China Wary About Overstimulating the Economy

When Chinese premier Wen Jiabao presented his annual government work report at the National People's Congress last week he set an impressive GDP growth target of 8% for 2009, but he disappointed investors who had been hanging on the hope that he would increase the country's already substantial stimulus package.

Wen's speech offered few surprises, instead reiterating many of the key features of China's earlier plan to emerge from the global economic malaise. Apart from the GDP target, the government wants to create 9 million jobs in the cities to keep urban unemployment below 4.6% and maintain the annual increase in the consumer price index (CPI) at an average 4%. Wen talked again about the need to encourage domestic consumption in order to reduce the country's reliance on exports.

Before Wen's speech, speculation was rife that the government would increase its Rmb4 trillion ($585 billion) stimulus package to as much as Rmb8 billion. But Lan Xue, Citi's head of China research, points out that there was never much truth to the rumour, and suggests it is probably a good thing that the government decided not to commit to more spending.

"As the government foresees the necessity to run a deficit for quite a few more years to come, we believe they need to run an accelerating deficit position to maintain the stimulating effect, and thus start with a deficit that is not too aggressive," says Xue.

Another positive result of the government's decision to hold back on boosting the stimulus package, says Xue, is that it will avoid creating excess capacity, especially on the infrastructure front. Slapping down new roads and building new bridges may not require as many unemployed people as initially expected, and it will increase the rate of non-performing loans. "What we are seeing is that focus is being shifted towards more social welfare-related spending such as unemployment benefits, healthcare spending and education spending," she says. Social stability goals could therefore be met by providing migrant workers, who have lost their jobs, with unemployment benefits.

J.P. Morgan's head of China research Frank Gong writes in a recent research note that the lack of extra spending could be due to complacency. Since exports and foreign demand have yet to reach the bottom, "policymakers might wait and watch whether the latest signs of recovery could turn into a more sustainable trend (and if so), they might consider the need for further near-term stimulus less imminent". He says that policymakers already appear satisfied with their efforts to rescue the economy.

There is still plenty of bad news coming out of China, however. A recent note by Morgan Stanley points to several signs of deterioration. Steel prices are down as steelmakers increase production on the expectation of increased demand in the near future. The demand for oil products is diminishing, with consumption down 16.6% year-on-year in January. And shipbuilders are revising their prices downward in the face of weakening demand for ships.

One piece of good news is that China's equity markets have rallied against the headwinds. The China Share Index 300 (CSI) was, as of yesterday, up 17.6% year-to-date, making it one of the best performing indices in the world so far this year. China's over-heated equity markets were the first to collapse last year, but the recent rise in the A-share market suggests that investors believe that things are going to get better in China in the near term.

"The A-share market has to have some anticipatory value to it—it can't be just noise," says Michael Kurtz, Macquarie's head of China research. This is despite the fact that he thinks that it is still a little too early for the stimulus package to be showing much of an impact yet.

The kind of effect that it will have in the near term is uncertain. Kurtz compares the current situation to the Zen riddle about what happens when an unstoppable force encounters an immoveable object. "The unstoppable force is vast quantities of liquidity being thrown into the system. But the immovable object is global balance sheet contraction, excess industrial capacity, a household sector that remains worried about the status of their jobs, and imported energy and commodity price declines."

"In the short term," he says, "it's tough to say how this will resolve, but in the longer term there will be inflation." This suggests that if China can resolve its short-term growth issues, it could be back in the same old inflation trap it was in last year.

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