UBS’s Anderson predicting a 6.7% rise.
Lawmakers in Washington, meanwhile, continue to pile pressure on China, arguing that the yuan is kept weak to make exports cheap. In April, the US filed World Trade Organization complaints against China, and US treasury secretary Hank Paulson continues to urge China to let the yuan strengthen. “The [Chinese] are moving quickly, but they are not moving, in my judgement, quickly enough,” Paulson said in a recent speech.
Boosting consumption
The more pressing issue, says Zhou, is whether or not China can successfully boost domestic consumption, to rebalance spending patterns in the Chinese economy and, hopefully, achieve more balanced growth. “China is not very experienced in this regard,” Zhou admits, pointing out that for years, public and production sectors have “done their job in line with the supply side, rather than the demand side”.
Beijing is acutely aware that domestic consumption will be a more reliable and safer driver for the economy. Increased consumption could translate into greater purchases of imports, which could start to have an impact on the politically very sensitive trade deficit between the US and China.
Ironically, says Zhou, the threat of protectionism, especially from the US, only redoubles Beijing’s efforts to “accelerate the domestic adjustment to stimulate domestic demand”. “It’s our consideration to go further and adjust structural policy to encourage consumption, to encourage the service sector and to encourage imports,” he says.
Zhou emphasizes the government’s policy to boost the service sector, which represents “very large potential demand” for wholesale consumption. There is “great room” in the service sector, he points out.
Constraints
But Chinese policy-makers are hemmed in, too, by other domestic considerations, chief among them the need to keep the urban job engine going. China is also reluctant to risk a major slowdown because its rural poor – the bulk of its 1.3 billion population – would suffer; Beijing needs to keep the economy in high gear until it closes China’s vast income gap, which has been rising between urban and rural areas. Rural per capita incomes are one-third of urban incomes.
The problem is that a big run-up in inflation or an economic bubble that bursts would be catastrophic for hundreds of millions. “Aside from ensuring financial stability, a lot of [the risk] has to do with the political system,” says Rogoff. “Maintaining political – and social – stability is still a huge challenge.”
How China will fare is still an open question. Even Zhou admits that, despite the government’s tireless reform efforts, risk is ever present. “The world economy, the domestic economy, it’s not always so certain,” he muses. “We have to deal with uncertainty in this world.”