China: Growth May Bring Tighter Money
Just how strong is the Chinese economy? Economic growth accelerated further during the second quarter, as the government on July 18 reported second quarter gross domestic product shot up 11.3% in the second quarter year-over-year and from 10.3% in the first quarter. The robust data would point to annual growth accelerating from 9.9% in 2005 to perhaps 10.5% or more in 2006.
While such growth would be only moderately higher than the annual average of 9.9% for the past dozen years, it is contrary to original projections from officials and semiofficial think tanks for moderation toward 9.0% growth in 2006. Accelerating GDP growth is heightening anticipation for further policy tightening measures. That may include the Peoples Bank of China extending its April rate hike, and perhaps allowing faster appreciation of the Chinese yuan.
The robust GDP growth parallels the strength in recent data, which saw June exports rise 23.3% year-over-year and imports increase 18.9% year-over-year. This brings total trade in China (which in 2004 surpassed Japan as the world's third-largest trading economy) to 23.4% year-over-year during the first 6 months of 2006, a reminder that global trade is booming.
Upcoming releases for June are expected to show a slight acceleration in industrial production from the year-over-year increase of 17.9% in May, and in retail sales from the May 14.2% year-over-year increase.
Official data showed urban investment spending rising to a cumulative 31.3% year-over-year through June, accelerating from 30.3% through May and the annual 27.2% in 2005. It implies year-over-year growth of more than 33% for June and has elicited concern about potential "over-investment" in some industries such as steel, cement, and aluminum that could interfere with stable growth.
The pick-up in GDP growth, just like the 10.3% year-over-year increase during the first quarter of 2006, exceeded expectations. Only a year ago government officials and economic experts had been projecting some easing in annual growth—closer to 8%—in 2005. It instead saw 9.9% growth, after significant revisions last December boosted growth to 10.0% during 2003 and 10.1% during 2004 (both from 9.5%). Though still not far out of line with the annual 9.9% average for the past dozen years, it will likely raise fears of potential overheating.
This suggests the growing likelihood for further tightening by the PBoC, after it surprised markets on Apr. 27 when it hiked its benchmark one-year lending rate by 27 basis points to 5.85%. The central bank followed this increase by raising the required bank reserve ratio by 0.5% to 8.0% (effective July 5), the first increase in two years, after officials expressed concern about the need to restrain rapid money and credit growth.
April represented the first rate increase since October, 2004, when the PBoC had raised interest rates for the first time in nine years. A motivation for that earlier rate hike had been to maintain positive real interest rates, after the CPI had climbed to 5.3% year-over-year during July-August, 2004, the highest in seven years, up from an annual 1.2% year-over-year in 2003. CPI subsequently subsided notably, narrowing to 0.9% year-over-year by September, 2005—mostly a reflection of a supply-related swing in food prices.
Inflation remains subdued, with the May CPI up 1.4% year-over-year and June CPI projected to rise to 1.5%. Though up from the nearly three-year low of 0.8% year-over-year in March, with inflation not yet spiraling out of control, there is no urgency for additional rate hikes in the near term. In fact, the PBoC reportedly had been avoiding raising rates in part out of fear that doing so would hurt fragile state-owned firms or generate a new round of nonperforming loans in the wake of the recent wave of investment, potentially destabilizing the banking sector.
Aside from the rate hikes in 2004 and now 2006, efforts toward restraint had largely taken the form of administrative control measures to rein in red-hot sectors such as property and the steel, aluminum, and cement industries. This included rejection of specific investment projects, and "window guidance" by the PBoC for commercial banks to restrict lending to certain industries. The rate increases can be viewed as one more step by Beijing toward greater use of the market mechanism.
On another front, Chinese officials might be prepared to tolerate an acceleration from what has until now been a glacial pace of yuan appreciation. Since adopting a managed float last July, after revaluation by 2.1% vs. the U.S. dollar, Beijing continues to intervene heavily in currency markets, limiting yuan appreciation to a cumulative 1.4% vs. the greenback in the 12 months since last July, and an even smaller 0.5% versus a basket of other currencies. Futures contracts imply less than 4% appreciation in the yuan to around 7.7 per dollar in 12 months, only a moderate acceleration.
Despite repeated encouragement from the G7 on the benefits of correcting global imbalances, Beijing has told the world that it would continue to pursue exchange rate liberalization at its own pace. It nevertheless might be wary that while the U.S. Congress has been pleasingly patient this year, threats of a protectionist tariff are likely to resurface with the approach of November elections in the U.S.
With China's second-quarter GDP growth hitting higher than double-digit rates, regional economies should take heart on anticipated continuing support from what is already the first or second biggest market for exports across Asia. From the perspective of the rest of the world, the likely strength will provide another reminder of the continuing momentum in this key engine of global growth.