With a week to go before the Olympics, President Hu Jintao made the unusual move of directly addressing a gathering of foreign journalists in Beijing. While preparations for the games played a part in the proceedings, the economy brushed most thoughts of sports aside.
“We have noticed that there are growing uncertainties and unstable factors in the international environment,” said Hu. “China’s domestic economy is facing increasing challenges and difficulties.
“Our first priority of macro adjustment is to maintain steady and relatively fast economic growth and curb excessive price rises.”
Hu’s language reinforced a message shift first seen at a July 25 meeting of the Politburo, the Communist Party’s top decision-making body. Since December, when Beijing pledged to shift to a “tight” monetary policy, it has focused on preventing overheating and inflation. Now, the message is that the government welcomes steady growth.
“Of course you don’t expect real, very detailed policy to come out of [the meeting]. But I think it’s very important because policy tone has officially changed,” said Wang Qian, an economist at JPMorgan in Hong Kong.
However, doubts remain over whether the change foretells a policy shift that will help China avoid the worst of a global downturn and maintain a healthy economy. Worse, the vagueness in Beijing’s approach to date could be a sign and a cause of even more problems.
Much clearer are the economic signs that prompted the change in tone.
The pursuit of a tight monetary policy, through measures such as lowering interest rates and lifting banks’ reserve requirement ratios (the proportion of assets banks must keep as reserves) has been ineffective, said Andy Xie, an independent economist. Rather than raising interest rates to deal with inflation and let money supply respond to price, China has tried to control money supply to keep inflation down, while keeping interest rates low.
“That is not a conventional policy … [and] it doesn’t look like [it] is working,” said Xie.
One sign is that continued high inflation figures pushed the government to quietly discard an annual consumer price index (CPI) growth target of 4.8%. Xue Lan, head of China research at Citi, said that figure “is a joke now.”
Consumer price growth has moderated somewhat after soaring food prices pushed it to 12-year highs earlier this year. The July figure of 6.3% year-on-year was down from 7.1% in June. However, growth in the producer price index (PPI), a measure of the value of products as they leave factories, accelerated to 10% in July, up from 8.8% in June.
A rising PPI could create more problems than a falling CPI assuages. Food comprises about a third of the CPI basket, making the index vulnerable to food price fluctuations due to short-term supply shocks. The PPI, on the other hand, is an indicator of stickier inflationary pressure as a result of rises in energy and raw materials costs. Manufacturers have sacrificed profits to keep end-user prices low and products competitive, but as input costs rise, that becomes more difficult.
“You cannot play a mind trick and hope it will go away,” said Xie. “China is in an inflationary era.”
Other numbers provide more reasons for concern. The renminbi has risen by 6% against the US dollar since January 1, making exports relatively more expensive. Meanwhile, the China Federation of Logistics and Purchasing said that manufacturing in China contracted in July for the first time since 2005.
It’s too early to say if an unexpected and broad-based rise in export growth in July – up 26.9% year-on-year – is a sign that some areas could be turning around, said Dong Tao, chief regional economist at Credit Suisse in Hong Kong. Certainly, the trend had been overall export growth moderation in the months before July: June export growth was down sharply to 17.7% from May’s 28.1%.
Exporters and small businesses involved in lower-end consumer goods have been hit particularly hard. Jerry Lin, executive account manager at Cotton Incorporated, a textile industry body, said weak foreign and domestic demand, a tight credit environment, and higher raw material prices and labor costs have all created difficulties.
Real estate has also suffered. Tighter liquidity, regulatory curbs on speculation and oversupply have combined to depress the residential property market.
The way the government is reacting to the slowdown indicates some uncertainty over how to proceed.
“What I see coming out from [the July 25 Politburo meeting] is an extremely messy policy environment,” said Citi’s Xue. “They are coming out with a tone that is trying to please everybody … [but] they have not come out with any exact policies to indicate exactly what they want to do.”
That is not to say that Beijing has been standing still. On August 1, the Ministry of Finance raised rebates of value-added taxes on textile and garment exports to 13%, from 11%. Cotton Incorporated’s Lin said this was a boon to apparel exporters, though less helpful for upstream manufacturers.
The problem, according to Rocky Lee, head of DLA Piper’s China private equity practice, is that the rebate doesn’t address root causes. “My discussions with government officials and some of the higher-level policy makers is that the rebate was merely cosmetic,” said Lee.
Potentially more helpful was the central bank’s lifting of annual loan quotas for commercial banks, by 5% for national lenders and 10% for their local counterparts. Raising the quota allows banks to issue an estimated US$26.2 billion in new loans, which it is hoped will create a friendlier credit environment for small and medium-sized enterprises (SMEs).
JPMorgan’s Wang said she expects to see more such selective easing of credit controls for SMEs and real estate, and no rate hikes for sectors facing difficulties.
Wang’s predictions are borne out by the experience of John So, a property analyst with brokerage ICEA in Hong Kong, who notes mainland developers are now enjoying easier access to credit.
But the easing of credit controls for SMEs and developers is a targeted measure. An agreement on overall policy direction is much harder to deliver. Broadly releasing credit controls, to take one example, would meet significant opposition from factions within the government who say that credit is already too loose and that the fault lies with risk-averse banks rather than any specific government policy.
Even if Beijing were to come to a consensus, it would not necessarily mean overnight change.
“For the Chinese government to implement policy, they have to have laws and regulations, and then they must have implementation rules and standards,” said DLA Piper’s Lee. “It’s going to take months before we get to that.”
No sea change
A lag of several months will cause concern in Beijing, where relative inaction belies real worries about instability. Xie says that despite the Politburo shifting its priority to a position of maintaining healthy growth, it will not relax its stance toward high inflation.
“The only thing that the Communist Party is terrified of more than unemployment is inflation,” he noted.
Unfortunately for the government, the current environment could generate both: Inefficient SMEs squeezed by rising inflation could be forced out of business. According to Xie, even if Beijing wanted to bail out failing industries, the scale of China’s economy would make this difficult.
A more effective tack to avert a domestic slowdown, and one widely expected by economists, is for Beijing to increase its investment in domestic infrastructure. That would allow the government to pump money into the economy, and also bring much-needed upgrades to the country’s transportation networks. Those increases would be above already massive spending: In 2006, Beijing invested US$103.4 billion in transport fixed assets, according to the World Bank, and the 11th Five-Year Plan called for over US$740 billion to be invested in infrastructure – US$554 billion in transportation infrastructure alone – between 2006 and 2010.
There is substantial room for investment and little chance of government-driven overcapacity due to poor existing infrastructure, said JPMorgan’s Wang.
Then there is the issue of the renminbi’s appreciation.
The renminbi’s steady rise has attracted large speculative inflows of cash – “hot money” – that create significant inflationary pressure. This is in addition to damaging the profitability of many exporters set up to compete mainly on price. As a result, despite pressure from the US and other quarters for China to quickly revalue its currency to offset trade imbalances, Beijing will be applying the brakes. Indeed, this is already happening: The renminbi has fallen about 0.6% against the US dollar since July 25.
“China is at the beginning of a huge deceleration in currency appreciation … it can’t afford to hike the currency as it has been [doing],” said Citi’s Xue.
However, Xue warns against excessive optimism, stressing that a relaxation in credit restrictions is no guarantee of a return to the bull market. Her position is backed up by Xie, the independent economist, who says that China is not just experiencing another cyclical downturn.
“Labor and energy are scarce resources, unlike in the past … a lot of businesses will not survive,” he said.
Not everyone views the situation so negatively. DLA Piper’s Lee claims to have seen an “unprecedented” amount of capital being raised for investment in China starting in 2009.
“[Investors] are certainly concerned about the current market cycle … [but] they take the view that the macro outlook is great,” he said. “It’s still one of the best places in the world to invest.”
Some hope may also be seen in domestic consumption. A JPMorgan report by Wang and her colleague, economist Grace Ng, noted “steady growth rotation” toward domestic demand. While sales growth on items such as jewelry, cosmetics and automobiles moderated in the second quarter, growth in sales of lower-end consumer goods like clothing accelerated. Overall, domestic retail sales were up 23.3% in July, 6.9 percentage points higher than the increase in July last year.
Even optimists, however, see that China’s economy is facing real risks. As Beijing takes time to work out its overall policy approach, China’s economic ailments are not going away.
“The flu shot needs to go in now,” said DLA Piper’s Lee.