China: Applying the Brakes to the Economy

2004

Jayanthi Iyengar

The steps taken by the Chinese government to cool down the Chinese economy seem to be working. Yet, it is too early to say whether they are adequate to check inflation and avert an interest rate hike, which would push up the manufacturing cost for companies operating in China.

The Asian Development Bank's (ADB) Asia Economic Monitor recently revised upwards it growth projections from 7.9% to 8.7% for 2004, explaining that this still represented a slowdown from the 9.1% growth notched by the Middle Kingdom in 2003. Clearly, the soft measures to rein in growth and fixed asset investments are yielding results, but not as fast as was initially assumed, while inflation continues its upward march.

In July, the Chinese consumer price index rose to 5.3%. This brings it on par with the Chinese central bank's one-year benchmark lending rate and raises the possibility of an interest rate hike. This measure is necessary to check hoarding, which may occur when the real rate of interest turns negative.

However, the Chinese government seems to be inclined to wait and watch the result of the measures taken thus far as well as developments in the US. The US Federal Bank has been raising its lending rates in a measured manner, which in turn could suck out some of the excess liquidity in China, as some investments flow back to the US, attracted by the higher interest rate regime.

To understand recent developments, one needs to understand global investment flows. Speculative capital has flowed into the Chinese economy during the last two years as the US Federal Bank set its interest rate at 1%. Investments poured into China, attracted by the higher interest rates, cheap labour and a large consumer base. This spearheaded an investment boom, led by the Chinese public sector, particularly in real estate, construction and infrastructure sectors.

The investment flows also created excess liquidity in the Chinese financial system, which exacerbated inflation. Estimates are that China may have invested US$200 billion more than it should and fixed investment may be 20% above trend. In order to absorb the excess created, China now has to bring down fixed investments below trend.

The Chinese government stepped in to curb runaway growth after the first quarter growth touched 9.8% and inflation crossed the 4% mark. The measures included directing the state governments and state enterprises to stop investing in infrastructure, while simultaneously directing the banks to stop lending to the overheated sectors. That, however, set off panic buttons. Since China was like a fast moving locomotive, many feared that the abrupt application of the brakes might result in a hard landing or crashing of the economy, instead of slowing it down to desirable levels. Three months down the line, the fears of a crash have receded, though the debate continues as to how softly the Chinese economy will land.

The Chinese government would prefer to decelerate the growth of its economy to 7% per annum. The World Bank and the ADB consider 7% to 8% per annum to be the desirable and sustainable rate of growth for China, while the Chinese economy, as of now, seems to be inclined to grow at more than 8.5%, at least in the current year.

From a business perspective, the impact of a hard or soft landing would be the same. It would curtail the Chinese demand for commodities and equipment supplies from countries that feed its investment boom. By some estimates, China presently consumes anywhere between 20% and 50% of the world's production of alumina, iron ore, zinc, copper and stainless steel.

WATCHPOINT: The US interest rate movement and Chinese inflation will determine the timing of a rise in Chinese interest rates.

 

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