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China's Economy

Published October 2006

As the third quarter drew to a close, analysts were predicting that the PRC economy would slow slightly through the end of the year and into 2007 compared to the blistering pace in the first half. The consensus estimate among economists is a 2006 year-end GDP growth figure of more than 10 percent, in contrast to the 11 percent first-half growth rate. The most important development in the third quarter appears to have been a slowdown in the pace of investment growth, thanks to old-fashioned direct, administrative controls on lending rather than indirect levers such as interest rates. Heading into 2007, economists are predicting a continuation of strong GDP growth -around 10 percent--with some impact on the export sector from a possible US economic slowdown and likely slowdown among EU trading partners.

Economy in Review

GDP growth through September slowed to 10.7 percent thanks in part to slower fixed-asset investment growth, which was 27.3 percent year on year through September. In the first half, fixed-asset investment growth of nearly 30 percent helped to drive GDP growth above 11 percent through June. Retail sales growth was 13.5 percent through September and inflation, as measured by the consumer price index, has been modest, at 1.3 percent for the January-September period. Utilized foreign direct investment growth has been falling in 2006. Between January and September, FDI was down 1.5 percent over the year-earlier period, to $42.6 billion.

Exports have continued to expand rapidly, up 26.5 percent in the January-September period over the same period in 2005. Imports rose 21.7 percent during the nine months through September. This lag in import growth has translated into a record global trade surplus of $110 billion through September. Though the preliminary September figure for foreign exchange (forex) reserves was $987.9 billion, most economists estimate that reserves are already past the $1 trillion mark--bolstering the case for faster renminbi appreciation (see below). Money supply (M2) growth slowed to 16.8 percent in September, according to preliminary reports, compared to 17.9 percent year on year in August--a sign of success for government tightening efforts.

Administrative Tightening Finally Slows Investment Growth

Investment growth appears finally to be responding to government directives, though Jun Ma, chief economist for Greater China at Deutsche Bank Hong Kong, says there is evidence that local officials may now be exaggerating the slowdown's magnitude in response to government pressure. Government efforts to stem bank lending have included two increases of reserve requirements a month apart over the summer. Analysts expect another increase in November. Reserve requirement increases primarily affect smaller banks, which may account for much of the lending the government wants to curtail.

Persistent low real interest rates have contributed to the fixed-asset investment surge, which has been fueled by retained earnings of Chinese enterprises. Companies would rather invest in new projects than keep their funds in the banks, where real interest rates are negative after taxes. Interest rates on deposits and loans were raised by 27 basis points in August after a similar increase of lending rates in April. Still, most economists agree that without interest-rate liberalization (or at least significantly higher deposit rates) rate hikes are mainly symbolic of central government wishes rather than incentives to change behavior.

The government implemented another round of administrative controls over the summer that appear to have been more effective than efforts earlier in the year. These include another reduction of the export tax rebate on steel and textiles, among other products, and new policies to curtail out-of-control land sales. The measures to stop runaway property investment have appeared particularly effective. The central government reportedly set up nine regional land sale offices staffed by central government officials. (Property revenue apparently has fallen outside of local budgets, and the central government reportedly intends for the new offices to change that.) The government has also enacted measures to rein in foreign investment in property. According to Jun Ma, illegal property sales have been the main drivers of the high fixed-asset investment growth numbers. The recent high-profile corruption case in Shanghai that led to the ousting of Chen Liangyu from the Chinese Communist Party Politburo reportedly involved the illegal diversion of pension funds into property investments.

The RMB Finally Starts to Rise

Of course, looming over any discussion of China's economy is the value of the renminbi (RMB). Some of the capital inflow driving up forex reserves and the money supply has been due to expectations of RMB appreciation, in addition to the trade-related inflows that most analysts say account for the bulk of the upward pressure. In late September, following US Treasury Secretary Henry Paulson's trip to China, the RMB rose against the US dollar at a slightly faster rate than it had since China revalued the RMB by 2.1 percent in July 2005 and linked the exchange rate to a basket of currencies. It had risen to 7.92 to the dollar in mid-October.

The economic case for another revaluation, or a more rapid appreciation, has grown stronger through 2006 as forex reserves and the trade surplus have continued to rise. Money supply growth until recently exceeded official targets, despite the People's Bank of China's (PBOC) stepped-up issuance of central bank bills and the government's efforts to allow more domestic holding of foreign currency. Press reports have indicated that PBOC supports appreciation, but PRC Minister of Commerce Bo Xilai complained publicly over the summer about the pain the appreciation had already inflicted on textile and other exporters to date, indicating differences within the government on the issue.

Though it is unclear exactly how China's basket exchange rate mechanism works, the recent exchange rate appreciation is likely due mainly to the government's allowing the rate to move more widely within the current band of 0.3 percent above or below the previous day's closing rate. Economists nevertheless predict that this slightly faster--still gradual--appreciation will continue, to 7.8 to the dollar, through the end of the year. The question remains whether this roughly 3 percent appreciation will be enough to quiet US critics of China's currency policy and slow China's growing trade surplus and capital inflows.

Government Priorities: Income Inequality and the Environment

Government calls for a "harmonious society" and for improvements in the environment have strengthened heading into the winter, as the Communist Party steps up preparations for the fall 2007 party congress. The economy may be indirectly affected by these initiatives, particularly at the micro level. China is on track to finalize the new Labor Contract Law, for example, which adds protections for workers and could translate into higher wage rates, particularly for lower-skilled positions. Increasing concerns about the quality (and quantity) of the water supply, among other aspects of the environment, may also raise costs, particularly for operations that generate wastewater.

On the macro level, however, most economists have concluded that the Chinese economy is not excessively overheated and that PRC leaders are content with the relatively rapid growth of the economy now that property investment appears to be better under control. Economists disagree about the extent to which a US economic slowdown will affect China, though most agree that a full-blown recession in the United States (which appears unlikely) would have a noticeable impact. Energy prices and, in the longer term, internal instability are other factors that economists say could have an impact on the macroeconomy.