For those of us who have been steadfast in our optimism on China, the blistering first-quarter GDP report throws down the gauntlet. The government has no choice but to move quickly and aggressively to rein in the excesses of this white-hot economy. To stay bullish on China – and that remains my view – policy makers must do a much better job in establishing traction with both the bank lending cycle and the real economy. China has no other choice.
The numbers speak for themselves. The 11.1% y-o-y comparison for real GDP in 1Q07 follows a 10.4% gain in the previous quarter and a 10.7% increase for 2006 as a whole. In was the second strongest quarterly comparison of the past 12 years – falling just short of the 11.5% increase posted in 3Q06 (see Exhibit 1). Gains in the period just ended were broad based, with exports (+30%) and fixed investment (+25%) leading the way. Collectively, these two sectors now account for more than 80% of Chinese GDP (see Exhibit 2). If the Chinese leadership is serious about controlling its economy – and I believe they are – then these are the two sectors that must now be brought down to earth.
China GDP report: how to bring the economy back under control
In the aftermath of this blistering 1Q07 GDP report, there is considerable focus in the markets on a new round of monetary tightening that will be needed to bring the Chinese economy back under greater control. While I have no doubt that additional actions will be taken by China’s central bank, I continue to believe that such moves are largely window dressing for a still blended economy. Fueled mainly by the combination of excessive bank lending and internal cash flow, China’s runaway investment boom has not responded to repeated tightening actions by the monetary authorities.
That’s certainly not for any lack of trying. During the past year, bank reserve ratios have been increased seven times while domestic lending rates have been hiked four times. But these actions haven’t put a dent in bank lending growth, which was still surging at a 16% y-o-y rate in March 2007. That shouldn’t be so surprising. Despite a long string of increases, bank reserve requirements stand at just 10.5%, well short of the 14.4% level of actual reserves currently maintained by Chinese banks. At the same time, even though short-term interest rates are over 100 bps higher than a year ago, at 6.4%, one-year lending rates still remain too low relative to the vigorous rate of underling expansion in the real economy.
As is typically the case in this still-blended economy, the real tightening is likely to come in the form of administrative edicts issued by the modern-day counterpart of China’s central planning agency – the National Development and Reform Commission (NDRC). By setting stringent criteria for project approval on a case-by-case basis, the NDRC has both the clout and the tools needed to exercise much tighter control over the investment process. I had expected a new round of administrative actions to be unveiled around midyear – tied to increasingly stringent requirements on energy consumption and greenhouse emissions. But in the aftermath of the blistering first-quarter GDP report, I now believe that the next series of administrative edicts will be announced sooner than that, followed by additional actions on energy conservation and pollution. The longer China waits, the harder it will be to strop its rapidly moving investment train.
From where I sit, the Chinese government has no choice other than to up the ante on tightening and macro control. It’s been about three years since the current tightening campaign began. Yet China’s GDP growth has accelerated steadily over that period, from 9.5% in 2004 to 9.9% in 2005, 10.7% in 2006, and now to 11.1% in 1Q07. Premier Wen Jiabao – China’s most senor manager of the economy – put it best last month when he characterized the Chinese economy as “unstable, unbalanced, uncoordinated, and unsustainable” (see my 19 March dispatch, “Unstable, Unbalanced, Uncoordinated, and Unsustainable”). Today, in the immediate aftermath of the 1Q07 GDP report, he reiterated his concerns over runaway exports and investment by all but telegraphing the message that another round of administrative edicts is in the works. In his words, “China will keep strengthening control over investment and bank lending…” He is speaking, in my view, of a China that wants to move now – before it’s too late to avoid the dreaded boom-bust.
China GDP report: current government objectives
China is attempting to achieve three objectives in the current tightening campaign: First, I think the government is aiming to get real GDP growth down to less than 10% by year-end 2006. Second, a deceleration in bank lending – the principal funding mechanism behind surging investment – is viewed as very important by Beijing policy makers; my best guess of their goal is to take a 16% comparison in lending growth in March down to the 10-12% range over the course of the next year. Third, and consistent with the first two points, I also believe China will successfully rein in excessive growth rates in both exports and fixed investment – the former making an increasingly easy target for “China bashers” around the world and the latter ultimately posing a threat of excess capacity, which could well trigger a corrosive bout of deflation. My best guess here is that Beijing is aiming to take both investment and export growth below 20% by year-end 2007. Such an outcome, if it came to pass, would have important implications for commodity markets and for commodity-sensitive equities.
It is clear to me that Premier Wen Jiabao has put his personal reputation on the line in favor of tightening further to slow the runaway Chinese economy. I think he will pull it off, but given the limited traction between the money supply and the real economy, it will definitely require more administrative tightening to get the job done. At this point in its growth cycle, China can’t afford the alternatives. The costs of failure would be huge – excess capacity, deflation, and protectionism. I am confident that China will not fail in its mission to regain control over its blistering economy. By moving sooner rather than later, China will avoid the dreaded hard landing of the classic boom-bust cycle. As I said, it has no other choice.
By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley’s Global Economic Forum