China’s astonishing rebound is turning into a broad-based recovery, but its exit strategy remains unclear and local property bubbles could become a serious problem. While growth in 2010 is likely to be the same as or higher than projected for 2009, the longer-term picture is less clear.
China’s Broadening Recovery
China’s growth remained strong in the third quarter, accelerating to 8.9 percent (y/y), up from 6.1 percent in the first quarter and 7.9 percent in the second. Seasonally adjusted q/q growth was about 10 percent annualized, down from about 17 percent in the second quarter. Thanks in part to government subsidies for a wide range of consumer durables, household consumption growth also appears to be holding up well in 2009. In fact, consumption grew faster than GDP; if this pattern continues, it will help rebalance China’s economy, as well as address global imbalances.
China will account for more than half of the growth of all emerging markets in 2009.
The recovery has also broadened. The share of non-state investment in total investment began to rise in the third quarter and housing and manufacturing are experiencing sharp, stimulus-induced recoveries. The Manufacturing Purchasing Managers Index (PMI) rose to 55.4 in October (from a low of 38.8 in November 2008), the highest level since April 2008. Housing starts increased sharply during the first three quarters of 2009 and turnover is high. According to a recent report by China’s Ministry of Labor and Social Security, China’s employment picture improved significantly in the third quarter of 2009 (after four quarters of declining total employment). Overall, GDP growth amounted to 7.7 percent (y/y) in the first three quarters of 2009 and is expected to continue to rise. The IMF recently adjusted its growth projections for China to 8.5 percent for 2009 and 9.0 percent for 2010. On current expectations, China will account for more than half of the growth of all emerging markets in 2009.
China’s rebound-turning-into-recovery remains heavily dependent on domestic investment growth, which has more than compensated for the drop in external demand. During the first three quarters of 2009, as China’s external trade fell by 20.9 percent (with exports down 21.3 percent and imports down 20.4 percent), investment accounted for 95 percent of China’s growth. Net exports subtracted 47 percent, while total consumption (households plus government) contributed 52 percent. Given that month-on-month exports have continuously risen since February 2009 and that the sharply reduced trade surplus may stabilize soon, the composition of GDP growth should begin to normalize in the fourth quarter, and the share of investment in growth is expected to be dramatically lower in 2010.
So far, China’s extremely effective stimulus programs have been primarily credit-financed, with credit responsible for approximately 85 percent of them during the first three quarters of 2009. Fiscal finance accounted for the remaining 15 percent. Borrowing by development companies, which are owned by local governments and must match central government funding for infrastructure investments, partly explains this credit expansion. Given the current imbalance, fiscal stimulus is expected to play a larger financing role in 2010. The fact that M2 (broad money) growth during the first three quarters of 2009 was a multiple of GDP growth while inflation remained negative points to growing excess liquidity in the economy and declining money velocity. Although the amount of new credit injected into the economy declined sharply after June, there is as yet no sign that monetary policy will be tightened soon.
Exit Strategy, International Cooperation, and Asset Bubbles
China appears to be waiting for the United States to tighten monetary policy before embarking on an exit strategy of its own. China is concerned that an economic relapse and/or large “hot money” inflows may follow early “unilateral” monetary tightening. While this is logical from China’s point of view, it is also potentially dangerous as America’s exit strategy may be delayed by its slow recovery, high unemployment, and falling real wages. As a result, if China waits for the United States, excess liquidity could emerge on both sides of the Pacific, potentially driving up international commodity prices even faster and fueling credit-financed asset bubbles. It would be better for all if China increased the flexibility of its exchange rate again and assumed greater monetary policy independence from the United States.1 Ideally, exit strategies and macroeconomic policies should be internationally coordinated as a recent meeting of the G20 concluded.
Some policy makers in China are concerned that domestic asset bubbles might derail economic growth, as they did in Japan in 1990–1991; however, though rising, both consumer and producer price indexes remain negative (y/y) and the evidence on domestic asset price bubbles is inconclusive. The average housing price index for 70 cities is up by only a few percentage points so far this year, but housing prices in select areas of Beijing are rising fast. The price of apartments in preferred downtown areas is reported to have risen by almost 40 percent since the beginning of 2009 and is now up to RMB 30,000 per square meter. There is anecdotal evidence of similar price jumps in selected areas of Shanghai and other major cities.2 Land values are also rising sharply in selected areas. However, it is not unusual for prime property to lead in an upturn. With regard to stock prices, the evidence of bubbles is even less clear. Stock prices rose very sharply—over 70 percent—during the first 7 months of 2009, but dropped 23 percent in August following rumors that China would soon begin to tighten monetary policy. They are now about 60 percent higher than at the beginning of 2009. Thus, there is no conclusive evidence that China is facing pervasive asset bubbles at this point. However, it is extremely important that the government remain alert to the risk in the months ahead.
Is China Serious About Economic Rebalancing?
Though China’s external trade fell during the first three quarters of 2009, its share in global trade increased as trade elsewhere contracted even more. As a result, China’s current account surplus will drop to approximately 5–6 percent of GDP in 2009, which represents a sharp improvement over the 11 and 10 percent of GDP surplus in 2007 and 2008, respectively.
Evidence on China’s intentions with regard to domestic economic rebalancing is mixed.
While the crisis has reduced the country’s trade surplus for now, evidence on China’s intentions with regard to domestic economic rebalancing—that is, reducing its reliance on exports and investment, while increasing its reliance on domestic consumption—is mixed. Senior leaders acknowledge the need for such rebalancing in speech after speech, but the government has done little to discourage export growth or to encourage sales to domestic markets. Many observers think China will resume an export-intensive growth strategy as soon as consumer demand in the United States and Europe revives, which is unlikely to happen any time soon. On the other hand, there are also indications that the government does intend to rebalance. For example, in light of the excess capacity in many industries, new lending to manufacturing enterprises has been relatively small and fiscal outlays for social services (mainly health, education, and social security) have increased significantly. There is also evidence that some individual counties in Eastern China are encouraging export industries in their jurisdictions to realign production lines and sales strategies to domestic markets.
It would be helpful if Beijing were to reinforce such local initiatives with clear policy signals, such as increasing the flexibility of the exchange rate. At this point, however, Beijing seems focused on another kind of domestic rebalancing: reducing regional inequality. For instance, investment growth in less developed central and western China (close to 40 percent) has exceeded investment growth in the more highly developed eastern portion of the country (28.1 percent) by a wide margin so far in 2009.
On balance, it is likely that growth in 2010 will be about the same as or higher than in 2009. Household consumption growth may slow somewhat (from the current level of about 10 percent) as government subsidies are terminated or reduced, and investment growth will almost certainly slow; on the other hand, net exports will probably cease to be a drag on growth. The IMF’s most recent forecast of 9 percent growth in 2010 seems reasonable.
The risk of a full blown domestic financial crisis or a Japan-style prolonged recession is small.
Beyond 2010, the picture is less clear. Much will depend on three factors: China’s exit strategy from the current monetary policy and stimulus-driven growth, its progress toward reducing dependence on exports and capital formation, and developments in the rest of the world. Three risks also remain. First, excess liquidity may drive up asset prices further and more broadly than has been the case so far in 2009. Second, non-financial corporations may use their surplus liquidity for operations in financial markets and fail to concentrate on their core business as a result. Third, the quality of bank portfolios could deteriorate to the point that financial instability is hard to avoid. However, the risk of a full blown domestic financial crisis or a Japan-style prolonged recession is small; China’s economic, financial and demographic characteristics today are very different from those in Japan in the late 1980s.
Pieter Bottelier, former chief of the World Bank’s resident mission in Beijing, is a nonresident scholar in Carnegie’s International Economics Program and senior adjunct professor of China studies at the School of Advanced International Studies (SAIS) at Johns Hopkins University.
1 China delinked the RMB from the United States in July 2005, but, in response to the international financial crisis, effectively re-pegged its exchange rate in July 2008. About one-third of the 21 percent real appreciation of the RMB against the U.S. dollar during that 3-year period has been undone so far in 2009. Because of the dollar’s depreciation against the euro and many other floating currencies, China’s real effective exchange rate has depreciated significantly so far in 2009.
2 This suggests that the price of a 100 square meter apartment in preferred areas of Beijing or Shanghai is now as high as or higher than that of one in preferred areas in major U.S. cities.