Significance: Chinese growth regained momentum in the second quarter of 2009 as GDP in real terms rose 7.9% year-on-year.

Implications: Growth was propelled by massive macroeconomic stimulus, while the collapse in world trade appears to have bottomed out, prompting a cycle of inventory rebuilding. However, such growth drivers may prove transitory in the absence of a sustained recovery in export demand, while rapid credit growth risks fuelling asset bubbles and already high levels of excess capacity in the economy.

Outlook: IHS Global Insight's June growth forecast for 2009 was revised upwards to 7.2%, with growth expected to accelerate to 8.3% in 2010. However, we continue to place emphasis on the structural imbalances that underlie high headline growth rates and could present significant policy challenges over the medium term.

Hitting the Gas

The economy staged a growth spurt in the second quarter of the year that surprised even some optimists. Official data released today show that GDP in real terms expanded 7.9% from a year earlier in the three months through June. The rate stood as a marked acceleration on the 6.1% year-on-year (y/y) growth recorded in the March quarter. For the first half of the year, the economy expanded 7.1% y/y on aggregate.

Stimulus Takes Effect

The export-centred structure of China’s growth left the economy acutely exposed to the slump in global trade. Authorities responded with massive macro-economic stimulus programmes. On the demand side, the government implemented a 4-trillion yuan (US$585.7-billion) emergency budget, with allocations focusing on transport, low-income housing, healthcare, research and development, and industrial structural adjustments. The spending programme is aimed at alleviating the structural constraints that continue to stunt private consumer spending as a mature growth driver. Uneven economic development, inadequate social security nets, and retrenchment in the inefficient state sector continue to constrain income growth and reinforce the propensity of households to save. Anomalously, consumption as a share of GDP in China has actually declined in recent years. On the supply side, the central People's Bank of China aggressively eased monetary policy, reversing tightening measures implemented in the first half of 2008 to contain inflation, resulting in a massive liquidity injection. Data published yesterday showed that the broad M2 measure of money supply expanded by a record 28.5% in June, accelerating from the 25.7% increase recorded in May. The rapid expansion in money supply also spurred heated loan growth. The balance of outstanding loans denominated in renminbi rose 34.4% on the year, marking another record high rate of growth. In April, outstanding loans increased 30.6% y/y.

Investment Surge

Unsurprisingly, investment has proved a major source of momentum. Urban fixed asset investments (FAI) rose 33.6% in the first half of 2009 compared to the same period a year ago, bolstered by the fiscal stimulus package and cheap credit. A quarterly breakdown of urban FAI was not immediately available. Industrial output gained traction, rising 9.1% in the three months through June y/y, and by 7.0% for the first half of the year as a whole. Finally, retail sales—which provide a proxy for private consumer spending—rose 15.0% in annual terms in the three months through June. The National Bureau of Statistics reported that urban per-capita incomes rose 11.2% y/y in the second quarter while rural per capita incomes increased 8.1%. Household disposable income has been further supported by continued disinflation. Average annual consumer price inflation slowed to 1.7% in June, marking the fifth consecutive month of decline.

Outlook and Implications

However, the real question remains whether the economy's recovery is sustainable. As the second quarter data indicate, output is gaining traction but the momentum may be more attributable to the booster effect of inventory re-stocking, following major adjustments in the fourth quarter of 2008 and early 2009, and to the current heated investment cycle. Private consumer spending growth has broadly remained static. Exports—the economy's main driver—continue to experience contractions, although the net trade position has been buoyed by concomitant deep reversals in imports as demand for industrial inputs has atrophied. Exports fell 21.4% on the year in June to US$95.4 billion, although the rate of decline moderated from the 26.4% contraction recorded in May, as demand in lead U.S. and European markets modestly firmed. Sequential data points to a recovery in global demand indicating that the nadir in the collapse in world trade may have been hit in the first quarter of the year, although trade volumes still remain below par and the sustainability of the upturn uncertain.

Although the investment surge may provide a growth boost in the short term, it threatens to exacerbate risks over the medium and long terms. China's economy is already dogged by high levels of excess capacity built up over previous investment cycles. Risks are exacerbated by the dominance of the state sector in mediating this investment surge and by the immaturity of risk-management systems in the banking sector. Chinese companies typically operate on low margins, relying on high-volume growth to generate earnings. The structural imbalances have been reflected in the conundrum of low underlying inflation in the Chinese economy in recent years despite blistering growth. If external demand fails to recover sufficiently, the limits of macroeconomic stimulus will be reached. A protracted downturn in growth would undermine the capacity of companies to service outstanding loans resulting in a fresh generation of non-performing loans on bank balance sheets. In extremis, current dynamics could lead to severe, localised stress in the banking system, delaying further progress towards capital account and associated exchange-rate liberalisation.

Short-term risks are also intensifying. Recent data indicates that the liquidity injection and the subsequent availability of cheap credit are re-fuelling speculative capital inflows into the economy, potentially fuelling asset bubbles. Previously released data showed that foreign-exchange reserves surged by US$178 billion in the second quarter to a record high of US$2.2 trillion. Foreign direct investment inflows (FDI), totalled US$31.2 billion in the three months through June, while the trade surplus stood at US$34.8 billion leaving the majority of the increase in foreign reserves unaccounted for. So-called "hot money" inflows probably account for the discrepancy between the level of foreign-exchange reserves and official external surpluses. China's stock market overtook Japan as the world's second-largest stock market in value terms for the first time in 18 months yesterday as the Shanghai Composite Index rose 1.4% to US$3.21 trillion. The Shanghai index has risen by a staggering 75% since the beginning of the year, providing further indication of a renewed boom in speculative investments.

The second-quarter data may presage a further upward revision of growth forecasts for 2009. In its latest interim round, IHS Global Insight revised up its projection to 7.2% from 6.9%, with growth expected to accelerate to 8.2% in 2010. The adjustment reflected our belief that the economy's downturn had bottomed out in the first quarter of the year. However, headline data masks latent downside risks generated by the unbalanced structure of growth, while a sustained recovery remains dependent on an upward trend in world demand. As is typical in recent years, current policy is proving more successful in stimulating growth on the supply side than in stimulating a more balanced distribution of demand across drivers, reflecting its politically appealing immediacy. China may be receiving headlines for its short-term success story but the risks associated with the eventual exit strategy from current huge stimulus, and amelioration of the imbalances that current policy is exacerbating, could provide significant challenges for authorities.

Global Insight (Reino Unido)