China's Economic Recovery Continues with 8.9% GDP Growth in Q3

A One-Dimensional Recovery Led by Investment

GDP growth in China accelerated to a high of 8.9% y/y during the third quarter, from 6.1% y/y in the first quarter and 7.9% y/y in the second, bringing cumulative growth in the first nine months to 7.7% y/y, according to data released by the National Bureau of Statistics today. The industrial sector, the main segment of the economy, expanded 8.7% y/y during the first three quarters, as growth of industrial added value accelerated to 12.4% y/y in the third quarter, from 5.1% y/y in the first and 9.1% y/y in the second, bolstered by restocking and a rebound of export demand.

Nevertheless, the recovery has remained a one-dimensional revival dominated by investment expansion. Total fixed-asset investment (FAI) soared 33.4% y/y in the first three quarters, driven by a 52.6% y/y expansion in infrastructure investment that was led by an 87.5% y/y rise in railway investment. Real estate investment growth has also picked up, coming in at 17.7% y/y during the first three quarters, accelerating from a 9.9% y/y increase in the first half. Such high investment growth has contributed 7.3 percentage points to China's GDP growth in the first three quarters, according to the NBS.

Retail sales, a proxy for domestic consumer spending, were still quite stable, growing 15.1% y/y in the first three quarters in nominal terms, underpinned by 24.5% y/y growth of auto sales that had been fuelled by auto purchase subsidies and tax breaks. Private consumption contributed 4 percentage points to GDP growth in the first three quarters, said the NBS. The external sector remains a weak link that has been dragging overall GDP growth, as total imports and exports dropped 20.9% y/y in the first three quarters, although the pace of decline narrowed markedly to 16.5% y/y in the third quarter from 24.9% y/y in the first and 22.1% y/y in the second, with a sharp upturn observed in September. During the first three quarters, exports plummeted 21.3% y/y while imports contracted 20.4% y/y, leading to a US$45.5-billion y/y cut of China's foreign trade surplus to US$135.5 billion.

Deflation Hits Turning Point

With output increasing, the deflationary pressure facing the Chinese economy has continued to ease and a turning point is probably already here. The consumer price index (CPI) dipped 1.1% y/y in the first three quarters, with synchronised falls in prices of food, clothing, transport, recreational service as well as residence-related expenditures. While this pace of decline remained unchanged compared with the first half in y/y terms, the index has actually been improving in month-over-month (m/m) terms for three straight months, as m/m change in CPI turned positive in July and rose 0.5% and 0.4% m/m respectively in August and September. Producer price deflation remained severe, though, as the producer price index (PPI) dropped 6.5% y/y in the first nine months, although the index has been rising in m/m terms for six straight months.

Outlook and Implications

Sectors to Watch

With the economy already on track to recovery, developments in a few key sectors need to be closely watched. One is the exports sector. Trade data for September as well as the recent upbeat news from the China Import and Export Fair, the main venue where China's exports orders are signed each year, indicate that the country's exports sector has bottomed out with the strengthening of overseas demand. Nevertheless, the recovery will be a slow one, as IHS Global Insight believes that expansion in consumer spending in advanced economies, mainly the United States, will be still restrained in the foreseeable future due to the lingering impact of the global financial crisis on household balance sheets.

Another sector to be watched is real estate, as strong real estate investment is crucial for continued recovery of the economy after the pullback of government stimulus spending in the year after next. While growth in real estate investment has gained much momentum over the past quarter, the big question now is how long the recovery will last, as the asset market recovery fuelled by liquidity injection has run ahead of the recovery of the real economy, leading to much faster property price inflation than wage inflation—which may ultimately restrain the continued rebound of the housing market and therefore real estate investment.

When to Exit the Easing Cycle?

The strong performance of the Chinese economy in the third quarter has dispelled lingering doubts, if there are any, on the strengthening of the Chinese economic recovery. Growth in the third quarter is expected to be even stronger, with the easing in export decline and a more favourable base effect. While recovery is well on track, the government is now facing a key economic policy challenge with respect to when and how to exit the easing cycle to unwind and control possible long-term damage that has been caused by the massive liquidity injection made by the government in its all-out efforts to bail out the economy.

Outstanding loans at the end of September stood above 122% of the 2009 projected GDP, far exceeding the previous historical high of 117% of GDP in 2003, while China's loans/GDP ratio typically has hovered around 100% in the last ten years. This liquidity bubble has helped induce rapid investment growth, which has begun to seriously affect China's overcapacity problem. Urban fixed investment to GDP ratio in the first three quarters of 2009 has risen to 61.1% from 48% in the third quarter of 2008. Though the liquidity bubble is unlikely to generate much inflationary pressure due to China's rising excess capacity, it could lead to asset price bubbles. This process appears to have begun. All the capacity build-up will haunt the economy if demand does not come back in a substantive way. Additionally, the bank loans that have helped to finance this capacity build-up could turn sour. Rising risks of widespread loan defaults and asset price bubble is a dangerous cocktail for a financial crisis.

Currently, the government is performing a difficult high-wire balancing act—preventing near-term economic collapse while ensuring the long-term health of the economy. It is therefore not surprising that the government has begun a limited tightening—targeting select industries to cut back their financing supply and restricting their investment expansion. In the larger economy, the government has also begun to cool down the monthly loan increase in the last three months, as lending has been halved from the monthly average in the first half.