Global Insight Perspective | |
Significance | GDP in real terms recorded surging growth of 11.1% in the three months through March, accelerating from the 10.4% rate recorded in the December quarter. |
Implications | Growth continued to be fuelled by external demand and bounding investment growth. The impact of monetary tightening and administrative adjustments has been minimal. |
Outlook | The structure of China's growth continues to fuel imbalances at home and political tensions abroad as external surpluses continue to bloat. With inflation accelerating, further, more forceful monetary tightening can be expected. |
Unrelenting Growth
China's growth remained undaunted in the first quarter of the year, riding the strong tailwind generated in the previous year. In the three months through March, GDP in real terms expanded by 11.1% on the year to 5.03 trillion yuan, accelerating from the 10.4% gain recorded in the fourth quarter. In 2006, the economy powered to its strongest growth in over a decade, expanding by 10.7% in annual terms.
Investment and exports continued to be the main drivers of growth. Investment has fuelled the economy’s buoyant growth cycle since 2002, boosted by high levels of liquidity in the financial system. Money supply has been buoyed by central bank interventions to sterilise the impact of huge inflows of foreign capital on the fixed exchange rate. In addition to export earnings and foreign direct investment (FDI), ”hot money” flows are further swelling external surpluses. In the first quarter of 2007, foreign-exchange reserves surged by US$135.7 billion to US$1.20 trillion.
Trade and Investment Remain Main Motors
The trade surplus more than doubled in the first quarter to US$46.4 billion from the levels recorded in the previous year. The surge came despite a sharp slowdown in export growth in March. The deceleration was attributed to the impact of administrative measures to curb the bloating surplus, led by cuts in export rebates. A rush of exports to the market before the new measures came into effect inflated the first-quarter surplus. Nonetheless, external demand remains strong.
The stimulus generated by surging exports continues to fuel investment growth. Data released earlier this week showed that urban fixed-asset investment (FAI) accelerated in the first quarter of the year. Total FAI rose by 25.3% on the corresponding period of 2005. The full-quarter rate compared with an annual growth rate of 23.4% for the first two months of the year combined, indicating that investment picked up in March. Credit growth is underpinned by strong expansion in the money supply. In March, the broad M2 measure of money supply rose by 17.3% on the year in March, slowing just slightly from the 17.8% gain recorded in February.
Tightening Measures Have Limited Impact
Money supply growth still remains heated despite aggressive tightening measures implemented by the People's Bank of China (PBoC). Over the past year, the PBoC has raised benchmark interest rates three times and raised reserve requirements for commercial banks six times. The tightening of monetary policy despite low levels of inflation is driven by concerns over the structure and pace of growth. Policy has aimed at rebalancing domestic demand growth away from investment to consumption, which as a share of GDP has fallen to around 40% from over half at the beginning of the reform period in the late 1980s. In India, by contrast, consumption accounts for around 61%. As previously stated, the intensive model of economic development has fuelled excess capacity in the economy, while productivity levels remain relatively low. At the same time, employment generation has been comparatively modest, in turn undermining consumption growth. Growing inequalities of wealth represent a growing challenge to the legitimacy of the ruling Chinese Communist Party (CCP). Finally, the intensive model of economic development is resulting in severe economic degradation.
Consumer price inflation accelerated in the first quarter, providing further justification for additional rate hikes. The consumer price index (CPI) rose by 2.7% in annual terms in the first quarter. In March alone, the CPI rose by 3.3% year-on-year (y/y), fuelled by rising food prices. Inflation remains a highly politicised issue in China, where wealth inequality is now worse than that of the United States, even in an ostensibly ”communist” system. However, the impact of further monetary tightening is expected to be limited given the sheer weight of momentum in the economy.
The Exchange Rate Conundrum
The argument then returns to the perennial issue of the equity of China's fixed exchange rate. Following the publication of March's record trade surplus data, authorities hinted that they may consider allowing greater flexibility in the yuan. Imported goods would become cheaper, boosting domestic consumption, while the central bank would have greater flexibility in reducing upward pressure on liquidity generated by the accumulating reserves. Domestic producers are making productivity gains, while abundant supplies of labour keep operating costs low. However, the same arguments also show why moderate adjustments in the exchange rate would have a limited impact on China's export prowess. The theory moreover neglects the developing intra-regional production chain that is consolidating former bilateral surpluses into China's external balances.
Outlook and Implications
Global Insight forecasts a modest deceleration in growth in 2007 to around 10.0%. External demand should moderate slightly as growth in the United States moderates. Changes to the tariff structure amid growing criticism of China’s export strength and a rising tide of protectionism may also blunt external sectors as indicated by March's export data. Concurrently, further measures are expected to tighten money supply and curb credit growth through further rises in the deposit reserve ratio and interest rates. The rationale for additional monetary tightening has been boosted by the pickup in inflation witnessed in the first quarter.
However, attempts to slow growth will be weighed against other considerations. The CCP will hold its 17th national congress later this year, during which the fourth-generation leadership will seek to cement its position. Aside from such political motivations, maintaining high growth rates is necessary to absorb the effects of continued restructuring. Placing growth on a more sustainable path over the long term depends on far-reaching reform of the rump state sector, the social welfare system, and financial markets—reforms which by their very nature pose a tricky political challenge to the CCP.