The first quarter of 2012 has been marked by political and diplomatic turmoil in China—with the Bo Xilai case and Chinese dissident Chen Guangcheng’s flight to the U.S. embassy in Beijing—but economic developments have been unfolding more or less as expected. Macroeconomic indicators so far are broadly encouraging, and a “hard landing” does not appear in the offing. Progress toward economic reform is consistent with the rebalancing objectives detailed in the 12th Five Year Plan, and there have been steps toward financial reform—though much more needs to be done.
A Controlled Slowdown and Signs of Rebalancing
As China attempts to rebalance its economic model, it has avoided a hard landing and continues to move in the right direction on key structural reforms. Prime Minister Wen Jiabao recently announced China’s official growth target of 7.5 percent in 2012—slightly higher than the 7 percent notional growth target set by the 12th Five Year Plan. Beijing will probably outperform the target for 2012. Although first quarter growth—8.1 percent year-over-year, or about 6.3 percent quarter-over-quarter—was the lowest in three years and April data showed further weakness in exports and industrial output, the economic slowdown that started in the first quarter of 2011 (see chart 1) will probably even out in the months ahead, as monetary policy and housing purchase restrictions are likely to be relaxed somewhat.
Although industrial value-added growth slowed to 9.3 percent year-over-year in April (negative month-on-month), the outlook for manufacturing appears to have improved (see chart 2), and headline consumer price index inflation (CPI) is likely to ease further in the months ahead, mainly because China’s producer price index was negative in both March and April (see chart 3). The combination of slowing growth and falling inflation is the main reason for the expectation that bank lending will increase and housing purchase restrictions will be relaxed in the coming months.
China’s rebalancing effort, shifting from reliance on net exports and capital formation to domestic consumer demand, is proceeding. The trade surplus, though very volatile from month to month, continued to shrink—amounting to $21.9 billion for the first four months of 2012, or less than 1 percent of GDP. An important cause of this decline is a widening deficit on the services account, which appears to be related to rapidly growing Chinese tourism and overseas business travel. The current account surplus for the first quarter of 2012 was some 30 percent lower than a year ago and may well fall below the IMF’s projection of 2.3 percent of GDP for 2012 as a whole, from 2.8 percent in 2011 (see chart 4).
Investment growth peaked in 2009 and continued to slow through the first quarter of 2012, as infrastructure investment remained weak after the termination of China’s stimulus program in 2010. However, the slowdown in housing construction—in response to the government’s efforts to control the real estate bubble in major eastern cities (as reported on in previous Bulletin articles on China)—appears to have bottomed out as property prices stopped falling during the first quarter of 2012 and even showed a small uptick in several big cities after about nine months of decline. Construction of government-sponsored “affordable housing,” meanwhile, has picked up in some areas. Chart 5 shows annual figures for gross fixed capital formation in China (there is no reliable quarterly metric, and the information for 2011 is not yet available).
It is possible that China’s extraordinarily low household consumption-to-GDP ratio (about 34 percent in recent years) bottomed out in 2010 or 2011 and will show an increase in 2012, for the first time in over a decade. Although there are questions about the statistical measurement of consumption in China, there is little doubt that China is rapidly becoming one of the largest consumer markets in the world. Household survey data suggest that consumption growth continued briskly through most of 2011 (around 8 to 9 percent, see chart 6) despite an overall economic slowdown. Provisional national accounts data for the first quarter of 2012, moreover, suggest that household consumption accounted for 43 percent of GDP growth, much higher than the 28 percent registered a year earlier. This suggests the possibility that household consumption growth will outpace GDP growth and lift the share of consumption in GDP.
The continued rapid rise of real urban wages has been a driving force behind structural changes in the economy. This increase is particularly marked for low-skilled migrants, who are in increasingly short supply due to demographic changes (see chart 7) and improving living conditions in rural areas. This is driving up unit labor costs (except in industries where productivity growth is keeping up with wage increases) and contributing to a change in the composition of manufacturing output toward capital goods and higher-technology consumer products. Many low-tech, low-margin manufacturing enterprises are closing or relocating to lower-cost areas in China or abroad. Over time, these structural changes will promote higher household consumption growth relative to GDP growth.
Apart from demographic factors that are driving up wages, especially for migrants, and unit labor costs in many industries, the most important factor behind structural change in manufacturing, and a gradual increase in the contribution of the service sector to GDP, is exchange rate appreciation. Since the renminbi (RMB) was first de-linked from the dollar in July 2005, the nominal RMB/USD exchange rate has appreciated by about 31 percent. The real RMB/USD exchange rate (adjusting for differences in the CPI in both countries) appreciated by about 42 percent. Using GDP deflators (instead of CPIs), the real RMB/USD exchange rate shows over 50 percent appreciation since July 2005. This is making China’s exports more expensive—a development that, in turn, is driving a shift to the production of higher value-added manufactured goods as well as services.
Financial Sector Reform Appears to Be Accelerating
An apparent acceleration in financial sector reform will further promote structural economic change in the right direction. In late February, China’s central bank, the People’s Bank of China, posted an important announcement, “Preconditions for China to liberalize its capital account have become mature,” on its website that summarized the results of a major internal bank study examining the merits of and possible strategies for capital account opening. The study’s overall conclusion is that the benefits of an open capital account to China’s economy outweigh the costs and that the time is ripe to pursue the necessary reforms more aggressively.
In the first phase of the proposed reform plan (spanning three to five years), the government would further loosen controls on foreign direct investment outflows, while encouraging foreign investment by Chinese enterprises using either foreign exchange or RMB funds, depending on the circumstances. RMB bank credit is already being made available for this purpose, and RMB internationalization will continue to be promoted in other ways as well. The second phase (spanning five to ten years) would focus on broadening and deepening domestic capital markets and on opening financial markets to foreign capital. Quantitative controls on cross-border capital flows are to be gradually replaced by market-oriented price controls.
Recent specific policy actions suggest that China has become more serious about financial sector reform. First, the Qualified Foreign Institutional Investor ceiling on foreign portfolio investment in China was raised from $30 billion to $80 billion. Second, the width of the daily RMB trading band in the interbank foreign exchange market was doubled (to 2 percent). Third, certain informal money markets in the city of Wenzhou, known as a bastion of private enterprise and a model for other cities, were legalized, while restrictions on private investment abroad by Wenzhou residents were relaxed. This is expected to reduce the cost of capital to small and medium-size enterprises (SMEs) in that area and facilitate overseas investment. These financial sector reforms will be supported by tax reductions in all service sectors.
Neither the announcement concerning capital account liberalization nor the actual measures adopted represent a breakthrough on financial sector reform, but they are nonetheless important steps in the right direction. It is furthermore important to note that SMEs’ access to banks in China appears to be improving. According to Nicholas Lardy at the Peterson Institute for International Economics, the share of SMEs in total business credit has increased in recent years. Most striking, the share of small (almost entirely private) enterprises increased from 22 percent in 2009 to 36 percent in 2011. Meanwhile, the share of large enterprises (almost entirely state-owned) declined from 37 percent to 27 percent and that of household businesses (including consumer credit) increased from 10 percent to 16 percent.
Major reform challenges still lie ahead. The most important near-term challenge for financial sector reform is to loosen control of deposit rates. This will almost certainly happen, but it is not clear when. In the medium term, growth must come down further, to 6 or 7 percent, if external and internal economic balance is to be achieved and sustained.
But it is clear that a structural transformation of China’s economy is already under way thanks to slower export growth and rising domestic production costs. There are currently no economic indications that a hard landing lies ahead. In fact, China’s economy may have “landed” already, making the chief risks at present more political than economic in nature.
Pieter Bottelier, former chief of the World Bank’s resident mission in Beijing, is a nonresident scholar in Carnegie’s International Economics Program and senior adjunct professor of China Studies at the School of Advanced International Studies (SAIS) at Johns Hopkins University.