| Overview
China's economy has continued to grow robustly, with some softening recently. So far in 2010, the slowdown in government-led investment (GLI) after last year's massive stimulus has partly been offset by strong real estate investment. Household consumption growth has held up well, reflecting a favorable labor market. Despite a rapid recovery of export volumes since the trough in early 2009, China's trade surplus has declined further due to surging import volumes and declining terms of trade. Inflation has picked up somewhat, but core inflation remains low. However, soaring property prices triggered tough property-specific measures. Leading indicators and industrial production data suggest some deceleration to a still rapid rate of growth.
China's economic outlook remains favorable. Despite concerns about fiscal risks in some high income countries, the global growth outlook remains favorable, in large part because of the strength in emerging markets. Nonetheless, risks around the global forecast are large. In China, after a rapid start to 2010, growth is likely to ease, mainly because of a partial normalization of the macro policy stance and the property measures. We project GDP growth of 9.5 percent for 2010 as a whole, and 8.5 percent for 2011, with risks both ways. Growth should be less investment-driven this year and benefit from more favorable external trade. Consumption is likely to remain supported by a strong labor market. The external surplus should decline somewhat further this year. Inflation is likely to remain contained this year by the absence of price pressures globally while a wage-price spiral is not likely.
Such prospects warrant further normalization of the macroeconomic stance, while keeping flexibility. Further consolidation of the overall monetary stance, as outlined, is needed to contain the key macroeconomic risks. Substantial uncertainty around a favorable baseline projection calls for policy flexibility rather than continued stimulus by default. The central authorities are rightly aiming to control lending by local government investment platforms. However, interest rates remain low. China could usefully let interest rates play a larger role in monetary policy. If policymakers remain concerned about capital flows, macro prudential regulation and more exchange rate flexibility would help.
Policy making needs to take into account several features of the medium-term outlook. Considering the prospects for its key determinants, trend growth is on course to decline in 2010-20, but to a still respectable rate. The contributions from labor and TFP are likely to decelerate somewhat while, with some rebalancing expected, capital accumulation should also slow. In setting growth targets for the coming decade, the likely slowdown in potential growth needs to be acknowledged. The expected deceleration of potential growth also places a premium on policies that can increase sustained productivity growth, including via more reallocation of labor, enhanced human capital, and innovation.
Moreover, further reforms are needed to ensure economic growth remains sustainable socially and with regard to energy and the environment. Fiscal policy reforms in several areas are key in this effort. Additional reforms in social protection and labor market arrangements are important both to foster productivity growth and improve social outcomes. The government's intention to strengthen the role of private enterprises in the economy and remove barriers they face is welcome. In this connection, it would be useful to clarify the role that the government envisages SOEs to play in China's economy.
Recent Economic Development
China's economic growth has remained strong. After bottoming out in early 2009 amidst the global economic crisis, sequential GDP growth was strong on the back of massive domestic policy stimulus, pushing GDP up 11.9 percent on a year ago in the first quarter of 2010 (Figure 1). Leading indictors and industrial production data suggest some moderation (yoy) in the second quarter, to a still rapid pace.[1]
Growth has continued to be supported by an expansionary macro policy stance. Headline fiscal policy has not been expansionary in the first 5 months of 2010 (see below, in the policy section). However, the monetary expansion remains large and this in part reflects quasi fiscal activity, notably via lending to local government investment platforms. After the 30 percent of GDP expansion of credit in 2009, outstanding loans rose another 7.6 percent of GDP in January-May (seasonally adjusted). In the first quarter of 2010 infrastructure construction and real estate received most of the new medium- and long-term (MLT) loans.
But growth has recently become more broad-based. In early 2009, exports collapsed and the massive stimulus effort boosted domestic demand, infrastructure investment in particular. More recently, net external trade has become less of a drag on growth as exports have accelerated alongside a rebounding world economy. Consumption growth has strengthened since 2008 while investment decelerated in the first quarter of this year, with government-led investment leading the slowdown (Figure 2). However, the stimulus measures led to some concerns about the role of SOEs in the economy (Box 1).
The slowdown in government-led investment (GLI) has partly been offset by strong real estate investment. The deceleration of GLI reflects the gradual phasing out of the policy stimulus and the high base left by the boom in 2009 (Figure 3). But, a favorable policy stance and ample liquidity fueled housing price increases since early 2009 and—with a lag—real estate investment. In mid-April, the government took measures to contain the housing price increases (see below). These measures are likely to affect sales volumes and prices. But, given the time lag in construction, the impact on construction activity is not expected until later in the year.
Household consumption growth has remained solid, in line with a favorable labor market. The recovery of consumer confidence and continued consumer spending growth since early 2009 are in large part fueled by a strong labor market (Figure 4). After bottoming out in early 2009, employment recovered on the back of the strong domestic economy. With the urban labor market survey indicating rising demand for labor, compared to supply, wage growth picked up again, at least for migrants.[2] Consumption is also fueled by strong sales of cars (accounting for around one-tenth of total retail sales) and housing, with the latter boosting sales of furniture, home appliances, and building materials.
Export volumes have recovered fast in the last 12 months, reflecting improved global demand and further market share gains. As the global economy recovered during 2009, China's export volumes strongly outgrew external demand (Figure 5).[3] In the first five months of 2010 they were an estimated 10 percent up on two years ago (before the crisis), even though global imports were still below pre-crisis levels then. The market share gains confirm that China's exporters have continued to boost price competitiveness, upgrade products, and enter new markets. In turn, this is helped by strong productivity growth, which has cushioned the impact of downward price pressures for manufactured goods globally and wage increases. Indeed, profit margins in sectors that export a large share of output such as textiles and electronics now exceed pre-crisis levels, even though export prices are still down substantially.
In spite of this, China's trade surplus has declined sharply since 2008 due to surging import volumes and declining terms of trade. In the first five months of 2010, the trade surplus was down more than 50 percent compared to the same period in 2008. Import volumes have surged across the board, including "normal" imports used in the domestic economy. Boosted by strong domestic demand, their particularly rapid growth at the end of 2009 and start of 2010 (yoy) is in part—but not fully—because of base effects (Figure 6).[4] In any case, given the outlook for domestic demand, this pace of "normal" import growth cannot be expected to last. Import data for the second quarter confirms a deceleration.
China's terms of trade have deteriorated substantially up until recently. China's terms of trade have been volatile in recent years. Between early 2009 and April 2010 they fell and in the first five months of 2010, they were still down on two years ago (Figure 7). The recent terms of trade loss is in part because of a surge in raw commodity prices. In addition, since early 2009, prices of China's exports, which are almost all manufactured goods, have fallen more and risen less than prices of manufactured goods imports, whereas normally these move in line. In all, almost one-third of the decline in the trade balance in the two years to the first five months of 2010 was due to the worsened terms of trade. With the trade surplus traditionally as the key driver of foreign reserves accumulation, its decline has somewhat slowed the accumulation of reserves, even though net financial flows were positive in the first quarter.
The peg of the RMB to the U.S. dollar transmits swings in the U.S. dollar to China's exchange rate. The U.S. dollar rose almost 15 percent against the euro between November 2009 and Mid-July this year, amidst the euro zone sovereign debt turmoil. This has translated into a similar appreciation of the RMB against the Euro zone, China's largest trade partner. As only about one-fifth of China's foreign trade is with the U.S., such U.S. dollar movements affect China's exchange rate with the bulk of its trading partners.
Inflation has picked up somewhat because of higher food prices, but core inflation remains low. Consumer price inflation reached 3.1 percent (yoy) in May, driven mainly by higher food prices and somewhat by higher "residence" items (housing costs) (Figure 8).[5] PPI inflation rose from -8 percent (yoy) in mid-2009 to 7.1 percent in May. However, the sequential increase in the PPI index has declined since March as raw commodity prices have stopped increasing (see below). Moreover, estimated unit labor cost has been constant in recent quarters, consistent with low core inflation and suggesting no wage-inflation spiral, despite the expansionary monetary stance.
However, property prices have surged on the back of the expansionary monetary stance and have triggered measures. Ample liquidity and low interest rates have boosted property prices, especially in large cities, where they were up 12.4 percent on a year ago on average in May, according to the official NBS data. The government took measures in mid-April aimed at containing the price increases rather than at curbing real estate construction. They included raising minimum mortgage down payment and mortgage interest rates,[6] virtually banning lending for people buying their third home, and asking local governments to increase land supply for and accelerate construction of "mass market and low-end housing." The measures have already impacted sales volumes. They are likely to also affect housing prices and—with a lag—construction activity.
Stock prices have declined on concerns about policy tightening. Share prices have received support from the recovering economy. However, concerns about the impact of policy tightening have weighed strongly on equity valuation. As a result, stock prices have moved up and down several times in the last 12 months. The mid-April property related policies had a particularly large impact because they reduced profit prospects in the real estate sector and increased concerns about further policy tightening. The A share market has fallen by 19 percent since mid-April and 22 percent since the start of this year.
Economic Prospects
Growth prospects in many high income countries are subdued and fragile. Their recoveries were kick started by unusually expansionary monetary and fiscal policies. But, in many of them, growth is held back by high unemployment and weak household balance sheets and bank credit, and it remains dependent on macroeconomic policy support. Meanwhile, high government deficits have led to rising sovereign risk premiums and more ambitious fiscal consolidation plans in several European countries as well as some renewed stress in the global banking system. Thus, the recovery is likely to be relatively slow in many high income countries.
However, the outlook for overall global growth is better now than it was in early this year. The global recovery has evolved better than expected. After the world economy shrunk in 2009, the Consensus Forecasts suggest that global GDP (excluding China) expands 3.0 percent this year and 3.0 percent in 2011 (Table 1 and 2). Many emerging markets and developing countries have returned to solid growth, with Asia in the lead and Eastern Europe lagging behind. Overall, global growth prospects remain quite good, in large part because of the strength in emerging markets. Indeed, recent Consensus Forecasts suggest stronger global growth prospects for this year and next than those done earlier this year.
Nonetheless, the uncertainties and risks around the central global forecast are large. The rapid increase in government debt in many high income countries has become a major source of risk. Market concerns about sovereign liquidity and solvency in the euro zone periphery or elsewhere could turn into a real and contagious sovereign debt crisis. More generally, there is a risk that the room for policy discretion in many high income economies has been sharply reduced, leaving the fragile recoveries exposed to new shocks. Most of the markets' attention has so far been on Europe. However, the U.S. fiscal outlook is also precarious. Additional downside risk stems from bank exposure to real estate, mainly in the United States and parts of Europe, while prospects of regulatory reforms in the U.S. could cause rating downgrades of large banks and raise borrowing costs.
With spare capacity in many industries, globally, price pressures are likely to remain subdued. After rising in most of February-April because of an improving global outlook, international raw commodity prices fell steeply again since end April, presumably on the back of the euro zone turmoil and signs that China's economy may be cooling. The spare capacity in many sectors, internationally, is set to continue to dampen pressures on prices of both manufactured goods and raw commodities including oil in the coming years.[7]
In China, growth is likely to ease somewhat. The first quarter outcome was modestly stronger than we expected in March. However, we now envisage a somewhat more pronounced deceleration in the rest of the year, reflecting the impact of the move towards normalization of the overall macro policy stance and the recent measures with respect to the real estate sector as well as the headwinds from Europe. In all, we leave our GDP growth forecast unchanged at 9.5 percent for this year and reduce that for 2011 slightly to 8.5 percent (Table 3).
In 2010, growth should be less investment-driven and benefit from more favorable external trade.
- Investment growth is likely to moderate this year. Government-led investment is decelerating, after the spectacular growth in 2009. Real estate investment is set to contribute significantly to growth most of 2010.[8] However, later in the year the impact of the recent property tightening measures should kick in. Given the sharply increased importance of mortgage financing since early 2009, in flow terms, the mortgage-related measures are likely to affect housing sales and presumably housing prices substantially.[9] The impact on construction activity is expected later in the year, given the inherent lags. The government aims to offset the impact on construction activity by increasing the supply of lower and middle income housing. However, given the modest share of such kind of housing and underperformance of targets in this area in recent years, it may be difficult to achieve this.[10] Investment in the services industry should remain solid, supported by the healthy outlook for domestic consumption. The outlook for manufacturing investment is less clear.
- Consumption should continue to grow solidly. Amidst favorable labor market conditions, income growth should remain robust. Moreover, despite some pick up in inflation, consumer sentiment is recovering.
l We expect net external trade to make a small positive contribution to real growth in 2010 and 2011. Following the rapid recovery so far, export volumes are likely to slow, sequentially, because of an eventual end to the inventory adjustment in partner countries and lower final demand growth, especially in Europe, China's largest trading partner. However, for the year as a whole that still implies rapid growth. We expect import volumes to outgrow export volumes somewhat, with a similar pattern—slowing sequentially in the rest of the year as investment slows (investment is relatively import sensitive in China). However, because exports were larger than imports last year, that still implies a mildly positive contribution of net external trade to growth.
The external surplus should ease down somewhat this year. In the first four months of 2010, international raw material prices recovered much more than prices of manufactured goods and China's terms of trade declined again. However, raw material prices fell sharply in May. Taking into account the global context and assuming they broadly stay at their May level the rest of 2010, the external surplus would decline this year in U.S. dollar terms and as a share of GDP (Figure 9).[11]
Inflation is likely to remain contained this year. The expansionary monetary stance since end 2008 has increased inflation expectations. However, inflation is basically determined by supply and demand for goods and services and China's prices are strongly influenced by global prices. Higher food prices and imputed rent are exerting some upward price pressure. However, the envisaged global context moderates China's inflation prospects, including via the absence of upward pressure on commodity and food prices. The China-specific factors behind high food prices are also not likely to be sustained. Moreover, continued low core inflation reflects the influence of China's pattern of growth, with large increases in the supply of goods and services, compared to increases in demand. Wage growth at the lower end of the income distribution may increase as a result of some widely published labor disputes and increases in factory-specific and minimum wages. This is in part a cyclical issue, reflecting the strong rebound in the labor market after an earlier downturn when wage growth slowed (Figure 10). Viewed over a two year horizon, these increases are within historical norms. The adjustment of individual companies to these pressures will vary. However, given the flexibility of China's labor market and the track record of China's overall manufacturing sector in absorbing wage increases and keeping unit labor cost growth down, this is unlikely to set in motion an unwarranted wage-inflation spiral.
Risks are two way and balanced. The renewed increase in risks to the global economy matters for China. However, sound macroeconomic fundamentals, absence of dependence on foreign capital flows and still binding capital controls mean that the impact of any potential global turmoil on China is likely limited to real economic impact via weaker trade. Domestically, the dynamics between economic developments and policy responses imply substantial risks and uncertainties, amplified by the types of instruments used, including with regard to the real estate sector. But, overall growth prospects remain solid and much less uncertain than a year ago. The risks related to rapidly rising housing prices have subsided because of the recent property tightening. Nonetheless, probably the most serious macroeconomic and financial risks are still those stemming from the monetary stimulus, including underlying pressure on asset prices, strains on local government finances, and NPLs.Goods price inflation may rise if actual output continues to outgrow potential output.
Medium-term projections
With China and the world economy recovering from the global crisis, and some rebalancing taking place in China, it is useful to revisit medium- and long-term prospects. This section summarizes the key conclusions of a recent medium-term scenario building exercise. This exercise was conducted to get a sense of how the pace and composition of growth may develop, both from the production (or supply) side and the expenditure (or demand) side; what the key implications are; and how China's living standards and the size of the overall economy may compare internationally in 2020. For more detail and discussion see World Bank China Research Paper No. 9.[12]
Considering the prospects for its 3 key determinants, trend growth is on course to decline in 2010-20, but to a still respectable rate. Our growth accounting exercise suggests that potential GDP gradually declines to 7 percent in 2016-20 as a result of the following factors (Table 4).
- The working population is on course to decelerate because of demographic developments. We expect overall employment to shrink somewhat in 2015-20.
- Total factor productivity (TFP) growth may also decline somewhat. This tends to happen as catch up proceeds. We expect the deceleration to be particularly noticeable in the coming years. In the recent 15 years, SOE restructuring, WTO accession, and very successful integration of China's manufacturing sector in a rapidly growing economy have boosted TFP growth to a remarkably high rate, including via large economies of scale. The contribution from these factors is likely to diminish somewhat in the coming decade.
- With a mild easing of the ratio of investment to GDP from 2011 onwards because of modest rebalancing, growth of the capital stock slows materially in 2010-20.
Looking ahead via the expenditure perspective, this scenario has several features (Table 5).
- Actual GDP would continue to grow broadly as fast as potential GDP, continuing the track record since the late 1990s.
- With some—but no drastic—further rebalancing expected, the share of consumption is likely to bottom out and to rise somewhat through 2015. The ratios of investment and saving in GDP edge down gradually.
- With economic growth in China likely to continue to be robust, import growth remains solid. Meanwhile, given the outlook for the world economy and exports, exports are not expected to outgrow domestic activity in 2010-15 in our scenario despite good competitiveness and further market gains. Thus, with export price increases assumed to lag domestic inflation, the export to GDP ratio should continue to diminish.
- The external surplus would rise in U.S. dollar terms, not as a share of GDP. This scenario uses fairly benign medium-term projections for raw material prices from the World Bank. On this basis, combined with the volume developments discussed above, the trade surplus would edge up in U.S. dollar terms but gradually decline as a share of GDP, from 5.1 percent in 2009 to 2.7 percent in 2015. The current account surplus would rise substantially in U.S. dollar terms and hold up, as a share of GDP, because of rising income on growing foreign assets.
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