Consequences of China's shifting economy
(Agencies)
Updated: 2005-04-29 10:21

The Chinese economy is now off the top of its investment-driven business cycle and is moving toward a position of substantial overcapacity, which may begin to weigh heavily on prices next year and should see exports surge.

China's gross domestic product grew by 9.5 percent in the first quarter, a higher figure than expected, while consumer-price inflation averaged a relatively modest 2.8 percent. January to March marked the seventh consecutive quarter of growth over 9 percent, with no discernible declining trend. However, the headline figure masks a clear deceleration in domestic economic activity, which has been offset by a substantial increase in net exports.

Most physical indicators showed clearly slower growth in the first quarter than in most of 2004. Monthly industrial production growth averaged 14.5 percent, down from a peak of 17.6 percent in the second quarter of last year. Electricity production averaged 13 percent growth, down from 15.7 percent in the second quarter last year. Fixed-asset investment grew by 22.8 percent, compared with 43 percent a year earlier. Perhaps more apparent, investment in new projects grew by less than 2 percent in the quarter just ended--a clear leading indicator of a much sharper slowdown in investment later this year.

The only major indicator that is not trending downward is the trade surplus. Normally, China runs a very small surplus, or even a deficit, in the first quarter, after which the quarterly trade surpluses grow progressively larger throughout the year. For example, last year a first-quarter deficit of about US$8.5 billion converted into a full-year surplus of US$32 billion. This year, China ran a surplus of US$16.6 billion in the first quarter, suggesting that the full-year surplus could well reach US$100 billion, or triple last year's figure.

Latent inflationary pressures appear to be building, on the evidence of large recent input price increases, which it is assumed must eventually feed through into consumer price inflation. However, so far this feed-through has not occurred. The year-on-year consumer price index rose 2.7 percent in March, and 2.8 percent on average for the first quarter. Raw material price inflation, while still high--10.1 percent in the first quarter--is slowing down.

This suggests that CPI inflation could rise to around 5 percent in the second quarter, based on a lag effect from last year's raw material price increases, but could well decrease later in the year.

However, there is more of a risk that the enormous over-capacity built up over the last three years of breakneck investment growth will spark a return to deflationary pressure sometime next year.

A short-term consequence of the current combination of excess industrial capacity and declining domestic demand will exert further upward pressure on the trade surplus, as manufacturers seek to clear inventories by exporting what they cannot sell at home. One sector where this effect is almost certain to show up is steel. China is likely to add 65 million tons of new steel capacity this year, while domestic steel demand on current trends is likely to rise by only 30 million tons.

The explosion of the trade surplus will exacerbate political tensions with developed-country trading partners, which are already nervous about "floods" of cheap Chinese exports. This will give rise to louder calls for Beijing to revalue the renminbi, the Chinese people's currency, already apparent in the recent threat by the U.S. Congress to impose a 27.5 percent tariff on Chinese imports if the renminbi is not revalued. Over the weekend, the European Union called on China to reduce textile exports to Europe or face restrictions.

However, one of the main pieces of evidence for the undervaluation of the renminbi--China's rapid accumulation of foreign exchange reserves--has begun to recede, even as the trade surplus balloons. In the first quarter, China added about US$50 billion in foreign exchange reserves, of which US$30 billion, or 60 percent, is directly attributable to the trade surplus and foreign direct investment (FDI). Other inflows thus totaled US$20 billion.

By contrast, last year China added US$216 billion to its reserves, of which just US$92 billion, or 42 percent, was attributable to trade and FDI. Other inflows averaged over US$30 billion per quarter. It is clear that as its investment cycle slows, China is becoming a less attractive destination for speculative capital.

The implications of this are that a modest revaluation of the renminbi--by say 5 percent to 10 percent--would have no impact on the trade surplus, which is determined by two structural factors: a surplus of domestic savings over investment and industrial overcapacity.

As the government tries to head off overcapacity by restraining investment, the savings surplus--and hence the trade surplus--will increase. Any renminbi revaluation large enough to counteract these forces--40 percent is a minimum estimate--would probably plunge the economy into serious deflation. Beijing will not take such a dramatic step. Instead, it is likely to pursue greater exchange rate flexibility by switching to a trade-weighted basket peg within the next six to 18 months in an effort to minimize the shift in the yuan-dollar exchange rate.

The short-term consequences as the economy comes off the top of its investment-driven business cycle and moves toward a position of substantial overcapacity will be a continued slowdown in investment growth, a modest rise in consumer-price inflation and a tripling of the trade surplus as the economy relies more on external sources of demand. Next year, inflation could give way to deflation, and the trade surplus will continue to grow as manufacturers try to clear inventories by exporting. However, Beijing is unlikely to bow to pressure to substantially revalue its currency, preferring a more modest move in the direction of exchange rate flexibility.