Global Insight Perspective
Significance	GDP expanded by 11.4% in 2007 from the previous year, with momentum moderating slightly in the fourth quarter.
Implications	Investment and exports remained the twin drivers of growth. However, the pattern of growth continues to exacerbate structural imbalances grounded in weak internal demand and excess supply.
Outlook	More robust policy measures are required to trammel surging investment and shift growth to a more balanced footing. However, as downside risks build in the external outlook, authorities may opt to act in the short-term interests of growth at the expense of long-term sustainability.

Still Rolling

The Chinese economy expanded at its fastest rate since 1996 in 2007, but signs of a slowdown emerged in the fourth quarter. GDP in real terms grew by 11.4% in 2007 from the previous year, according to data released today by the National Bureau of Statistics (NBS), marking the fifth consecutive year of 10%-plus growth. In nominal terms, GDP totalled 24.7 trillion yuan (US$3.4 trillion), up from 22.1 trillion yuan in 2006. However, in the fourth quarter, momentum tempered modestly. Growth slowed to 11.2% from 11.5% in the three months through September.

The Symbiosis of the External Sector and Domestic Investment

Investment and exports remained the twin engines of growth in 2007 as industrial output rose by 18.5% on the year. Fixed-asset investment (FAI) rose by 24.8% from the previous year as monetary tightening and administrative controls failed to restrain spending. Credit growth continues to be fuelled by rapid expansion in the money supply. Liquidity is being inflated by central bank intervention to neutralise the impact of surging foreign capital inflows on the exchange rate. Abundant liquidity has also been funnelled into property and the stock market, raising concerns over potential bubbles building in each.

Highlighting the strength of that tide, previously published data showed that the trade surplus surged by 47.7% on the year to a fresh record high of US$262.2 billion. Total exports rose by 25.7% on the year to US$1.22 trillion in 2007 as imports grew by 20.8% over the same period to US$955.8 billion. Exports were boosted by the continued strong performance in the textile and footwear sectors, while other sectors, notably electronics and metals, witnessed marked acceleration in shipments. Imports continued to be inflated by high global commodity costs—as well as rising food prices as demand for key staples increased amid supply disruptions—while surging rates of domestic and foreign investment continued to pull in capital goods and components for the country's manufacturing processing platforms.

Foreign direct investment (FDI) rose to a fresh record high of US$74.8 billion in 2007, up 13.6% from a year earlier, with capital inflows boosted further by undocumented "hot money". Swollen by surpluses on the capital and current account, foreign-exchange reserves rose by 40.0% on the year to US$1.53 trillion.

Balancing Growth Across Drivers

Policy has been directed at achieving a more balanced distribution of growth to reduce risks associated with China's extensive model of development. The financial intermediation system continues to discriminate against productive non-state investment, promoting excess savings in the non-state sector. Inherently inefficient state-sector investment is fuelling excess capacity in the economy, with firms producing in low-priced volume to boost slim margins. Any marked slowdown in growth could undermine the ability of firms to service debt, potentially resulting in a fresh generation of non-performing loans (NPLs) in the banking system. Capital-intensive growth is also less efficient at generating employment than the more labour-intensive tertiary sector. Growing income insecurity, compounded by the absence of comprehensive security nets, and the widening wealth gap between urban and rural areas have dampened consumption. As China continues to produce more than it consumers, the imbalance is reflected in the country's bulging current-account surplus.

Finally, extensive growth has resulted in increasingly severe environmental degradation, while bulging external surpluses are stoking tension in international trade relations, set to be accentuated as the momentum of global growth slows. Subsequently, export rebates were cut, interest rates raised six times, and reserve ratios lifted to two-decade highs, while the renminbi gained 7% over the year.

Inflation as a Mirror

On the face of it, the measures appear to be bearing fruit as the cooling of growth in the fourth quarter was tied to a slowdown in exports to their lowest rate in five years. Retrenching demand in the United States as the fallout from the sub-prime loan crisis unfurls is likely to have equally contributed to the slowdown. Concurrently, full-year data indicate that retail sales—a proxy for household spending—rose by 16.8% in annual terms, accelerating from the previous year.

However, the growth in retail sales is more attributable to spiralling inflation. In 2007, the consumer price index (CPI) rose by 4.8% in average annual comparisons—its fastest rate of gain since 1996. In December, the CPI rose by 6.5% on the year, retreating modestly from the 11-year high peak of 6.9% hit in November. Inflation has been fuelled by soaring food prices as pork supplies have been hit by blight and grain production by unseasonable weather. High global commodity prices have further inflated input costs compounded in the eastern seaboard by rapid wage inflation. Surging inflation has further undermined disposable income. Pointing to building upstream pressures, factory gate prices rose by 5.4% on the year in December, accelerating from the 4.6% gain recorded in November.

Inflation remains a highly politicised issue in China, accentuated by intensifying income inequality, and prompting authorities last week to impose a series of controls on key staple goods ahead of the Lunar New Year holiday. Given the supply-led nature of current price pressures, monetary adjustments will have a negligible impact. Indeed, non-food prices continue to hover in the 1.0-2.0% range—a reflection of weak demand and excess supply. The schizophrenic nature of current price trends neatly encapsulates the structural pressures emerging in the economy.

Implications and Outlook

Monetary tightening is aimed at curbing money supply growth and reining in investment to reduce productive supply in the economy. However, the intensity of tightening measures implemented so far has been ineffective in reining in liquidity growth. Years of administrative controls on lending following the 1997/98 Asian financial crisis have left banks with excess reserves, blunting the impact of increases in the reserve ratio. Both loan growth and broad money-supply (M2) growth picked up in 2007. Similarly, with nominal GDP around 15%—8% higher than the one-year lending rate—the opportunity cost of investment for the Chinese companies is simply still too low, while real interest rates have fallen sharply. Increasingly cognisant of the risks to the long-term sustainability to growth, authorities are expected to step up monetary tightening in the second half of 2008 after the Olympic Games in August. Investment is expected to moderate, combining with slowing exports to temper growth.

However, the risks of a hard landing are now accentuated. As the probability of recession in the United States intensifies, darkening the outlook for global growth as a whole, more severe constraints on investment could leave the economy without drivers given the still shallow state of private consumption. The case argued by many quarters that China can emerge as an engine of growth independent of demand in the United States and Europe is hollow, refuted squarely in the country's current-account surplus. The U.S. Federal Reserve (Fed)'s aggressive monetary easing could further deter interest rate increases in China for fear of fuelling inflows of speculative capital and additional upward pressure on the renminbi. More rapid liberalisation of the exchange rate and the capital account is inhibited by the immaturity of the domestic financial system and the downside risks to domestic demand growth, forcing continued reliance on the economy's export engines. Authorities may therefore back away from harsh policy measures, as short-term interests of growth are prioritised at the expense of amelioration of structural imbalances in the interests of long-term stability.