After the storm

On a sunny December afternoon at a Shanghai wet market, Ms Wang, a stall owner, repeatedly smashes a box of frozen chicken parts against the ground to break them apart. Momentarily interrupted from her task, she laughs when asked about inflation.

"There won’t be any big changes next year," she said, arranging legs and breasts. "Prices are fair and stable."

A shopper buying pork, surnamed Gong, is less cheery. She has seen prices rising – winter storms hit some food supplies in late 2009 – and the prospect of more increases worried her. Things are hard for her family, she admits – "But we’ll make it through."

The same might be said of China’s economy in 2010. After a year of unprecedented state-led investment and what central bankers have almost comically undersold as a "moderately" loose monetary policy, everyone is asking what comes next. How will the government manage to bring balance to an economy thrown off-kilter by a huge fiscal and policy response to the global economic meltdown?

The consensus appears to be that, with the help of strong central leadership, China will "make it through." But it is unclear what form this leadership will take and indeed what "making it through" will mean – not just this year, but as China addresses its longer-term economic goals.

A clue as to the direction policy makers may take came with two announcements in December, by the Politburo and the Communist Party’s Central Economic Work Conference. Both supported continuing "proactive fiscal policy and moderately easy policy," and the work conference called for "balanced" stimulus.

Beijing’s oft-mentioned goal of promoting consumption-led growth featured, though beyond continuations of temporary treatments like rebates and tax cuts, much of it focused on measures such as improving China’s social security net that will not be felt for years. Inflation wasn’t mentioned; instead, both statements emphasized maintaining high levels of growth in the short term.

Political necessity

Shen Minggao, chief China economist at Citi in Hong Kong, says that is unsurprising. First, the government is loath to risk interrupting the stimulus at a time when the global economic climate remains uncertain. Supporting labor-intensive sectors such as manufacturing and construction creates jobs and minimizes the prospect of social unrest. Second, 2010 is a critical year for leaders to be promoted to the next generation of government.

"They have to deliver before they are nominated, and investment growth is still the best way to promote near-term growth," Shen said.

Government investment and easy monetary policy certainly did the trick last year. The US$586 billion stimulus package – the world’s largest as a percentage of GDP – was backed up by a host of sector-specific policies and an enormous credit binge. Banks issued nearly US$1.4 trillion in loans in the first nine months, nearly double the full-year target. The 8% GDP growth figure that had seemed so far away last January proved to be within reach – but it came at a cost.

"It took 30% of 2008’s economy to get 6% nominal GDP growth.  That’s not a very good return on the amount of money that they put in," said Jim Walker, managing director of private economic research house Asianomics in Hong Kong.

The spike in liquidity has also led to strong growth in asset prices, prompting fears of bubbles in the stock and property markets. A senior regulator’s comments in December that more than two-thirds of the US$1.4 trillion in loans went to large customers – concentrated in infrastructure, energy, real estate and transportation – did little to soothe worries of overcapacity and bad loans.

Beijing’s pledge that it will pursue a flexible policy and more strictly control loan growth and investment in 2010 shows that it recognizes some of those concerns. Economists expect gradual tightening, with no substantive shift in monetary policy until the second half of the year.

The desire to tighten may be accelerated by the threat of inflation. China’s consumer price index rose 0.6% in November, ending a 10-month streak of falling prices. Rising prices of commodities such as coal are expected to add to pressures on consumer and producer prices next year, and could even delay much-needed reform in some sectors.

"The Chinese government will be reluctant to increase residential electricity prices because that may put pressure on inflation," said Dave Dai, a power sector analyst with CLSA in Hong Kong.

Power producers won’t be alone in their pain if input costs continue to rise. Andy Rothman, chief China macro strategist at CLSA, says that stiff competition in many industries could force companies to absorb higher costs rather than passing them on to consumers, with deleterious effects on profits and businesses.

Private revival

Even if inflation and rising input prices prove relative non-issues, Beijing will eventually need to shut off the flow of government investment while tightening liquidity. There are doubts that private investment will be able to take over. Citi’s Shen notes that Beijing has been trying for years without success to find specific ways to promote private investment.

The steep increase in housing starts in November – up 194% year-on-year – may give an indication that private investors are keen to put their money to use. However, Shen argues that the kind of investment needed is of a less speculative and spectacular nature – small and medium-sized enterprises expanding their businesses, helped along by lenders.

"We really need to see small privately owned banks that are relatively more keen to support private firms," he said.

There are also risks associated with tightening for companies that have borrowed heavily to finance expansion. While larger, state-linked firms may have the chance to refinance debt on more favorable terms, interest rate hikes could prove painful to a range of sectors.

Lu Ting, China economist at Merrill Lynch, believes the pain would be acute enough as to make rate hikes unlikely; more possible are reserve requirement ratio increases to more directly control lending. Beijing’s took just such a targeted step in December, requiring large banks to increase their ratio of capital to risk from 8% to 11%.

But the degree to which Beijing implements tightening policies may not be entirely according to its own preferences. Much as China’s response in 2009 was influenced by the collapse of export markets, its path in 2010 will depend on the state of global recovery.

With little agreement on the prospects for the world’s economy in 2010, there is significant debate about what is in store for China. Jing Ulrich, chairman of China equities and commodities at J.P. Morgan, believes the economic momentum will remain, driven by a combination of public investment, a revival in private real estate investment, a strong consumer sector and improving external demand. Mild inflation would not call for severe tightening, and overcapacity in many industries would prevent price rises from being passed on to consumers, she wrote in a recent research note.

Walker of Asianomics is more dour: China may make it through, but it will be a tough year ahead. He expects inflation will trigger policy tightening at a time when weak external demand will require loose monetary policy to maintain activity levels.

"If I was worried about the Chinese economy this time last year, I’m doubly worried about it now," Walker said.