The growth picture
China’s government reported that, in the first quarter of 2013, real GDP was up 7.7 percent from a year earlier. This was slower than expected and slower than the 7.9 percent growth recorded in the fourth quarter of 2012. This is the first time in 20 years that growth has been less than 8.0 percent for four consecutive quarters. Growth of fixed-asset investment, while strong at 20.6 percent, was worse than the market expected. China is clearly becoming a more mature economy with growth that is more consistent with middle-income affluence. So while many people will long for the blistering 10–12 percent growth of the past, it is entirely normal that China would shift to a lower rate of growth, especially as labor force growth has basically ceased. Thus the rapid growth that was needed to absorb new entrants into the labor force is no longer an issue. The government is projecting growth of 7.5 percent going forward. The real question is whether even this level can be sustained given the severe imbalances in the Chinese economy.
In addition, there is the question as to whether the growth will continue to come from government-financed investments in infrastructure, or from domestic demand—principally consumer demand—that is needed for a sustainable growth path. It is not clear at this point if China is going to make that transition anytime soon. In any event, financial markets were disappointed with the Chinese figures, especially as growth came in lower than the market had predicted. Indeed the market was hoping for acceleration in growth. Equity markets across Asia declined on this news.
Going into the second quarter, there are signs of weakness:
- In April, industrial production was up 9.3 percent from a year earlier, and retail sales were up 12.8 percent over a year ago—both figures represent a slowdown in growth.
- The government reported that its purchasing manager’s index (PMI) for services fell from 55.6 in March to 54.5 in April. This indicates continued moderate growth of services, but at a slower pace.
- The government reported that the PMI for manufacturing dropped from 50.9 in March to 50.6 in April—just barely above the critical 50.0 level, below which output declines. In addition, an index of new orders in China’s manufacturing sector fell from 52.3 in March to 51.7 in April. These reports mean that the manufacturing sector is barely growing.
- The government reports that, in April, consumer prices were up 2.4 percent over a year ago. This is well below the government’s target of 3.5 percent inflation. In addition, wholesale prices fell 2.6 percent in April versus a year ago. This is likely due to declining commodity prices as well as excess capacity at factories. The divergence of wholesale and retail prices will boost the profit margins of retailers. Declining wholesale prices are likely to lead to lower consumer-price inflation in the coming months. Lower inflation will give the government leeway in deregulating the prices of resources and utilities. Such price controls lead to inefficient use of resources, which in turn restrain productivity growth and contribute to pollution.
China is clearly becoming a more mature economy with growth that is more consistent with middle-income affluence.
The slowdown in economic activity, of course, is partly due to policies implemented by the new regime. The effort to scale back borrowing by local governments is having a dampening impact on fixed-asset investment—much of which is financed by local governments. The anti-corruption campaign, including discouraging the entertaining of government officials, appears to be suppressing retail sales.
The question now is what the government does next. Although inflation is modest, the central bank may not want to ease policy further lest it encourage excessive borrowing or more property price increases. There is concern that, given the excessive growth of credit and a property price bubble, the government may not have the flexibility necessary to stimulate the economy.
An easing of monetary policy and the opening of new sources of credit would only exacerbate the credit market problems. More fiscal stimulus would boost the parts of the economy that are already growing rapidly, such as investment in infrastructure, but it would do little to assist the economy in shifting toward more sustainable forms of growth, such as consumer spending. Yet the government may decide to engage in more investment-driven stimulus. In other words, China appears constrained in its ability to undertake reforms that are necessary for long-term structural adjustments and sustainability.
On the reform front
China’s government announced that it will take action aimed at reducing capital controls. Specifically, it will allow freer movement of currency in and out of the country. In addition, it will create a mechanism to allow the Chinese to invest money outside of China. These initial steps could later be followed by measures to remove obstacles to foreign portfolio investment in China’s equity and bond markets, as well as measures to allow the Chinese to borrow money overseas. The reduction in capital controls is ultimately aimed at allowing free movement of the exchange rate and making the renminbi a fully convertible currency. This would help to boost the use of the renminbi in trade and reserve accumulation. It is likely that if the renminbi were to become convertible, then more trade and investment would take place in renminbi, thus removing some of the currency risk that Chinese businesses face. In addition, allowing the Chinese to invest overseas could remove some of the upward pressure on the value of the currency.
The deregulation of capital flows is highly relevant. It has been reported that capital flow into China accelerated sharply—likely due to two factors. First, quantitative easing in the United States, Japan, and United Kingdom has led to very low interest rates in those countries. This in turn has led investors to seek higher returns elsewhere, including in China. Moreover, Chinese enterprises are increasingly borrowing abroad and bringing hard currency back through various channels, including export invoicing. Second, some investors now expect an increase in the value of the renminbi. Consequently, they are putting money into China in anticipation of a currency appreciation. The irony is that the inflow of capital is putting upward pressure on the currency. The government must decide to either allow the currency to rise or purchase foreign currency reserves in order to prevent appreciation. The latter would entail increasing the money supply when the leadership is concerned about inflation. It is reported that, in the first three months of the year, the government purchased $157 billion in foreign reserves, thereby preventing appreciation. However, in April the government allowed some appreciation.
Finally, the Chinese government announced that other reform efforts will be speeded up, including new controls over local government debt. The government said that the national government agency responsible for approval of local government debt issuance will more closely scrutinize debt issuance. Specifically, it is expected to pay more attention to debt issuance when the vehicles used by local governments have a low bond rating and when debt levels are already high. The government is keen to limit local government debt, which has already grown explosively and poses a risk to the financial system. Actually, local governments are forbidden by law from issuing debt or borrowing from banks; however, they have established an estimated 10,000 special-purpose vehicles to issue bonds to pay for infrastructure development. For projects that fail to generate a positive return, local governments service these debts through the sale of land use rights.