China's Economy: Another Blazing Quarter

The mainland's 11.9% second-quarter growth rate blew past market expectations and suggests more aggressive cooling measures are on the way

China's supercharged economy just won't let up. On July 19, Beijing announced a set of torrid economic numbers that came in ahead of already bullish market forecasts. China's $2.8 trillion economy clocked 11.9% growth in the second quarter, the fastest pace in about 12 years.

Fixed-asset investment in factory plants and public works projects shot up 25.9% in the first half of 2007. (It was up 24.5% for all of 2006.) Even more disturbing, inflation jumped 4.4% in June, well above the official target of 3%. With second-quarter gross domestic product growth roaring even faster than the 11.1% recorded January through March, China is now on track to surpass Germany's nearly $2.9 trillion economy—and become the world's third largest—by yearend.

While there is no doubt China needs fast growth to keep generating jobs for its legions of farmers and workers, the latest numbers are reigniting concerns of overheating, big time. So analysts are predicting another interest rate hike, perhaps imminently, following two earlier this year that brought rates on one-year loans to 6.57% and on deposits to 3.06%, as well as the cancellation of a 20% tax on deposit interest income.

Yuan Revaluation on the Way?

"We expect the government to tighten policy decisively" in the second half, wrote Hong Kong-based Goldman Sachs Group (GS) economists Hong Liang and Yu Song in a July 19 report that followed the release of the Chinese economic numbers. "The economy is swimming in liquidity, so there have been ample funds for new investments," says Hong Kong-based Jing Ulrich, chairman of China equities at JPMorgan Securities (JPM). She is predicting a 27 basis-point hike in both lending and deposit rates as well as another 50 basis-point increase in banks' reserve requirement ratio for later this year and an end to deposit interest income.

The Chinese economy is "accelerating, not moderating as the government wants. This will clearly call for a government response," says Glenn Maguire, chief Asia economist for Societe Generale based in Hong Kong, putting most of the blame for that on investment financed by companies' retained earnings. He predicts China's central bank will probably raise rates in the next few days, but also aim for a large one-off revaluation of the yuan later this year.

"The bulk of investment is financed by retained earnings. The easiest way to cool profits is to allow the yuan to appreciate," he says, predicting a one-off 3.5% revaluation by yearend. The yuan has appreciated about 9.4% since July, 2005, according to Bloomberg data. Second, Maguire says, Beijing needs "to reintroduce austerity measures and a clampdown on regional government" spending, a perennial problem for the central government, which struggles to rein in local officials across the mainland.

Keeping Inflation in Check

As well as investment, another concern for Beijing is fast-growing inflation, up 3.2% in the first half (and 4.4% in June). That's mainly driven by soaring food prices, up 7.6%, with grain prices up 6.4% and meat prices up an astonishing 20.7%. The rise in meat prices is mainly driven by an ongoing surge in pork prices, China's staple meat, which has led to hoarding by anxious Chinese citizens and prompted Chinese Premier Wen Jiabao earlier this year to publicly vow to contain further price rises.

"We are keeping a close watch on what direction the accelerated economic growth is taking," said Li Xiaochao, spokesman for the National Bureau of Statistics, speaking at the press conference where the latest numbers were released. But "whether or not the economy is overheated is a comprehensive issue that should be viewed from different angles," he continued. "Investment is still facing rebounding pressure. This will require concrete measures." Expect the latest soaring GDP numbers to usher in at least a few economic policy tweaks by Beijing in the coming weeks.

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