Scrutinizing China's Every Move
By David Cohen
China has come of economic age, and the world is starting to take notice. Case in point: global reaction to two late-October events. A report that the Middle Kingdom's third-quarter gross domestic product had moderated to a 9.1% year-over-year growth pace, from a 9.6% rate in the second quarter, sent a tremor through world markets.
But the real eye-opener came when the People's Bank of China (PBOC) raised the country's one-year benchmark interest rate by 27 basis points, to 5.58% -- the first such hike in nine years. Stocks of commodity-goods providers -- buoyed all year long by huge demand in China -- dove on fears that China's torrid growth might be starting to slow.
Many analysts had been calling for an increase to maintain positive real rates after China's consumer price index had climbed to 5.3% year-over-year during July and August. That was up from an annualized 1.2% pace in 2003 -- marking the most widespread inflation in seven years. But the move was a surprise. So was the reaction, even though commodities have regained some ground since then.
What's going on here? China's rapid rise as an economic powerhouse is finally getting the notice it deserves. Chinese finance officials were the center of attention in their debut appearance as invited guests to the G-7 meeting in Washington last month.
Of course, this development isn't all that new. Real GDP in the Middle Kingdom has averaged almost 10% for the past 20 years. Even discounting for the accuracy of the data, this far surpasses any other major economy over that span.
Equally noteworthy has been China's emergence as a major player in world trade. Export growth (in nominal U.S. dollar terms) averaged near 17% annually from 1993 through 2003, trailing only the U.S., Germany, and Japan as the fourth-largest exporting nation. China is now the second-largest customer, behind the U.S., for exports from Japan, Australia, and many of the other Asian economies.
HUGE GREENBACK PURCHASES.
Fueling this growth is the movement toward a market economy, including the privatization of tens of thousands of state-owned businesses once central to Communist Party rule. And the result has been massive volumes of foreign direct investment (FDI) -- reaching $52.7 billion in 2002 -- leaving the country neck-and-neck with the U.S. for global leadership in that category. A new phase began in 2003, when foreign and private investors were permitted to buy majority stakes in large enterprises the government had previously refused to sell.
The size and growth of China's domestic market, plus the allure of low wages and production costs, can no longer be ignored by any corporate player in the world stage. That's why electronics, telecom equipment, and chemical and machinery manufacturers have been flooding the mainland with new production technology.
Perhaps attracting most attention this year has been the Chinese currency, the yuan, which has been pegged at 8.28 yuan to the U.S. dollar since 1994. To maintain this peg in the face of the substantial capital inflows and an ongoing moderate current-account surplus, China has made massive purchases of dollars in currency markets. Its foreign-exchange reserve holdings climbed to $514.5 billion in September, placing it second only to Japan as the largest holder of dollar reserves.
Capital inflows have accounted for a bigger portion of the recent balance-of-payments surpluses, with an annual merchandise trade surplus of $25.7 billion in 2003. This compares to reserve accumulation of $117 billion last year and a modest trade surplus of $3.9 billion during the first nine months of 2004, when China added $111 billion to reserves.
The aggregates obscure a massive bilateral trade surplus with the U.S. ($124 billion in 2003), to a large extent offset by China running a trade deficit with the rest of the world and, in particular, with its Asian neighbors (with the exception of Japan). Along with raw-material imports, this deficit reflects Chinese assembly of components imported from Asian neighbors and exporting the final products to the U.S. In a sense, the bilateral U.S.-China imbalance is a proxy for the U.S. deficit with all of Asia.
And it explains why China is coming under mounting pressure to allow appreciation of the yuan vs. other currencies in order to adjust its balance of payments. Ironically, the dollar-yuan peg was welcomed during the Asian financial crisis of 1997-98, when China helped contain the instability by holding steady in the face of devaluations by many neighbors. By David Cohen
RIPPLES THROUGH ASIA?
Chinese officials now hint at moving toward flexibility over the "medium to long term," but pointedly decline to give a timetable. Appreciation of the yuan vs. the dollar could help achieve some relief from recent imported-commodity price-inflation pressure, while posing little threat to domestic employment amid current robust economic growth.
Some adjustment appears likely within the next six to nine months, probably in the form of permitting the yuan to fluctuate within a band range vs. the dollar, rather than a simple revaluation of the peg.
Other Asian nations are watching closely. If China allows its currency to rise a bit against the greenback, that could allow others to tolerate some appreciation of their own. Many have intervened heavily in currency markets over the past year, buying dollars to prevent appreciation of their own currencies -- out of fear of losing competitiveness to China.
A COOLING EFFECT.
A general appreciation of Asian currencies vs. the dollar would be welcomed as an appropriate way to correct the unsustainable U.S. current-account deficit, which is the world's primary trade imbalance.
Allowing the yuan to rise could also aid Chinese efforts to cool off its white-hot economy. Until the recent rate hike, efforts toward restraint had largely taken the form of central-government controls to rein in overheating sectors, such as the property market and the steel, aluminum, and cement industries. The PBOC also made moves to raise bank-reserve ratio requirements.
These measures have achieved some success, as GDP growth has now gone from 9.9% in the fourth quarter of 2003 to 9.1% year-over-year. Annual growth in 2004 is still projected to be on par with last year's 9.3%, but projections have it headed toward 8% in 2005.
Chinese policymakers also seem to be making some modest headway on the inflation front. The year-over-year increase in CPI eased to 5.2% in September, from 5.3% in July-August. CPI excluding food is up a modest 0.7% from the prior year as of September -- that's modest by any measure.
The interest rate hike can be viewed as a prudent step toward controlling inflation and reducing the eventual risk of the bursting of an asset-price bubble. But many analysts are already anticipating at least a full percentage point hike in rates in the coming months. A single rate increase of 27 basis points will hardly be sufficient to cool off such a robust economy.
The hike also symbolizes a shift in the policy mix toward more market-oriented mechanisms and more welcome -- rather than blunt -- administrative measures. The PBOC reportedly had been avoiding raising rates partly out of fear it would hurt fragile state-owned companies.
NOT WEIGHTED BY DEBT.
Now that the Chinese central bank has acted, concerns are rising that trying to cool down overheated sectors by hiking rates could generate a new round of nonperforming loans in the wake of the recent wave of investment. This would be potentially destabilizing for the banking sector and would be one of the worst-case scenarios triggering a "hard landing" for the economy. However, government finances appear sufficiently healthy to continue to provide whatever capital injections are necessary for the banking sector.
Ratings agency Fitch points out that yearly foreign direct investment inflows of 3% to 4% of GDP and high domestic savings have allowed China to finance growth without building up external debt obligations. These obligations remain low, at 14% of GDP. This distinguishes China from the Asian economies that experienced financial crises in the late 1990s following booms in investment and credit growth. At the same time, soaring foreign-exchange reserves provide China with valuable liquidity.
One important point to remember: China's economic growth has been remarkably stable. It continued to boom through the 1997-98 Asian economic crisis (despite loss of competitiveness relative to devalued regional currencies). And economic expansion kept up during the cyclical downturn experienced by many of its trading partners during 2000-01.
A VITAL GENERATOR.
Though challenges remain, the prospects are reasonable for China to avoid a hard landing that could spill over to the export-dependent economies across Asia.
But its policy moves are being watched and weighed as never before. With China increasingly seen as a vital engine for world growth, markets have begun to treat its economic data and policy moves much as they would those of any other global economic powerhouse.
Cohen is director of Asian economic forecasting for Action Economics