Chinese Economy Shrugs Off Official Controls as Growth Surges in Q2

Momentum Undaunted

The National Bureau of Statistics (NBS) today published second-quarter economic data showing surging economic activity during past few months. Second-quarter GDP growth leaped to 11.9% year-on-year (y/y)—0.8 percentage point higher than the corresponding first-quarter figure, and raising the overall rate of growth of the economy to 11.5% y/y at the end of June. The surge in output reported today has been foreshadowed by recent regional production data from major coastal regions. However, the magnitude of the acceleration in second-quarter output has increased the strength of State Council and National Development and Reform Commission (NDRC)’s macro control measures, not to mention another interest-rate increase from the People's Bank of China (PBoC). The NBS and other government agencies went out of their way to condition domestic expectations over second-quarter and first-half data in recent weeks, especially in terms of inflation and capital spending figures. Nevertheless, these figures may raise eyebrows in international markets today.

The Roots of the Acceleration

This growth figure appears to be a tale of resurgent industrial activity, which was up 19.4% y/y in June. The 18.7% second-quarter growth figure looks at first like a mild acceleration from the 18.3% y/y first-quarter figure, though industrial output appears to have accelerated significantly during the latter half of May and during June. Private firms reported the strongest output growth for the second quarter at 26.6% y/y. Agricultural output was up by a reported 4% y/y at the end of June, with service sector output up by 10.6% y/y.

In addition, 24 of the 39 industries tracked by the NBS reported increases in the second quarter. Interestingly, output growth from large-scale producers fell two percentage points, despite still posting 21.7% y/y output growth. Profit growth has followed this surge in output, as the NBS reported that growth in second-quarter profits jumped 16.6 percentage points to 42.1% y/y.

Investment Strong, but Not Startling

Urban fixed-asset investment (FAI) growth slowed moderately during June, with the level of capital spending at the end of the month 28.5% higher y/y—four percentage points below the rate reported for the same month of 2006. Overall, total FAI spending was up 25.9% y/y at the end of the second quarter.   

Real estate investment was up 28.5% at the end of the second quarter—just below the 29% y/y growth figure reported for secondary industries generally, and up 4.3 percentage points over the level reported at the end of the second quarter of 2006. Investment in the services sector was reported to be up 24.6% y/y. As a testament to the government's commitment to the development of western and central China, capital spending in western regions was up 35.6% y/y at the end of the second quarter, and 30.2% y/y for China’s central regions. 

The rate of investment growth indicates that government efforts to contain spending have had a limited impact. Investment continues to be fuelled by abundant liquidity in the financial system as the PBoC intervenes to stem upward pressure on the exchange rate, generated by huge foreign capital inflows. 

Broadly measured, (M2) money supply growth in China slowed by just 1.4 percentage points during the first half of 2007, with the overall supply figure up 17.1% y/y at the end of June. This rate is down 0.2 percentage point from the corresponding first-quarter figure, indicating that increased sterilisation measures have had a temporary impact. More narrowly measured, M1 was reported to be up 20.9% y/y during the first half—seven percentage points above the corresponding rate for the first half of 2006. Interest rates have been raised four times since April 2006, while the reserve deposit ratio has been increased eight times. Administrative controls have also been imposed on investment and adjustments made to the tax regime to trammel export growth.  

However, external trade held mostly steady during the first half, up 23.3%. Nevertheless, even stable growth helped to boost first-half exports to US$546.7 billion (up 27.6% y/y overall), with imports up 18.2% to US$434.2 billion to leave China's external surplus at US$112.5 billion. Reported foreign-exchange reserves at the end of June were US$1.3326 trillion. Reported foreign direct investment (FDI) was up 12.2% y/y during the first half, coming in at US$31.9 billion. 

Retail China

Government policy has been aimed at remodelling the economy's capital-intensive growth by boosting consumption and related service sectors.  During June, retail sales were up 16.0% y/y, with a 15.8% y/y rate reported for the second quarter and a 15.4% y/y rate reported for the first half of 2007—China’s strongest retail figures since 1997. Retail sales growth gathered pace during May and June, driven by spending in urban areas, though county-level sales data also appear strong. 

Retail sales appear to have been supported by strong income growth during the first half, with urban incomes reported to be up 14.2% y/y. This rate of urban income growth is four percentage points higher in the first half of 2006, as output gains have translated into income gains. Rural income data were conspicuously absent from this data release, underscoring China’s growing geographical disparity.

Unrelenting investment threatens to aggravate already-high levels of excess capacity, while potentially storing up a fresh generation of non-performing loans (NPLs) in the banking system. Concurrently, productivity and employment relative to the level of investment remains low, creating inefficiencies in the economy.  In addition, a spate of environmental incidents suggest that manufacturing boom continues to devastate waterways and foul the air. In addition, the NBS and other agencies have officially scrapped attempts to develop a methodology and reporting mechanism on "green GDP", which would provide a quantitative measurement of the environmental costs associated with China's economic growth.

Inflation

The NBS released overall consumer price inflation data today, though delayed the release of specific commodity and producer price data by at least another day. The June figure of 4.4% y/y helped to drag the figure for the first half up to 3.2% y/y, which is itself 1.9 percentage points above the rate for the first half of 2006. Monthly data for specific commodities was not provided, but the NBS did provide first-half price growth figures, with food prices rising by 7.6% y/y, the cost of eggs up 27.9% y/y, and the cost of meat up 20.7% y/y. For producers, ex-factory prices were up just 2.8% y/y at the end of the first half, linked to the 3.8% y/y increase reported for the cost of materials, power and fuel. The divergence between factory gate prices and consumer price inflation highlights the headline pressures that have inflated the consumer price index (CPI) in recent months following restrictions on the supply of food. Core inflation remains relatively subdued due to the excess capacity in the economy and the structural imbalances in domestic demand, caused by inefficient resource allocation and increasing income inequality. Nevertheless, with price movements remaining a highly politicised issue, the acceleration in inflation provides the PBoC with a rationale to raise interest rates.

Outlook and Implications 

The blistering rate of second-quarter growth indicates that the economy's momentum remains undeterred by the monetary tightening cycle. Growth had been expected to slow as adjustments to export tax rebates and easing U.S. demand slowed exports. However, the economy continues to defy such expectations. Inevitably, the debate will shift to the perennial issue of the equity of China’s fixed exchange rate. Greater flexibility in the yuan, proponents argue, would boost domestic consumption as imports become cheaper, while the PBoC would have greater flexibility in reducing upward pressure on liquidity generated by accumulating reserves. More accelerated exchange-rate reform is supported by domestic producers’ productivity gains, while abundant supplies of labour keep operating costs low. However, the same arguments also show why moderate exchange-rate adjustments would have a limited impact on China's export prowess. The theory moreover neglects the developing intra-regional production chain that is consolidating former bilateral surpluses of individual countries in China with advanced markets into China's external balances.