A remarkably stable outlook for China

As we were wrapping up the work on our new China Quarterly Update (of which I am the main author), looking at our main conclusions and messages on economic developments in China, prospects, and the key policy challenges and tasks, I noticed that, despite lots of new data and all the headlines about changes, likely changes and risks, our overall conclusions and views have not changed all that much since June, when we released the last one. Noticing this was sobering but also somehow comforting.

In any case, the third quarter data that came out almost two weeks ago confirmed that China’s growth has moderated somewhat, but to a still healthy pace. GDP growth declined from 10.6% in the first half to a still surprisingly strong 9.6% (yoy) in the third quarter, with the slowdown led by industry.

The composition of growth has shifted. The domestic economy has cooled through 2010 as the stimulus impact is fading out and the monetary stance is being normalized. Investment and urban consumption have decelerated, and so have imports.

Meanwhile, with exports strong and a broadly unchanged growth pattern so far, net external trade has contributed significantly to (yoy) growth in the second and third quarter (see Figure 1) and the external surplus is rising again, even though this was masked in the first half of 2010 by terms of trade effects.

• Notwithstanding some recent easing, China’s highly competitive exports have grown rapidly through 2010, continuing to outpace global imports.
• The expansion of import volumes has slowed alongside investment.
• China’s terms of trade (TOT) were very unfavorable in the first half of this year because commodity prices were rising rapidly while export prices were still very subdued, presumably because of spare capacity in manufacturing industry worldwide. But recently the TOT have turned around as commodity price increases have moderated while export prices have picked up.

Thus, while in the while in the first quarter of 2010 the trade surplus was US$47.7 billion lower than a year ago, in the third quarter it was US$ 26.5 billion higher than a year ago.

The RMB has appreciated somewhat against the US dollar in recent months. However, because of depreciation of the US dollar against many currencies, China’s nominal effective exchange rate has actually depreciated in recent months, although it is still stronger than in mind 2008, when the temporary peg vis-à-vis the US dollar was officially abandoned.

With respect to the global outlook, there is a lot of concern about the expected slowdown in several high income countries (HICs), especially the US. However, global growth prospects for the rest of this year and 2011 are actually fairly favorable. This is in large part due to emerging market strength. Aggregating the country specific projections from professional private sector forecasters—rather than using the forecast of an international organization—prospects for global GDP in 2010 and 2011 are  better now than at the start of this year.

But that is the baseline, and it is true that there are real risks to it. One pronounced risk is a weaker outlook in high income countries and the impact of the possible resulting monetary easing on international liquidity and capital flows. Another one is the global imbalances—the combination of large current account deficits in some countries, notably the US and large surpluses in other countries, including China. These imbalances pose risks in their own right. In addition, in a bad case scenario they could trigger unhelpful policy responses.

Global price pressures remain contained by spare capacity in many countries. But raw material prices have risen again recently and there are upward inflation risks internationally.

China’s own economic prospects remain pretty good, notwithstanding risks both ways. Growth may ease a bit further as global growth decelerates and the macro stance is normalized further. However, investment should remain supported by the traditional growth drivers and consumption by a robust labor market. We have edged up our GDP growth projection for 2010 to 10% after the third quarter data. We see growth moderating to 8.7% in 2011 and easing somewhat further in the medium term.

Pushed up by higher food prices, inflation may stay above the 3% target for a while. It is unlikely to escalate as core inflation should remains in check. However, impact from renewed raw commodity price increases is still in the pipeline and raw commodity prices may rise further. What about wage pressures? Wages in manufacturing increased a lot earlier this year. We looked at the experience in manufacturing over the last decade (in a box in the quarterly). So far, respectable wage growth has been combined with solid productivity growth, and ULCs have remained well behaved. Will this change in the future? If, as many argue, China’s surplus labor has dried up and China is about to enter a new development phase, with a tighter labor market, we could expect this to change. I do not think China is at this stage yet—there are still too many people living on the country side. But I guess it is not unreasonable to expect a tighter labor market in the years ahead than in the previous decade. 

On current trends and policies, the external surplus is on course to rise in 2011 and the medium term. Our medium term export projections are fairly conservative, with more modest growth of world trade in the medium term and a substantial slowdown in the pace of market share gains. As a result, import growth is somewhat faster than export growth in our medium term forecast—a feature that assumes some combination of real exchange rate appreciation, adjustment of prices, and rebalancing towards domestic demand and services. Even so, with export substantially larger than imports, this still produces a substantial rise in the external surplus in the years ahead (Figure 2).

We think a further normalization of the macroeconomic stance is needed to guard against macro risks. The key concerns are asset price increases, strained local finances and NPLs, while inflation risks cannot be ruled out. Two way risks call for policy flexibility. The authorities seem broadly on track to normalize the overall monetary stance and meet the 2010 quantitative targets. They have also started to raise interest rates, although interest rates will need to rise more. International liquidity and financial capital flows pose challenges to monetary policy. However, given China’s capital controls and the modest role of financial capital inflows in China, quantitatively, these should be more manageable in China than in some other emerging markets and they should not be a reason not to increase interest rates. Nonetheless, measures can be taken to enhance protection against unwanted capital flows.
 
The preparations for the 12th 5YP (2011-2015) call for focus on structural issues and reforms. Changing the growth pattern is rightly a key target. The need to rebalance to more domestic demand led, service sector oriented growth seems stronger now than 5 years ago, in part because the international environment is less favorable.  It is tempting to think that high wage increases in the coming years will raise the role of household income and consumption. However, I do not think rebalancing will happen by itself—it will require significant policy adjustment.

This Update also discusses policies that would help boost private sector development, focusing on opening up sectors and reducing entry barriers, addressing investment climate constraints, and supporting research and development and innovation by the private sector. Further progress in energy conservation and renewable energy calls for further rebalancing the pattern of growth, energy pricing reforms, more market-based mechanisms, lower cost of renewable energy, and accelerated development and diffusion of new energy technologies.