East Asia and Pacific Economic Update, December 2012 - China

December 19, 2012

Recent Economic Developments

The growth rate of China’s economy in the third quarter was 7.4 percent (year on year), below thehistoric trend and the lowest in the past 14 quarters. However, the data on industrial production and fixed asset investments suggested that China’s economy was bottoming out. Quarter on quarter growth (seasonally adjusted annualized rate) picked up from 8.2 percent in second quarter to 9.1 percent in third quarter. The negative contribution of net exports to gross domestic product (GDP) growth also narrowed from -0.7 percentage points in the first half to -0.4 percentage points in the first three quarters.

On the domestic front, fixed asset investment (FAI) growth increased, mainly in government-influenced sector. In September, FAI grew by 21.1 percent (year on year) in real terms, 3.6 percentage points higher than in August. FAI-financed by state budget, bank loans, and SOEs picked up, as the impact of easing credit conditions and public investment in infrastructure is beginning to show. The impact is expected to continue to be felt into 2013, as the authorities have accelerated the approval of large projects: some 25 urban rail projects, three highway construction projects, 10 city infrastructure projects, and seven ports and waterways projects

totaling more than 1 trillion yuan were announced in September. One area where FAI growth rate slowed was the real estate sector as the central government sought to cool down the housing market, which has been showing signs of overheating. However, some policy fine-tuning was seen recently, for example, on housing provident fund and mortgage subsidies.

Consumption growth was robust, accounting for 55 percent of the first three quarter GDP growth, supported by continued household income growth. Labor market conditions were favorable, with employment growing robustly, and demand for labor still outnumbering supply. Wage growth was 7.7 percent in the third quarter. Inflationary pressure remains at bay. Consumer price index (CPI) grew by 1.7 percent (year on year) in October, marginally lower than 1.9 percent (year on year) in September. With the slowing domestic economy and weak global demands, producer price index. (PPI) growth has declined for the eight consecutive month, reaching -2.8 percent (year on year) in October, driven by falling commodity (raw materials) prices.

On the external front, real exports grew by 11.1 percent, and imports, by 4 percent (year on year) in September, a rebound from 1.4 percent, and 1.7 percent, respectively, in August. Light manufactured goods were the biggest contributor to export growth. While exports growth to the three major trade partners (United States, EU, and Japan) slowed, those to the rest of the world remained robust, and the export to Asia, excluding Japan, grew fastest. China’s external terms of trade continue to improve as import prices of commodities decelerate more rapidly than export prices of manufactured goods. Foreign direct investment remained weak, growing only by 3.8 percent (year on year) in the first three quarters. These developments dampened foreign exchange accumulation.

The monetary stance has been accommodating in the third quarter, leading to an increase of total social financing. People’s Bank of China decreased the benchmark interest rate by 0.25 percent in June and then again in July, which was the first cut since 2008. In the third quarter of 2012, the traditional bank loans grew 16.1 percent (year on year) on average. Meanwhile, corporate bond financing expanded sharply, growing 78 percent (year on year) in the first three quarters, albeit from a low base.

Outlook and Emerging Challenges

Our projections for GDP growth in 2012 and 2013 are 7.9 percent and 8.4 percent, respectively, reflecting weak external environment, property market corrections, and impact of supportive policy measures. CPI inflation is likely to stay on its declining trend and average 2.8 percent for 2012 as growth stays moderate, commodity prices weaken, and asset price increase decelerate. It is expected to rise slightly to 3.3 percent in 2013 from a growth pickup and the lagged effects of the loose monetary stance in the second half of 2012. With uncertainties in the global economy, rising labor costs, and a recovery in domestic demand, China’s current account surplus is estimated to narrow from 2.8 percent of GDP in 2011, to 2.3 percent in 2012, and 2.2 percent in 2013. However, downside risks remain in the uncertainty of the euro area, China’s biggest trade partner.

In the longer run, GDP growth is projected to moderate somewhat because of the structural shift of the economy, which is anticipated to move away from investment- and export-driven growth. The anticipated slow recovery of the global economy, ebbing effects of this round of domestic stimulus, and the aging population contribute to this forecast. Consumption is projected to remain strong and inflation to remain moderate at around 3 percent, but investment growth will likely slow. World Bank forecasts are consistent with the government’s target annual growth rate in the new five-year plan of 7.5 percent.

China’s near-term policy challenge is about balancing the trade-off between supporting growth and reforming. There are concerns about the inertia for a structural reform to shift away from investments. Given China’s still significant fiscal space and the already accommodative monetary stance, the burden of any countercyclical response should fall on fiscal policy. Currently, most of the stimulus policy is still through the government-influenced infrastructure investment. However, the policy response would need to be crafted with longer-term effects and objectives in mind. Relative to previous episodes, fiscal stimulus would ideally be less credit-fueled, less local government-funded, and less infrastructure-oriented. Fiscal measures, such as targeted tax cuts, social welfare spending, and  other social expenditures to support consumption, should attract first priority.