China's Economy: Not Red Hot, but in the Pink

China Economic Quarterly

Rumours of China's reheating are greatly exaggerated. Despite widespread reports trumpeting the surprisingly high gross domestic product growth of 9.5 per cent in the fourth quarter of last year, all the evidence shows that the economy is slowing down, not heating up.

There were three reasons why economic growth surged in the last quarter, up from 9.1 per cent in the previous quarter. First, agriculture posted its best performance in many years, buoyed by a 9 per cent rise in grain yields. Most of this rise appeared in the fourth quarter, since nearly two-thirds of the year's grain is harvested in the autumn.

Second, exports surged beyond expectation. In 2003, the last-quarter trade surplus was US$16.4 billion. Last year, it was US$28.1 billion.

Finally, consumption showed strong growth. Real growth in retail sales last year, at 10.2 per cent, was the strongest since 1996. More important, retail spending accelerated throughout the year, and in December was more than 12 per cent in real terms.

All these factors contributed to especially strong growth in the fourth quarter. Do they mean that China's economy is heating up again? Not at all: they show that growth is being redistributed through the economy in a healthier pattern.

For the past three years, China's economy has been powered by unparalleled levels of investment, funded by cheap credit from state-owned banks. Consumer spending remained weak, and the trade balance shrank.

Last spring, recognising that investment had reached unsustainably high levels, the government started to curb bank lending and rein in "excessive" investment. The goal was not to slow growth, but to end the economy's addiction to investment.

Of course, a sharp reduction in investment will lead to an overall growth slowdown if consumption and export trade do not pick up the slack. What appears to have happened in the second half of last year is that investment did slow sharply, and consumption and exports did take up the slack. Even as consumption and exports were rising, the three indicators that most worried the government - growth in credit, fixed asset investment and industrial production - were falling. Loan growth, which peaked at 23 per cent in August 2003, fell almost continuously through the year and was down to a manageable 11 per cent in the final quarter of last year.

Measured on a three-month rolling average, which helps smooth out seasonal lumps, industrial production growth fell continuously from last April's peak of nearly 21 per cent to 15 per cent in December. And growth in fixed asset investment, the biggest single problem, fell from about 25 per cent in real terms in 2003 to 19 per cent last year.

Monthly figures for all three indicators showed no evidence of a rebound in the fourth quarter last year; instead, all showed continued declines.

So, in short, the economy is now rebalancing, with less growth coming from investment and more from consumption and exports. This is good, but what does it portend for this year?

China's problem is that the rate of investment is so high that investment growth must be cut even more drastically - into single digits - to reduce the economy's reliance on investment for growth. But such a cut would lead to sharply lower overall growth, unless offset by equally large rises in exports and consumption.

Our bet is that investment growth will continue to slow sharply: officials have made it clear that investment and credit curbs will remain in place for several more months. Meanwhile, consumption and exports will continue to rise, but more slowly. This means that China is almost certainly heading for a growth slowdown this year. But this will not be catastrophic: barring a world financial system meltdown, GDP growth of 8.5 per cent for the year is achievable. Reheating is not on the cards.

(Originally appeared in the January 31, 2004 issue of South China Morning Post in Hong Kong, reproduced here with permission.)