Summary
- GDP grew 11.1 percent in the first quarter of 2007. Similar growth is expected in the second quarter.
- China's trade surplus hit $63.3 billion at the end of April--88 percent higher than in the first four months of 2006.
- Foreign exchange reserves also jumped spectacularly in the first quarter, up $135.7 billion since the end of 2006.
- The RMB appreciated more slowly than expected in the first few months of the year--at an annual rate of about 2 percent. In mid-May, China widened the band within which the currency may fluctuate per day from +/- 0.3 percent to +/- 0.5 percent.
- Though the economy as a whole is not overheating, overheating is a risk in industries where investment has been high in recent years.
- The consumer price index rose to 2.8 percent in the first four months, boosted by rising food and fuel prices.
- In the first four months of the year, consumption, measured by retail sales, rose 15.1 percent over the same period in 2006.
GDP
China's economy expanded at a faster-than-expected rate of 11.1 percent in the first three months of the year, largely driven by fixed-asset investment and exports. Similar growth is expected in the second quarter. Most economic indicators delivered a stronger performance than in the first quarter of 2006 (see Table 1), leading economists to expect cooling measures such as higher interest rates and reserve requirements, as well as administrative directives on bank lending and project approvals. Because inflation remains relatively low and the economy shows no sign of transportation bottlenecks or raw material shortages--classic indicators of an overheating economy--cooling measures are expected to be moderate.
Forex Reserves Skyrocket
Foreign exchange (forex) reserves jumped spectacularly in the first quarter, up $135.7 billion since the end of 2006. Although a significant portion of the increase can be attributed to export earnings and inflows of foreign direct investment, a large chunk--$73.3 billion--is unaccounted for, according to press reports. Some reports have suggested that this amount could be the result of the unwinding of several currency swaps, the return of money to the central bank as it prepares to set up an entity to invest a portion of the reserves in higher-return investments, and the return of money raised abroad by Chinese companies' initial public offerings. But by mid-May, when reserve accumulations were running at about $45 billion a month, some analysts were suggesting that at least some speculative inflows were involved.
Bubble in the Stock Market
Indeed, some analysts connect the massive forex inflow to the enormous gains in the domestic stock markets. The Shanghai market is reportedly up 40 percent this year and 200 percent in the last 18 months. For most people, investment options in China are limited to bank savings accounts and the stock markets, and individuals are investing heavily in the market in the hope of striking it rich. A burst bubble could have unpleasant social consequences. On May 30, the stock market's benchmark index lost 6.5 percent after the government tripled the tax on stock trades. Economists expected this would have only a temporary effect on the market. UBS AG expects the government to take further measures, likely more administrative restrictions on new inflows, measures against leveraging, and taxes on capital gains and short-term sales.
The RMB's Slow Appreciation
The renminbi (RMB) appreciated more slowly than expected in the first few months of the year--at an annual rate of about 2 percent--possibly in an attempt to discourage speculative capital inflows. (A rapidly appreciating RMB would likely attract even more speculative inflows, making China's economy even harder to manage.) The RMB has gained a little more than 6 percent since 2005, including the July 2005 revaluation of 2 percent. In mid-May, press reports cited a Chinese Academy of Social Sciences economist who supports the government's gradual approach and who argued that a rapid rise in the currency would strain the economy. In addition, the Ministry of Labor and Social Security released a report saying that appreciation of another 5-10 percent would result in 3.5 million more unemployed and affect 10 million farmers.
UBS opines that China has two choices: re-peg the RMB or do a significant one-time revaluation. Though the RMB broke the 7.70 barrier in mid-May, observers noted that it only did so as the US Congress convened hearings on the subject and as the Strategic Economic Dialogue (SED), which took place May 22-23, approached.
With trade numbers indicating China's trade surplus hit $63.3 billion at the end of April--88 percent higher than in the first four months of 2006--China's delegation faced strong pressure from the US side to let the currency appreciate. In what many analysts described as a move to defuse some of the tension before the second SED meetings, China on May 19 widened the band in which the RMB may fluctuate per day from +/- 0.3 percent to +/- 0.5 percent. Since the 2005 revaluation, the RMB had never tested the 0.3 percent barrier.
China's protestations that it cannot afford a stronger currency seem to be undermined by the fact that its trade and current account surpluses are growing more rapidly than ever, despite the appreciation seen so far. Nevertheless, despite the SED discussions, a larger revaluation is not expected, as PRC officials and economists have consistently said the RMB will maintain its gradual pace of adjustment.
Investment Still High
Though the economy as a whole is not overheating, overheating is a risk in industries where investment has been high in recent years, such as steel, cement, autos, and real estate. Despite government efforts to cool these sectors, investment in, for instance, the manufacture of nonmetallic mineral products (many of which are used in construction) rose 41.2 percent, while investment in the smelting and pressing of nonferrous metals jumped 54.8 percent in the first quarter. Reflecting high levels of previous investment, production of alumina, aluminum products, ferro alloy, 10 types of nonferrous metals, and cars each jumped between 30.8 and 53.7 percent year on year.
The source of much of this excess investment is corporate retained earnings. Many state-owned firms are profitable; in the first two months of the year industrial profits jumped 43.8 percent over the first two months of 2006. Because they have not been required to pay dividends and have had limited options for otherwise channeling retained earnings to efficient uses, firms tend to reinvest profits in more capacity or in other projects such as real estate development. When firms build excess capacity, downward pricing and margin pressures result, increasing loan default and bankruptcy risks.
Chinese officials appear to be heeding recommendations by numerous analysts on ways to remedy this situation. On May 30, China announced that it would require the 158 central-government-owned firms that report to the State Asset Supervision and Administration Commission to pay dividends to shareholders later this year. A Wall Street Journal article reported that provincial and local governments would be responsible for formulating dividend policies for companies under their control.
CPI Is Rising, But Is Not Yet a Worry
The consumer price index rose to 2.8 percent in the first four months, boosted by rising food and fuel prices. Core inflation remained low. The government seems unfazed by the rise for two reasons. First, inflation stayed below 3 percent for the period. (The government aims to keep inflation no higher than 3 percent for the year.) Second, rising food prices help boost rural incomes--a key policy goal. The State Information Center forecasts CPI of 2.9 percent in the first half.
Consumption Grows Steadily
In the first four months of the year, consumption, measured by retail sales, rose 15.1 percent over the same period in 2006, 16 percent in urban areas and 14.6 percent in rural areas. While this growth is welcome, consumption is still weak compared to fixed-asset investment and is not yet a main driver of China's economy. (Reflecting earlier investment in real estate, in April sales of furniture jumped more than 50 percent, while decoration and building materials leapt more than 30 percent.) Rising incomes may be boosting consumption in both rural and urban areas, but structural reforms and a stronger social safety net will be needed to boost consumer confidence--and consumption--significantly.
Money Supply up, Will Interest Rates Follow?
Cash and deposits (M2) rose 17.1 percent in April, higher than the 16 percent target for the year. Banks lent RMB 1.8 trillion in the first four months of the year, more than half the 2006 total. To help cool lending and absorb forex inflows, the central bank has twice raised reserve requirements 0.5 percentage points since the end of the first quarter. The first hike took effect May 15, and the second will kick in on June 5. And on May 19, the rate for a one-year deposit rose 0.27 percentage points, largely to keep real deposit rates positive, and the one-year lending rate rose 0.18 percentage points. These rate changes and reserve hikes are largely aimed at keeping the economy steady, rather than reining it in.
