IHS Global Insight Perspective

Significance: As China enters 2011 with strong growth prospects under its belt, policy-makers have shifted their focus to combating inflationary pressure and pushing through the reforms necessary to enable sustainable growth through the 12th Five-Year Plan period.

Implications: Beijing has got a liquidity battle on its hands, with strong credit growth and a fast-expanding money supply exerting pressure on consumer prices and asset markets. This is the issue to watch for 2011.

Outlook: IHS Global Insight's growth outlook remains strong, with GDP projected at 9.5% for 2011, on the back of improved U.S. prospects and renewed domestic demand momentum. A vastly expanded money supply means that growth could very well surprise on the upside.

Growth Slowdown Moderates Through Q4 2010, Bringing Full-Year to 10.3%

China has scored another year of scorching growth in 2010, recording 9.6% year-on-year (y/y) in the final quarter bringing full-year growth to 10.3% y/y, according to data from the National Bureau of Statistics (NBS). As well as quite probably being China's last year of double-digit growth, 2010 was the year that China's economic structure settled back to an appearance of its pre-crisis "normality", as growth gained support from the export sector once again and investment spending slowed somewhat. It was also the year that China overtook Japan to become the world's second largest economy, at 39.8 trillion yuan. As opposed to a year previously, growth stabilisation has now fully given way to structural issues and inflationary pressures as the prime focus of economic policy-making.

Industrial production, a coincident indicator of overall economic activity, rose 13.5% y/y in December to bring the full-year to 15.7% y/y, largely in line with a soft-landing scenario. For 2010, heavy industry kept gains ahead of light industry—despite government restrictions on energy-intensive firms through the end of the 11th Five-Year Plan period—rising 16.5% y/y, in contrast to light industry's 13.6% y/y. In terms of geographical spread, coastal China saw industrial production grow 14.9% y/y for the year, with the west growing at 15.5% y/y and the centre pulling ahead, at 18.4% y/y.

Urban fixed asset investment came in at 24.5% for the year, with the mild slowdown through the year highlighting the retreat of investment spending through 2010 that accompanied the winding-down of the November 2008 fiscal stimulus. Fixed asset investment in rural areas rose 19.7% y/y. Despite the second round of administrative measures in October that have softened—but not slashed—price gains in the property market (see below), real estate investment has remained resilient. Full-year investment in property grew 33.2% on the year to 4.8 trillion yuan, a remarkable 20% of urban fixed asset investment. Support was provided by the characteristically steady retail sales, a rough proxy for household consumption, which gained 19.1% for the year.

In terms of China's external sector, data released earlier in the month showed a rather dramatic pull-back in December's foreign trade. Export growth slowed to 17.6% y/y, the slowest pace of expansion through 2010 and almost half of November's 34.9% y/y expansion. Import growth also decelerated sharply to 25.6% y/y, down from 37.7% y/y in November. This shrunk the trade surplus to an eight-month low of US$13.08 billion, a handy occurrence given President Hu's current trip to the United States.

Trade volumes in 2010 recovered from 2009's poor showing, exceeding pre-crisis levels. For the full-year 2010, China's foreign trade totalled US$2.97 trillion, up by 34.7% from 2009. Exports surged 31.3% and imports soared 38.7% y/y, while the trade surplus dropped 6.4% on the year to stand at US$183.1 billion. Electrical and machinery goods still dominated the country's trade in 2010, with the exports of such goods soaring 30.9% on the year to hit US$933.4 billion—nearly 60% of China's total exports—and such imports surging 34.4% y/y to stand at US$660.3 billion, 47% of the total.

Rampant Liquidity…

The deluge of liquidity that has flooded into the economy over the past year continues almost unabated. Full-year bank lending reached 7.95 trillion yuan, well past the 7.5-trillion target set by regulators. This is down from 2009's remarkable 9.6 trillion yuan, but given that 2009 was almost double the 4.9 trillion seen in 2008, this is hardly a case of severe monetary tightening, despite movement on interest rates and reserve ratio requirements. Indeed, with such runaway liquidity, it is easy to see how China has achieved another year of double-digit growth.

Banks bumped up against their full-year quotas in December, then sailed past them, lending 480.7 billion yuan, up over 100 billion yuan on December 2009. M2, the broad money supply, continued its strong growth in unison, climbing 19.7% y/y in December, up 0.2 percentage points on the month previously, though down 8 percentage points on the year before. Worryingly, market rumours suggest that—with quotas renewed—banks lent over 500 billion yuan in the first week of January alone, drawing warnings from the regulators that the month's total should not exceed 12% of the full-year figure, thought to be at 7.2-7.5 trillion yuan. As always, it looks unlikely this target will be met.

…Is Driving Inflationary Pressure

As largely expected, inflation blasted through the government's full-year 3% target in 2010, with the consumer price index (CPI) coming in at 3.3% y/y. Public hype surrounding China's inflation problem will temporarily subside, given that December's consumer prices rose 4.6% y/y. This was down from the 5.1% y/y growth in November, which was driven by 11.1% y/y gains in food prices. However, with direct government intervention in food prices—Carrefour, for example, was reportedly ordered to give officials two days' notice before raising vegetable prices—and a more favourable base effect, it is hardly surprising that food prices have subsided, smoothing the overall CPI number. Food prices gained 9.6% y/y in December, down from the 11.7% y/y clocked in November. That said, the trend behind non-food CPI is still looking troubling, growing at 2.1% y/y in December, up from November's 1.9%. Meanwhile, prices at the factory gate, the producer price index (PPI), have also seen some moderation, rising 5.9% y/y in December, down from November's 6.1% y/y, for a full-year rate of 5.5% y/y.

Whilst the real estate market continues to pull back in y/y terms, to growth of 6.4% in December, down from 7.7% in November and 8.6% y/y in September, month-on-month (m/m) gains demonstrate the still-strong upward pressure in the market. Prices were up 0.3% m/m in December, marking the fourth straight month of sequential gain. As usual, the national rate masked divergent regional trends. Sanya, in Hainan province, saw y/y price gains of 43% in December, whilst Guangzhou, in Guangdong, saw gains of just 0.4% y/y. The underlying drivers of the property market boom remain unchanged, despite the two rounds of aggressive administrative tightening. Strong credit creation over the last two years, not to mention rampant off-balance-sheet lending, is pushing liquidity into the market. The two rounds of measures have softened, rather than reined in, the market. Continued price gains heighten the chance of a third round of administrative measures, as authorities struggle to keep price gains below income growth and remain fearful of the impact of a fully fledged property tax or significant interest rate rises.

Outlook and Implications

The economy sails into 2011 with renewed domestic demand strength, with measured tightening having limited impact. A new wave of credit expansion is driving inflationary pressure, in both consumer prices and asset markets, with a reacceleration in construction and fixed investment. Despite December's slight retreat in CPI, the demand side of the inflationary picture remains unchanged, as evidenced by creeping non-food inflation. In short, tightening has been timid, in effect doubling-down on the liquidity-driven investment-heavy growth model from which policymakers are, at least rhetorically, attempting to shift away.

IHS Global Insight expects the government to continue with its measured tightening stance through this year, reflecting the change to a "prudent" monetary policy. We expect two benchmark interest rate rises—possibly more—in 2011, in combination with more reserve ratio requirement (RRR) tinkering and direct credit controls. That said, to date, RRR increases have not brought credit growth down, neither have tentative moves on interest rates, as inflation outpaces the 50-basis-point increase we have seen during the last four months and rate levels remain severely suppressed. Although there have been announcements pointing to a break from the traditional full-year loan quota system, it remains unclear whether this change will actually take place. In fact, as rumours emerged that January's first-week lending had surged, regulators were reported to fall back on quota allocations, demanding banks stick to 12% of a full-year amount for the month.

Although inflationary pressures in non-food consumer prices and asset markets are to be watched, they are not at dangerous levels yet. Should rampant liquidity drive inflationary pressure still higher, the policy dilemma facing the government will merely intensify. Interest rate hikes are widening the differential between the United States and China, at a time when the renminbi continues its crawling peg against the U.S. dollar, causing increasing pressure from inflows seeking the carry trade and one-way currency bet. In this respect, raising interest rates to slow the economy could have the opposite effect, in addition to increasing distress to balance sheets at the local government level and punishing mortgage holders. Moreover, if further asymmetric rate rises (squeezing net interest margins at the longer-end, retaining them at the shorter-end) succeed in drawing cash away from the property sector and back into deposit accounts, bank reserves will build and credit creation could grow, as banks feed to interest rate-insensitive SOEs, compounding efforts to reel in liquidity.

An improved outlook in the United States will provide additional support to China's external sector going forward, allowing a slightly faster renminbi appreciation schedule. IHS Global Insight expects an appreciation of 5-6% in 2011, against the U.S. dollar. It should be noted that a 5-6% nominal appreciation, in combination with the significant difference between U.S. and Chinese inflation rates, means that the renminbi is appreciating relatively quickly in real terms. Our growth outlook remains strong, with GDP projected at 9.5% for 2011, on the back of the U.S. outlook and renewed domestic demand momentum. A vastly expanded money supply means that growth could very well surprise on the upside. As such, the risk of a sharper-than-expected growth deceleration after 2011 increases, as inflationary pressures and rampant credit creation take their toll.