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China's economy: now the bad news

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In Brief

China’s real GDP growth moderated to 6.1 per cent in the first quarter this year from 6.8 per cent in the fourth quarter last year. But this was much better than market expectations.

Seasonally-adjusted quarter-on-quarter comparison suggests that the Chinese economy has already been experiencing a V-shaped recovery. In terms of headline economic growth, the worst is probably over.

Even March’s economic data, compared with those of the January-February period, showed clear evidence of improvement. The Purchasing Managers’ Index (PMI) for the manufacturing sector returned to 52.4 in March, a level above 50 implying expansion of economic activities. Growth of industrial value-added picked up from 3.8 per cent in January-February to 8.3 per cent in March. The decline in power generation eased from -3.2 per cent to -0.7 per cent.


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Urban fixed-asset investment growth accelerated from 26.5 per cent to 30.3 per cent, despite continuous decline in fixed-asset investment price index. The sudden investment boom was obviously the result of aggressive stimulus policies. The growth in retail sales value moderated from 15.1 per cent to 14.7 per cent. The negative price index, however, suggests a faster growth of retail sales volume in March.

Sales of big-ticket items also started to improve significantly. Both auto sales and housing sales rebounded sharply during the past months. Growth of residential investment also accelerated from 1 per cent during the first two months of this year to 7.3 per cent in March. All these contributed to a new boom of the construction sector and recovery of steel consumption.

Recent developments supported my earlier forecast of 8 per cent growth of the Chinese economy in 2009. As I have laid out before, there are two major factors underpinning my relatively optimistic views. First, production slowdown during the past months probably overstated moderation of underlying demand due to drastic adjustment of inventories, especially in resource-related sectors. But once this adjustment is over, probably toward the end of the first quarter, then production activities are likely to reaccelerate sharply.

Second, despite the fact that China has been implementing market-oriented reforms for thirty years, the authorities’ ability to mobilize resources in order to support growth has not been weaken. On the contrary, it has been strengthened.

It’s unfortunate that most outside China watchers had been skeptical about the government’s ability to achieve 8 per cent growth. Hopefully, the latest data should help settle this growth debate once and for all. Although some would argue that it is too early to conclude that the Chinese economy is already on the way up, most financial industry economists are likely to lift their growth forecasts in the coming months.

A widespread upward revision of growth forecasts may help improve capital market investors’ confidence in Chinese growth. While many China watchers were probably too pessimistic in the past, it is also important to avoid excessive optimism going forward. My assessment of China’s economic conditions in 2009 has always been ‘a soft landing in headline growth and a hard landing in corporate earnings’. While GDP growth may maintain its upward trend, it is mainly a result of Government policy. Such change in the economy is very different from the upswing during a normal economic cycle.

At least during the coming quarters, adverse changes in a number of areas deserve close attention. First, as long as there is no bottoming of the global economy, it is difficult to imagine a real recovery for the Chinese economy. Recently, the U.S. economy has shown initial signs of late recession cycle, including bottoming of housing investment, advanced inventory adjustment and firming corporate surveys. But it remains extremely risky to call for recovery of the U.S. economy. The Japanese and European economies appear to be even weaker. These suggest significant uncertainties about Chinese export recovery. Without strong exports, growth will have to continue to depend upon stimulation policies.

Second, China’s fiscal stimulus has just started and will likely play a greater role in supporting economic growth in the coming quarter. During the past quarter the most important policy was monetary policy or credit expansion. The amount of newly extended loans during the first three months of this year almost equaled that of last year. Such extraordinary expansion underscores the government’s ability to boost economic activities but also points to significant risks going forward, especially for the banking sector.

The China Banking Regulatory Commission already decided to more ‘scientifically manage’ credit policy in the coming months, which probably means slowing loan growth. Whether or not the authorities introduce more ‘scientific management’, the economy faces even more uncertainty.

Third, the key macroeconomic problem, deflation, is likely to exacerbate. Many economists worry about a potential inflation problem following recent dramatic expansion of monetary base at home and abroad. In a way, they are right, because according to the money theory, the greater the money supply, the greater the inflation pressure. The trick is that not all the increased liquidity is circulating actively. More importantly, the output gap is going to rise, which points to deflation, not inflation, in the near term. The most obvious example is the export sector. A collapse in exports implies a significant overcapacity problem in the export sector. And rising overcapacity should push down prices.

Finally, the government is able to support headline growth, but it won’t be able to support full employment. Simple mathematics exercises would confirm that job creation by new infrastructure spending is probably not sufficient to offset job losses in the manufacturing sector. The actual unemployment rate could rise steadily in the coming year. And high unemployment is bad news for consumption and social stability.

To conclude, although the growth numbers have turned for the better, the deterioration of the microeconomic picture is only just beginning. For policymakers, the biggest challenge is social instability, as a result of rising unemployment. And for investors, the biggest challenge is deteriorating corporate earnings. Although recovery of the economic growth brought about investment opportunities in certain industries, it is far too early to call this a major turning point in capital markets.

The author will be a speaker at the China Update (at ANU) again this year for which registration has just opened.

3 responses to “China’s economy: now the bad news”

  1. Yiping’s article attempts to demonstrate that 8% growth of the Chinese economy this year, though seeming a bit on the optimistic side to many, is more likely achievable than not. If it does as hoped, it will be good for the recovery of the global economy in general and a blessing to the Australian economy in particular given China is Australia’s top trading partner and has underpinned the mining boom of the more recent years.
    A point in the article touches the likely trend of price levels. The author argued that the key macroeconomic problem, deflation, is likely to exacerbate, contrary to many economists concerns about a potential inflation problem as a result of recent dramatic expansion of monetary base. It argues that the pessimistic view of the inflation issue would be right if the normal money supply mechanism works as usual, but it isn’t at the moment – though the quantity of money base increased, the speed of its circulation declined. So a different equation is at work now. He also argues that the rising output gap will have a downward pressure on price.
    This, however, raises an important issue in managing the price level in the coming months and perhaps a couple of years. While the slowing in the speed of money circulation now may work may relieve the authority from worrying about inflation for now, the pressure is likely to be greater if and when the speed of circulation picks up and returns to its normal course sometime in the future. The difficult to predict the precise timing and its exact course will increase the pressure for the authority to do a finer job in fine-tuning monetary policy, especially given the unprecedented nature of the scale of global including China’s monetary expansion. A truly difficult and real test, but perhaps not necessarily impossible to overcome. Let’s hope so.

  2. I agree completely that the future monetary policy decisions are likely to be extremely difficult, both for the Fed in the US and the PBOC in China. My main point is that criticising the Fed or PBOC for the very loose monetary conditions in dealing with the crisis/recession risks is misplaced or at least wrong-timed. Their top priority is to end crisis and avoid deeper recession. The central banks will not be doing their jobs if they don’t take any actions now simply because there could be future inflation risks. Inflation risks are for tomorrow, while crisis/recession risks are for today.

    In way, the inflation risks might be a good worry to have, because those risks could only emerge after the crisis/recession risks abate significantly.

    Even after the crisis risks die down significantly, I am so sure if inflation will be the main challenge the world will face. Central banks often make all sorts of mistakes, but most reputable central banks normally would not repeat their recent mistakes. I believe that the central banks worldwide will also be highly alert about future inflation problems. So once signs of inflation emerge, the key risk might be for the central banks to tighten too quickly and too aggressively in order to avoid high inflation problem. But that could hurt the recovery momentum prematurely. I think this risk is actually higher than the inflation risk.

    It is always difficult to predict policies and their consequences, let alone during crisis times. So I agree completely that the future path of policy and inflation deserve close monitoring.

  3. In my judgment, China will be able to achieve just 6 per cent growth by the end of 09 due to various factors – and even this growth will not be stable as such due to factors like rising social unrest, unemployment, and also rising income inequalities in different segments of the economy.
    Due to melting of Himalian glaciers, water in the yellow river is just 10 per cent compared to 30 years back; food crisis also looming on the horizon due to reduced irrigation due to rising industrial pollution in the economy, 40 per cent of ground-water is not suitable for humans nor for fish.
    Recent estimats tell us that about 75 lakh people die due to growing industrial pollution; deaths due to coal mining, newly born babies also getting sick more, and more.
    In view of the above disturbing factors, growth rae of 9 per cent is not possible indeed

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