Global Insight Perspective
Significance	GDP in real terms expanded by 10.6% on the year in the first three months of 2008.
Implications	Unbounded investment growth continued to provide impetus to growth, offsetting the negative impact of crippling snowstorms and the entrenching trend of slowing exports.
Outlook	Global Insight projects that growth will slow to 9.8% in 2008 as external demand moderates. However, the still-heated expansion of credit, accelerating inflation, and the potential for a more protracted downturn in the United States will fan the risk of a hard landing for the economy.

Bearing Up to Domestic Storms and Darker External Climes

The Chinese economy lost some momentum in the first quarter of the year but growth still outstripped expectations. Data released by the National Bureau of Statistics today showed that GDP in real terms expanded by 10.6%, slowing from the 11.2% gain recorded in the final quarter of the year. The outturn marked the ninth consecutive quarter of double-digit growth in the economy. Advance consensus market forecasts had projected a more pronounced slowdown in growth to around 10.0%.

The economy had been expected to lose some impetus after snowstorms crippled central and southern parts of country in January and export growth continued to trend down. The severe weather at the beginning of the year resulted in production facility closure, destroyed crops, and fundamentally undermined supply and distribution networks. Government estimates at the time posited that the severe weather had cost the economy some US$15 billion. Concurrently, the trade surplus declined for the first time since 2004 in the first quarter. Data released previously by the Ministry of Commerce (MOFCOM) showed that the trade surplus shrank by 10.8% in annual terms to US$41.42 billion in the three months through March. Exports rose by 21.4% on the year to US$306 billion. The rate of growth, though brisk, marked a slowdown from the 27.8% gain recorded in the previous quarter. Export growth has moderated following adjustments in export tax rebates and more fundamentally as demand in the United States retracts as the impact of the sub-prime loan crisis unfurls. Conversely, import growth remains buoyant, boosted by high global prices for oil, commodities, and food staples. Imports expanded by 28.6% on the year during the first quarter. Industrial production, which remains closely tied to export trends, rose by 16.4% on the year.

Investment Provides Support but Compounds Problems

However, offset was provided by still unbridled investment growth. Fixed asset investment (FAI) rose by 24.6% on the year during the first quarter as monetary tightening evidently failed to curb liquidity growth. The government raised the reserve requirement ratio for commercial banks by a further 50 basis points on 18 March to a record high of 15.5%, draining an expected 210 billion yuan (US$29 billion) worth of liquidity from the economy. The reserve ratio has been raised four times since the government announced that it had adopted a tightening stance in monetary policy in late 2007. However, adjustments to date remain inadequate versus the strength of stimulus to liquidity growth generated by central bank intervention to neutralise the impact of surging foreign capital inflows on the yuan exchange rate. Moreover, administrative controls on lending imposed in the wake of the 1997/98 Asian Financial Crisis have let banks with substantial excess reserves blunt the impact of monetary adjustments. Consequently, annual money supply growth continues to range above government targets.

Inflation and China's Consumers

In addition, real short-term deposit rates remain deep in negative territory following the recent spiral in consumer price inflation. Figures released today showed that consumer price inflation eased back only marginally in March from the 11-year high hit in February. The consumer price index (CPI) rose by 8.3% on the year, retreating from the 8.7% rate recorded in the previous month. For the first quarter as a whole, inflation rose by 8.0% from the corresponding period of 2007. Inflation continues to be fuelled by surging food prices, reflecting domestic shortfalls aggravated by the severe weather at the start of the year, compounded by surging international prices for staple grains. Food prices soared by 21.0% during the first quarter in annual terms.

Tellingly, however, non-food inflation remains effectively dormant, illustrating the risks inherent in the current structure of growth. Non-food inflation continues to range at around 1.0%. Domestic demand remains stunted by a series of unresolved structural imbalances in the economy. Excess capacity is being created by the investment surge with the profit margins of inefficient state owned companies supported by high-volume, low-priced production. 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. Retail sales, a rough proxy for consumer spending, accelerated in the first quarter of the year, ostensibly contradicting such nay-saying. Total sales rose by 20.6% on the year during the first quarter. However, nominal retail sales growth is being inflated by sharp growth in prices, with consumption still constrained as a growth driver.

Implications and Outlook

As the economy moves into 2008, it faces a growing multiplex of problems. Export growth is expected to continue to temper as the negative impact of the U.S. downturn is compounded by slowdown in the European Union (EU) and Japan. As downside risks mount in the external environment, more aggressive monetary tightening is required to contain risks generated by the sustaining investment boom while high inflation will undermine consumer spending power. However, aggressive monetary tightening could rob the economy of impetus generated by investment just as its other main driver, exports, slow. Moreover, the U.S. Federal Reserve (Fed)'s aggressive monetary easing acts as a further deterrent to domestic interest rate increases, for fear of fuelling inflows of speculative capital exerting additional upward pressure on the yuan. More rapid liberalisation of the exchange rate and the capital account, which could potentially square the conundrum, is inhibited by the immaturity of the domestic financial system and the risks posed to domestic demand growth. As these contradictory pressures intensify, the potential of a hard landing for growth is increasing. A key variable will be the depth and duration of any U.S. downturn given the still dominant role of export demand in the economy. Global Insight currently forecasts growth to slow to 9.8% in 2008, although that projection remains increasingly prey to budding downside risks.