News that China’s economy expanded 11.3% in the second quarter, its fastest rate of growth in 12 years, did nothing to quell the premonitions of a hard-landing if China does not take drastic measures to cool its economy.
The failure of curbs introduced after first-quarter growth hit an already strong 10.3% simply added to concerns.
"There is agreement that the economy is growing too rapidly for China’s own good, that it is not a sustainable recipe," said Stephen Roach, global chief economist at Morgan Stanley. "The government has taken several actions, beginning late April, to deal with it. So far the actions have not worked and I suspect they will have to take more."
Other economists are not convinced the growth is too hot to handle. Standard Chartered’s Stephen Green cites low consumer inflation of 1.3% as reason for hope.
"It is difficult to see what the problem is really in terms of the macro economy," he said. "There are certainly imbalances and potential problems with the exchange rate, but apart from that the economy is growing and it’s growing without inflation."
Green argues that major structural reforms in recent years, combined with surging productivity and a new middle class driving consumption in the eastern seaboard cities has given China a little leeway from traditional economic constraints, enabling it to grow faster without inflation, the traditional measure of overheating.
But even if growth numbers are sustainable, there is widespread agreement that imbalances are veering out of control.
Record trade surpluses of US$13 billion in May and US$14.5 billion in June, and an acceleration of capital inflows from foreign direct investment and speculative money betting on a stronger yuan, drove China’s foreign exchange reserves to a record US$941 billion at the end June.
In the same month, the money supply grew by 18.4% and fed accelerating investment growth, which rose by 30.8% in the second quarter, well above the government’s 18% target for the year. Investment accounts for about 40% of GDP.
While the People’s Bank of China (PBOC) has become relatively hawkish, it has moved carefully for fear of derailing slowly increasing domestic spending.
A one-time 27 basis-point increase in lending rates to 5.85% in April, leaving deposit rates untouched, seemed likely to be the only rate hike the bank was prepared to make, preferring instead to limit credit supply through reserve ratio hikes.
However, it took analysts by surprise last month, suddenly raising both the 1-year lending and deposit rates by 27 basis points. The move is not without risks, particularly for the country’s banks. Sitting on US$3.6 trillion in bank deposits, they could be hit hard by increasing interest payments, tempting them to boost lending to offset losses, which would undermine government efforts to curb loans.
Interest rate hikes could also derail slowly rising import demand, leading to a further blowout of the trade surplus and foreign exchange inflows. The PBOC is gambling that low credit card penetration and an already deeply ingrained savings habit will cushion consumer spending from the rates’ full impact.
Speaking before the August rate hike, Henry Ho, head of China research at investment bank UBS, said the key to addressing imbalances is stimulating domestic consumption and thus imports.
"The balancing act is to sterilize inflows without extinguishing domestic demand," he said. "And while two 0.5% reserve requirement ratio hikes in as many months suggest that the PBOC is erring on the tight side, macro tightening will not lead to a significant downturn."
Economists seem largely united in the belief that macroeconomic controls will be ineffective until China moves to liberalize its exchange rate. The principle involved here is called Monetary Trilemma, which holds that no economy can have a fixed exchange rate, be open to foreign currency flows and operate an independent monetary policy at the same time.
According to Carl Weinberg, chief economist at High Frequency Economics, as the PBOC tightens monetary conditions, foreign currency inflows will increase to replace the domestic credit that has been removed. This will happen overtly through foreign funding of domestic profits or through "illicit inflows into yuan", causing a surge of foreign exchange reserves.
The same thing happened in September 2003 and June 2004 when China raised reserves to combat an overheating economy.
"The real effort to rein in excessively fast economic growth – if Beijing is really worried about this at all – will have to come from other policies," Weinberg wrote in a July research paper.
Roach agrees: "China is not a fully functioning market economy so you can’t expect market-based instruments like interest rates or bank reserve ratios to work. The real measures that will work in China eventually will be the administrative controls on project finance that will come out of the National Development and Reform Commission (NDRC)."
The NDRC is warming to the task, ordering a review of every investment project that exceeds US$12.5 million, or US$3.75 million in the most overheated sectors.
Moves by the State-owned Assets Supervision and Administration Commission (SASAC) to prepare the ground for state firms to make dividend payouts, which they are currently exempt from, are also a step in this direction.
More than half of all capital spending in China is now funded out of the retained earnings of companies. The country’s 169 biggest state firms earned profits of US$78.75 billion in 2005, equal to about 3.4% of GDP. This means there is a large amount of money that has nowhere to go but back into the company.
Asian Development Bank (ADB) Chief Economist for China Min Tang contends that dividends could be used to divert investment into areas like rural health, education and infrastructure.
By improving the social safety net in these areas, China could reduce the high savings rate, boost consumption and reduce the necessity of banks to lend.
"Essentially, the economy is overheating and monetary tightening is important in slowing growth," he said. "But structural reform is needed to divert money into rural areas and increase consumption. I cannot see any better program."
The "new socialist countryside" model outlined in the 11th Five-Year Plan in March suggests this is indeed the direction in which the government wishes to go.
A research note released on August 8 by the State Information Center under the NDRC predicted curbs would see investment and exports slow in the second half of 2006, but domestic consumption would pick up to ensure that the economy continued to grow at a massive 10.4% for 2006.
Morgan Stanley’s Roach said that there is still a strong case for rapid growth in China, but that the world’s fourth largest economy is unlikely to sustain the average 9.5% growth it has managed over the last 27 years.
"The point is that China now needs to rebalance to a more sustainable growth model. It needs to move away from being overly dependent on exports and investment to really developing more of a consumer-oriented culture that will drive internal demand.
"I think China will do just fine, as it moves on down that road but it needs to begin the heavy lifting of that rebalancing right now."