Chinese growth: Is there a slowdown?

If there isn't, the consequences on global growth and prices would be much more serious

The scorching pace of growth in China has become a cause for global concern. Analysts are tracking data and every official Chinese pronouncement for any signs of an impending slowdown.

The growth story is being questioned because of the background of a weak monetary and banking system with a fixed exchange rate management policy. Standard & Poor's predicted this month that it would cost $ 650 billion to bail out all of China's lenders, which it called the world's most vulnerable.

Developments in China have global contagion effects on account of its sheer size and share in the world markets. The country consumes 7 per cent of the world's oil supply, 30 per cent of iron ore output and 27 per cent of all steel products, among others. This has been one of the primary factors for rising commodity prices worldwide.

The strong demand from China has been the reviving factor for the economies of south-east Asia, particularly Korea, Taiwan and Japan. An internal International Monetary Fund (IMF) study estimates that a 10 per cent decline in China's imports could shave 0.5 percentage points off Asia's economic growth rate.

China's battle to control its economy and simultaneously revive its financial system has worldwide implications. Chinese officials are already talking about the slowdown "" in July, the National Development and Reform Commission, China's top economic planning agency, said, "The nation might not need to raise interest rates after all. Investment is under control and inflation may have peaked at 4.4 per cent."

The Chinese slowdown story continues to be hotly debated. That the economy is far from a slowdown can be seen from a recent analysis by Morgan Stanley. If this were true it would have serious consequences on global growth and prices.

A slower second- quarter Chinese GDP growth rate in 2004 is the source of this confusion. Not only did the 9.6 per cent year-on-year increase for the second quarter of 2004 represent a fractional moderation from the 9.8 per cent pace of the first quarter, but it came in well below market expectations that were in the 10.5 per cent to 11.0 per cent range.

In the industrial sector, the overheating continues, with growth at 16.2 per cent in June, lower from the peak comparisons of 19.4 per cent in the first two months of this year yet, well above the 10 per cent trend-line increases of the past 10 years.

Other data points offer mixed signals, at best, in gauging the progress in China's slowdown. The most encouraging trend shows up in the deceleration in fixed investment from peak growth rates of 53 per cent in January and February of 2004 to 18.5 per cent in May. Yet growth in bank lending has not moderated significantly, being at 16.3 per cent in June, well above the 10 to 12 per cent trend line.

Meanwhile, Chinese inflationary pressures seem to be easing off a bit. While the consumer price index (CPI) moved up to the 5 per cent threshold, most of the acceleration remained concentrated in agricultural products.

At the same time, Chinese imports continued to surge with a growth of 50.5 per cent in June (year-on-year), well above the 40 per cent gains recorded in 2003. Although, the Journal of Commerce's metals index has flattened out since mid-July, it is still holding at levels 50 per cent above those prevailing in the first half of 2003.

Similarly, shipping activity remains relatively firm. While the Baltic Dry Index plunged from February through June 2004, it has subsequently rebounded sharply in July and is still more than twice the levels prevailing in early 2003.

In China, macro-economic policy initiatives can only perform a limited role, because over 70 per cent of the total investment comes from the public sector. Its financial system is characterised by high rates of non-performing assets (NPAs) "" between 20 and 30 per cent.

The Chinese banking system, weighed down by years of state-directed lending to profitless government enterprises, could go the way of the east-Asian economies in 1997.

In the case of exchange rate management, China has resisted any correction in the fixed peg of Yuan "" 8.276 to 8.28 to the dollar "" despite the volatility in the currency markets. This has ensured that Chinese exports compete cheaply in the world markets, although margins are coming under pressure with import costs rising.

Every major international economic crisis in the past 15 years, except Brazil (2002) had been rooted in an exchange rate that remained too fixed for too long. China may be safe for now, partly because strict capital controls lock domestic savers into the bankrupt banks.

China had gone through a similar situation in 1992-94, when runaway growth and inflation created a crisis. This was tackled by an increase in interest rates and credit curbs.

This resulted in massive unemployment, crash in the property market and huge bad loans for the four big banks. This time round there is an additional problem of exchange rate correction.

That the task is difficult can be seen from the recent remarks of China's Premier Wen Jiabao in front of the State Council when he warned of the "difficulty and complexity of macroeconomic control" and cautioned against a "blindly optimistic" assessment of the prospects for a soft landing. Experts at other international banks and Asian Development Bank have echoed a similar opinion.

Will it learn from recent banking crises in Japan and Russia?

(The writer is an economist with L&T Ltd)