China's economy refuels in mid-air

Exports and investment lead the way, while food prices drive inflation.
The Chinese economy expanded by 11.5% in the first six months of the year following an unexpected resurgence of economic activity from early 2007.

The Chinese government has so far met with little success in reining in growth, which picked up further between the first and second quarters of the year. Although more cooling measures can now be expected, the strong economic impetus of the first half of 2007 means that real gross domestic product (GDP) growth for the year is now projected to come in at 11.3%.

Standard & Poor's Ratings Services expects the authorities to be cautious in applying the brakes. This suggests that the growth momentum could remain in the double-digit range for yet another year, with growth forecast at 10.2% in 2008.

Exports and investment lead the way

Similar to the previous two years, China's trade balance and capital spending were the main sources of GDP growth in the first half of 2007. The 28% increase in exports was greater than most forecasts, partly reflecting exporters rushing their goods out before the government began to apply export tariffs and terminated tax rebates.

These measures were introduced in a bid to stem the growing US-China bilateral trade balance, which rose to $232 billion in 2006. However, the unexpectedly large gains in net exports also gave rise to suspicions that part of the recorded export receipts was really disguised capital inflows (for further information see the article Pressure On China To Narrow Its Trade Surplus Will Increase Policy Risks, published on July 20, 2007, on RatingsDirect, the real-time Web-based source for Standard & Poor's credit ratings, research, and risk analysis).

We do not expect export growth to sustain its first-half momentum for the rest of 2007, while imports are likely to rise at a faster rate. The 84% leap in China's trade surplus in this period is therefore projected to decelerate markedly to less than 30% for the year as a whole. In 2008, the trade gap is likely to grow at a single-digit rate as export growth eases while imports increase to meet stronger domestic demand.

Despite the introduction of several administrative measures and several interest rate hikes, capital spending has shown few signs of slowing so far in 2007. While central government projects and SOE investment growth have eased over the year, activity in other sectors - particularly real estate - has continued to accelerate. Fixed asset investment in the first half of 2007 rose to 26.7%, from 24.5% in 2006. Although the impact of policy measures is likely to be greater in the second half of the year, we still expect investment to rise at a faster rate in 2007 compared to a year earlier. The pace of investment growth should, however, ease off in 2008 as continuing monetary and administrative measures take effect.

Compared to exports, we expect consumer spending in China will continue to lag. Stronger wage growth and rising asset prices have boosted consumer confidence and spending, which is reflected in the strengthening growth of retail sales in 2007. Nevertheless, the expected 14% increase in consumption expenditure in the year will result in a further slide in its share of GDP. Consumption expenditure in 2008 is forecast to slow to around 13.5% as inflation eats into the purchasing power of household incomes.

Food prices drive inflation

As economic activity grew briskly, consumer prices also rose sharply and the CPI is expected to record a 3.8% gain for the year as a whole. Inflation, however, has been driven largely by rising food prices, reflecting the impact of adverse weather conditions both in China and elsewhere. Core inflation, which excludes food and fuel prices, remains benign at close to 1%. In part, this is due to China's still ample supply of workers, which continues to keep wage pressures in check. Continued overcapacity in a number of industries also helped to cap price increases.

Inflation for 2008 is forecast to fall back to 2.5% in 2008, lower than in 2007 but above the average of recent years. This projection assumes that food prices will stabilise next year while inflationary pressures from other sources are likely to increase. The Chinese government's crackdown on unlicensed investment and pollutive industries could ease the excess supply in a number of sectors. Furthermore, wage pressures are forecast to increase as the pool of excess labor shrinks further.

More policy actions coming

The exceptional economic growth momentum in the first six months of 2007 appears to have convinced policy makers that overheating is no longer confined to specific sectors. Thus while more administrative measures are certainly on the cards, the administration has also expressed a greater willingness to use monetary policy as a means to cool the economy. Following three hikes in the first seven months of 2007, we expect further increases in official interest rates to follow. At least one further 27 basis point increase is expected this year and lending rates are likely to be about a percentage point higher by the end of 2008.

While evidence of more widespread overheating is becoming clearer, the Chinese government is not expected to slam down hard on the brakes. Over the next year or so, the leadership of both the Communist Party and the government will undergo important changes. During this period, officials will be even more wary of triggering unrest among the population through a sharp slowdown in the economy. It is likely that the monetary authorities' cautious handling of the economy will therefore maintain buoyant economic growth in 2008.
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