USCBC Analysis: China's Economy

First Half, 2004

China's economy logged 9.6 percent growth in the second quarter of 2004, down from the first quarter's 9.8 percent and the 9.9 percent growth in last year's fourth quarter. Although the GDP figures were clouded by an upward revision of the 2003 base numbers, other statistics confirm that China's controlled economic stabilization is unquestionably under way. Money supply growth has fallen to its lowest point in two years, and both investment and industrial production are declining from early 2004 peaks.

The PRC government first struck at credit with higher reserve requirements at the end of 2003. When fixed-asset investment failed to shrink quickly enough, Beijing increasingly turned to administrative fiat. After privately instructing banks in late April temporarily to stop lending, the central government raised the reserve rates a second time and selectively banned projects in overheated sectors. As a result, growth in fixed-asset investment and industrial output slowed markedly over the second quarter, although domestic consumption and exports continued to grow.

The consensus view is that China's economy will continue to slow in the second half of 2004 and into 2005. Both Premier Wen Jiabao and central bank Governor Zhou Xiaochuan have indicated strong political support at the central level for maintaining cooling measures, though they are encountering resistance at the local levels, especially in the more developed coastal regions. Zhou and other central bank officials will certainly continue to watch inflation rates, which, pushed by rising grain prices, now exceed 5 percent. But interest rate hikes seem unlikely as long as inflation remains confined to food and fuel and the current tightening policy continues to be effective. Current forecasts project roughly 9 percent GDP growth and 4 percent inflation for 2004, and 8 percent GDP growth for 2005.

Investment and Output

Fixed-asset investment growth dropped from 43 percent year-on-year in the first quarter to 22.3 percent in the second. The dip in investment has hit the real-estate sector, which accounted for 32.5 percent of fixed-assset investment in the first half of 2004, and indirectly, producers of machinery and construction materials. (According to Hongkong and Shanghai Banking Corp., every RMB 100 of fixed-asset investment creates RMB 33.5 in demand for machinery, RMB 20.5 for building materials, and RMB 5 each for services, energy, and transportation.) Industrial production growth stood at 15.9 percent in August and has declined steadily from a peak of 23.2 percent in February. Annualized growth in the production of cars and cement dropped from 37 percent and 24 percent in the first quarter to 4 percent and 9 percent, respectively, in August.

The slowdown is largely the result of assertive central government policy. In April, the government blitzed the economy with a number of strong-handed measures, including a nationwide injunction on lending, the high-profile shutdown of one of Jiangsu's largest private steel plants, and the kickoff of a wave of corruption and illegal land-use investigations. The same month, the State Council raised lending requirements for four overheating sectors--steel, cement, aluminum, and real estate--with required capital contributions raised from 25 percent to 40 percent for steel and from 20 percent to 35 percent for the others. In addition, the Ministry of Land Resources, along with four other cooperating ministries, recently wrapped up a year-long investigation of unused and illegal development zones, which resulted in many of them being shut down.

Growth will undoubtedly continue, but it will be more narrowly focused. A State Council working conference in July stressed that the financing and approval of profitable projects should continue, especially in sectors with shortages, such as energy production, transportation infrastructure, and consumer manufacturing. Many of the government inspection teams sent out in May and June are finishing their work, and greenlighted projects are proceeding. Banks are starting to lend again, although at a more cautious rate. FDI is also steadily recovering from anemic growth rates in the second half of 2003--utilized FDI grew 12 percent to $33.9 billion in the first half of 2004, up from 1.4 percent in the whole of 2003 (see Foreign Investment in China paper). While foreign direct investment (FDI) only accounts for 8 percent of China's total fixed-asset investment, foreign-funded companies produced 28.1 percent of China's industrial output in the first half of 2004.

Given the continued difficulty of limiting local investment, it is clear that the PRC government will hold steady in its restrictive policies and monitor local-level activity closely. The International Monetary Fund (IMF) has warned China to watch extra-budgetary local spending, which remains outside the purview of the central government. Analysts recommend government efforts to slow investment and output even further to 14-15 percent and 8-10 percent, respectively, through the end of 2004 and 2005, to give the economy time to digest the record levels of investment from the last few years.

Consumption and Trade

Private consumption is growing but is not yet pulling its full weight as a driver of economic growth. Retail sales growth in the first half of 2004 rose to 10.2 percent--2.2 percent faster than the same period last year. One contributor was rising rural income which, thanks to direct grain subsidies, the repeal of certain agricultural taxes, and high grain prices, grew more than four times as fast as in the same period last year (10.9 percent vs 2.5 percent). But these gains in rural income are partly policy-driven and may not be permanent, and China's household survey, which monitors expenditures, also shows that high rates of savings are cutting into private consumption. Urban workers, faced with unemployment and a weak pension system, are saving just under 30 percent of their income, up from 20 percent in 1998. Consumption continues to trail production in several sectors, including autos, in which high sales growth of 43.7 percent in the first half has started to slump in recent months. Despite recent price wars, analysts report that 100,000 cars are sitting in inventory in China, and the National Bureau of Statistics has cut its 2004 forecast for auto sales from 40 percent growth to 18 percent. Telecommunications equipment showed the highest sales growth, at 52.3 percent. The PRC Ministry of Commerce predicts retail sales of consumer products in 2004 will grow 10.5 percent to exceed $604 billion, and sales of capital goods will grow 15 percent, reaching $1.21 trillion.

External trade has also provided surprisingly strong support for economic growth. Total trade grew 39 percent in the first half, with exports increasing 35.7 percent and imports increasing even more (see China's Trade Performance paper). China ran a $6.8 billion global trade deficit in the first half of 2004. With raw materials and capital goods forming nearly 85 percent of China's imports, most companies expected the downturn in domestic investment to slow China's export-oriented external trade and are predicting that imports and exports will slow in the second half of 2004. But they may be underestimating the power of FDI: more than half of China's exports are produced by foreign-funded enterprises, and FDI is flowing quicker than ever.

Prices

Inflation has passed the 5 percent danger mark set by China's central bank, the People's Bank of China (PBOC). The consumer price index (CPI) hit 5.3 percent in July and August after averaging 3.6 percent in the first half of 2004. Two things make PBOC reluctant to raise interest rates. First, inflation is primarily driven by high food prices; non-food prices stayed flat except for housing, which grew 3.7 percent in the first half. Grain prices, which jumped 26.7 percent in the first half and continue to edge upward, are high but support government efforts to raise rural incomes. Observers expect prices to fall after the autumn harvest and ease through the end of the year. Second, PBOC would prefer to use more targeted instruments than an interest rate hike, which would add considerable strain to the shaky banking system. Officials maintain that China can handle some inflation as it is coming off a relatively long period of deflation.

Nevertheless, inflation is a real concern. The real interest rate on short-term lending is nearly negative. A negative interest rate would knock the cost of capital to zero and would likely cause increased demand for loans--a dangerous situation for a financial sector already struggling to reel in its lending. To regulate rising prices, the central government instructed local governments in May to control prices of staple goods and to stagger price rises appropriately.

Government spending and revenue

Government revenue continues to see little fluctuation. In 2003, revenue and expenditures were 18.7 percent and 21.6 percent of GDP, respectively. This year, revenue is forecasted to edge up slightly to 19 percent of GDP and expenditures to slip to 21.2 percent of GDP, leading to a marginally smaller budget deficit.

To watch

• Financial sector reform   Observers note that inclusion of nonperforming financial assets and pension obligations could push China's debt, currently at 20 percent of GDP, to above 50 percent of GDP. China's debt will only grow if companies squeezed by the government's current austerity measures are hit with higher interest rates and consequently default on their loans. Smaller firms have already lost access to credit, and firms with riskier positions and leveraged debt, such as the private conglomerate D'Long Group, have had to scramble to cover their investments or face default. Financial sector restructuring has not been cheap. The government injected $45 billion into Bank of China and China Construction Bank at the start of 2004, infused another $33.7 billion into the state banks via asset-management companies' purchase of nonperforming loans, and has recently begun an unprecedented bailout of D'Long Group, which holds more than of $2.6 billion in assets.
• Oil prices   Escalating oil prices, which hit a record price of $54 per barrel in mid-October, may also depress the economy. According to Morgan Stanley's Andy Xie, China is consuming seven million barrels of oil a day, only half of which it produces at home, and the spike in oil prices will cost it an additional 2.3 percent of GDP (compared to a base price of $20 per barrel). China's thirst for oil is driven by continued strong demand for freight transportation, consistently high car sales, and persistent electricity shortages. Many businesses have purchased diesel fuel generators in the wake of power shortages in two-thirds of China's provinces this past summer. The PRC, aware of its reliance on oil and its inability to negotiate pricing, is quickly building infrastructure for a strategic reserve and has commenced fuel oil futures trading in Shanghai and has allowed flexibility in fuel prices.
• Revitalization of the Northeast   The Northeast (Liaoning, Heilongjiang, Jilin) has lagged behind eastern provinces in converting its industrial base to efficient private or semi-private producers. The government recently established a pilot tax program in the Northeast to shift from a production value-added tax (VAT) to a consumption VAT in eight industries, including autos, chemicals, and oil, which will lighten the tax burden on potential investors. The government also gave enterprises new flexibility in tax accounting for assets and reduced resource taxes on oil extraction, while raising the lowest individual income tax bracket from RMB 800 ($96.6) to RMB 1,200 ($145) per month. (see Dongbei at a Glance paper).
• Environmental problems   China's air and water pollution are severe and apparent to anyone who has visited the country. The huge public health and economic damages are only just now being tallied. The World Bank estimates the damage at 8-12 percent of GDP per year, including medical costs, lost workdays, disaster relief outlays, and damage from acid rain. China itself is running a pilot "green GDP" program, in which provincial GDP estimates are revised to reflect the environmental damage and resource depletion caused by economic growth. China will find the lower GDP figures unpalatable, but enforcement of environmental measures is impossible unless local officials are held accountable for local environmental conditions.

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Last Updated: 27-Dec-04