China not slowing down as expected


Updated Mon, 06 Sep 2004 00:00:00 GMT

OVER the last one-and-a-half years most of the economists had been setting aside the threat of rising global inflationary expectations with the belief that China would slow down sharply.

The difference in opinion had been on whether there would be a soft landing or a hard one. The land of dragon has once again mystified all with its strength. All economic indicators points to China still growing too fast and there is no slowing down in sight as yet. Would this necessitate a re-look at the global demand equation? We examine the Chinese economy for such signs.

Chinese administration has been worried about the very strong pace of investment growth. Even in the second quarter of this year the investment growth remained above 25 per cent.

The authorities consider that a sustainable rate of growth would be around 15 per cent. Measures were brought in last year to slow down the investment growth rate. These measures were largely quantitative.

The deposit reserve requirement of banks has been raised thrice. Certain bodies cannot lend into specified sectors such as steel, cement and real estate. The credit growth has fallen from 23 per cent in third quarter of 2003 to around 15.5 per cent in July 2004.

Even the money supply indicators show slower expansion. The M1 and M2 measures of money supply are growing at 15 per cent from 20 per cent. In first half of this year, the foreign exchange reserves went up by $67 billion to touch $470 billion.

The central bank has sterilised around $54 billion by selling Treasury Bills. There are signs that the reserve requirement hike is curbing credit growth but not to the desired levels. The quantitative restrictions are open to breach due to improper monitoring or corruption.

One sign that the investment growth is not slowing down is that the demand of crude oil and the commodities from China remains relentless.

The Chinese crude oil consumption is around 6.5 million barrels a day as per OPEC figures and is expected to move over to 7 million barrels per day next year.

There is news of electric power shortages in almost 24 of the 31 provinces in China and power black outs are common. The traffic on highways and railways still is the highest in a decade.

The railway capacity is only able to meet half of the demand of transportation. This anecdotal evidence points to continued strength in the economy.

The underlying inflationary pressure is far higher than the official price indicators suggest. Even though the WPI and CPI show around 6.4 per cent and 5.3 per cent in July, the actual number may be closer to 10 per cent.

As there are price controls in place it blurs the real picture of inflation and makes it harder for price change to curb investment.

It is obvious that for investment growth to slow down the controls must stay in place for the next three quarters.

It seems that only 30-40 per cent of the slowdown process has been achieved.

There are further signs of intervention. Electricity and refined oil prices were hiked last week.

The central bank continues to urge banks to reduce lending to overheated sectors.

It would be difficult to avoid monetary tightening. We think that China would have to hike interest rates by around 50 basis points to stop real interest rates falling too quickly.

In the Asian region, China and India are two countries where the real deposit interest rates are now negative and there are signs of real lending rates turning negative.

There is a clear threat that negative real interest rates would further increase the incentive for investments. Both China and India would have to guard against this scenario.

One argument against higher interest rates is that it would hurt private consumption. One might think that a deposit rate hike encourages household to save more and spend less, creating a substitution effect. This is not a valid reason.

In China, the total consumer loans are around 1.4 trillion Chinese RMB (Renminbi), whereas the total deposits from households is around RMB 11 trillion.

An increase of one per cent of interest rate would add income of around RMB 100 billion which would create a considerable income affect.

Data shows that consumption growth is not sensitive to interest rates in China.

It is clear that it would take a longer than expected time for China to slow down. This effort would also require monetary policy measures.

This clearly has a loud message for the other central banks which would have been hoping that a Chinese slow down would give a respite from inflationary pressures.