China’s financial system is healthy, and its leaders are providing a swift and strong economic stimulus, but no one knows how far global trade will fall. Amid statistics showing a severely slowing economy, China’s first-quarter data also emitted signals that domestic stimulus may already be taking hold. However, the international trade situation remains too volatile in the short term for any single set of statistics, either positive or negative, to become the final word on China’s medium-term economic prospects.

At least three concurrent developments explain China’s sudden and severe economic difficulties this winter and early spring. They are the collapse in international trade volume heavily affecting China’s coastal regions, a sharp real estate slump dating from the anti-inflation credit and investment tightening of late 2007, and conscious official policy steps beginning in early 2007 to restructure export-oriented industries in southern China by closing a large number of small, inefficient, and pollution-generating factories there.

In response, China’s large stimulus, launched late in 2008, is pumping money into a wide range of domestic investment and consumer programs. The stimulus seems to have at least prevented collapse. If necessary, the general health of China’s financial sector and government finances offers considerable space for further supportive intervention. But with powerful forces pulling in different directions, the dénouement of China’s economic drama at this point cannot be certain. The speed of China’s recovery will be based on how quickly the country can stimulate domestic demand—which can and is being encouraged by its economic policymakers—and how soon global trade demand stabilizes—which is out of policymakers’ hands.

Sharp Economic Slowdown
China’s first-quarter data reported that GDP grew 6.1 percent over a year earlier, a further slowing from 6.8 percent in the fourth quarter of 2008 and 9 percent for 2008 as a whole. However, China’s growth deceleration was not due to a dropping trade surplus, which fell only 2 percent from a year earlier (exports did drop 20 percent, but imports fell 31 percent, reflecting in part the processing-trade nature of much of China’s trade). Instead, slow growth of domestic demand, which grew at only 7 percent despite over four months of extraordinary domestic fiscal and monetary stimulus, is to blame for weak GDP growth. 

However, weak domestic demand growth appears to have been heavily driven by a large drawdown in inventories, not by diminished fixed-asset investment or retail sales.  While investment, together with inventory change, only grew at a 5 percent pace over a year earlier, nominal fixed asset investment grew 29 percent (at a time when China has little inflation).  Retail sales grew by 15 percent.  How long do we have to wait before restocking needs will be reflected in faster output growth? If signs of a pickup in domestic demand continue, that moment will have to come in the not too distant future.

Ultimately, therefore, these strong demand numbers for fixed-asset investment and retail sales are encouraging. But the danger is that if world demand for China’s exports weakens substantially later in 2009 so that the trade surplus declines in a big way, then China will slip into lower GDP growth despite the end of destocking and any stimulus-induced acceleration of domestic demand.  

This is China’s major concern. With its financial system largely insulated from the toxic assets crippling other economies, the potentially most dramatic global crisis development for China is the current severe contraction in world trade. Yet, while this contraction has hurt many economies like Japan and Korea that supply China with parts, kits, and raw materials, it has not been reflected in GDP decline in China. Imports could also be falling because manufactured output initially intended for export is substituting for imports on domestic markets—this is undoubtedly also part of the inventory change trend.

Consistent with slow growth of industry (industry and construction together only increased 5.3 percent), manufacturing output growth slowed to 5.1 percent in the first quarter, a dramatic deceleration of 11.3 percentage points from a year earlier. However, manufacturing appears to be picking up steam again in March.

The employment effects of these developments are difficult to ascertain. Urban employment continued to increase in the first quarter, but only by 1.6 million – an 11 percent decline from the quarterly increase in urban jobs a year earlier. More significantly, export-oriented manufacturing dropped last year, resulting in unemployment for at least twenty million rural migrant workers formerly working in coastal factories according to officially cited numbers. This figure represents roughly 3 percent of China’s economically active population. The true figure is thought by some analysts to be twice as large.

Medium-term Recovery Promising, but Far From Certain
Counterbalancing the triple impact of China’s trade collapse, year-long real-estate slump and anemic first-quarter domestic demand growth, has been a government stimulus announced late last year, which offers a range of programs to expand domestic investment and consumption. The announcement stressed bank loans as the main funding vehicle, implying government guidance and a strongly accommodating central bank monetary expansion. Combining accelerated spending on existing projects with large new programs, the initial stimulus announced in November promised to spend 12 percent of 2009 GDP over two years on a ten-point list of projects, including affordable housing, railroads and other transport infrastructure, earthquake relief, healthcare, education, rural infrastructure, and environmental projects. In following months Beijing announced additional programs and adjustments, including real estate stimulus, light manufacturing support, and support of its steel and vehicle industries.

The results have been obvious on the input side, with very rapid growth of bank loans. Preliminary data for January-March show new bank lending was 2.5 trillion yuan more than new bank lending a year earlier, an increase equivalent to 7.7 percent of 2009 GDP. In real estate, private analysts report preliminary data for March showing that down-stream real estate construction activity accelerated substantially. At the same time, in March the official Purchasing Managers Index (PMI) shifted into the expansion range with a new value of 52.4, up from 47.5 in February and 43.4 in January.

These are promising additional hints that the economy may have already begun its recovery. The World Bank’s just published East Asia Region Update report has concluded that by mid-year, China’s economy will be recovering well and supporting recovery in other East Asian economies. Nevertheless, while 6.1 percent GDP growth in the first quarter is quite an accomplishment, these results are still too early to validate trends for the year. The balance between a dramatic decline in foreign trade activity and a possible substantial domestic demand expansion has not yet fully played itself out.

If, reflecting falling exports, China's trade surplus halved in 2009—a plausible outcome—then for China to achieve GDP growth close to the 8 percent government target, domestic demand (including inventory changes) would have to grow at roughly 12 percent, not the first-quarter’s 7 percent rate. Investment and government spending would have to play the leading role (growth of near 14 percent) because household consumption growth is unlikely to accelerate much beyond its 7 percent pace in 2008.

When all is said and done, China is in a relatively strong position compared to most crisis-stricken countries. Its financial system is healthy and liquid; its government finances are in good shape; it has institutions that can quickly ramp up public spending; and its government is determined to provide however strong a stimulus may be necessary while at the same time funding programs designed to speed up reform of the economic system. The great unknown is how bad and how long the slump in global trade will be.