Perspective

Significance

Gross domestic product (GDP) in real terms grew by 10.2% on the year in the three months through March, sustaining momentum from last year, when the economy expanded by 9.9%.

Implications

Fixed-asset investment and exports continued to drive growth, stoking concerns over credit risks building in the economy and existing problems with oversupply.

Outlook

Global Insight has raised its 2006 growth forecast to 9.5%, from the initially projected rate of 9.4%, as more aggressive monetary policy measures to curb investment growth remain absent.

No Sign of Relenting

The Chinese economy's momentum proved relentless during the first quarter of 2006. In the three months through March, gross domestic product (GDP) in real terms surged by 10.2% on the year, according to National Bureau Statistics (NBS) data published today. The economy grew by 9.9% year-on-year (y/y) during 2005, after expanding by 9.9% and 9.8% in the third and fourth quarters of the year, to supersede Italy as the world's sixth-largest economy.

Outlook and Implications

Once again, fixed-asset investment and a renewed surge in the net export position proved the main drivers of growth. Fixed-asset investment soared by 27.7% on the year to 1.4 trillion yuan (US$174.7 billion), with urban investment rising by 29.8% y/y, against a more muted gain of 18.1% in rural areas. The breakdown of urban investment showed that capital expenditure surged by 47.1% y/y in primary industries, fuelled by heavy investments in the coal sector, and by 32.7% and 27.5% in secondary and tertiary sectors respectively. Capital continued to pour into the real estate sector, with investment totalling 279.3 billion yuan - a 20.2% increase on the year.

Credit growth has been underpinned by rapid expansion in the money supply, as the central bank mops up huge inflows of foreign capital to maintain stability in the yuan exchange rate. In 2005, money supply in broad terms expanded by 17.6% y/y. In the first quarter of this year, the surplus on the balance of trade swelled to US$23.3 billion. Exports rose by 26.6% y/y to US$197.3 billion, against a 24.8% increase in imports to US$174.0 billion. Actual foreign direct investment (FDI) expanded by 6.4% on the year to US$14.2 billion. Foreign exchange reserves surged by US$56.2 billion from the end of 2005, indicating the scale of pressure exerted by capital inflows and the aggressiveness of the central bank's management in response.

The Risks of Too Much Growth

The continued strength of investment growth carries significant risks. Heedless expansion of capacity, predominantly by state-owned enterprises (SOEs), fuelled by the funnelling of credit through state banks, is exacerbating oversupply in the economy, while the inefficient allocation of resources still constricts the growth of productive private-sector demand. In addition, the investment cycle that began in 2002 could further compromise the balance sheets of state-owned banks already encumbered with huge volumes of non-performing loans (NPLs). Although the rate of investment growth in the state sector has slowed, it still accounts for over 50% of total investment. However, conversely, the shift of investment growth to the non-state sector also holds risks, as commercial risk practice in the banking system remains immature. The ability of authorities to centrally curb investment flows will weaken in line with the development of the market economy.

Government policy is currently focused on diversifying growth from its continued skew to investment and exports, through the cultivation of private consumption. However, private consumption growth remains remarkably stable, despite the robust growth recorded by other demand-drivers. Retail sales - a proxy for household spending - rose by 12.8% in the three months through March to 1.8 trillion yuan. Annual growth in domestic sales has consistently treaded the 12-13% range. The comparative weakness of private consumption growth reflects structural imbalances in demand, ranging from excess savings in the private sector (denied unfettered access to financing options) and rising levels of unemployment (as state sector reform proceeds) to the widening wealth gap between the interior and the booming eastern seaboard.

Reforms Emphasised Again,to Ensure Sustainable Growth

Structural reforms to reduce the distortions generated by the rump state sector, distribute growth more evenly and contain burgeoning credit risks in the already weakened financial system remain key policy challenges for the state, as acknowledged last month at the annual National People's Congress. In addition, the fresh surge in external surpluses is set to re-fuel international tensions over the equity of the yuan's exchange rate; Beijing is likely to respond with further calibrated adjustments, supported by the gradual liberalisation of capital controls. However, although the challenges are significant, the economy's still-blistering rate of growth, grounded in its as-yet-incomparable competitive advantages, provide a sound base for these reforms to be implemented. Global Insight expects momentum to sustain in 2006, albeit at a slightly more moderate pace. Following repeated government warnings over the unsustainability of current rates of credit expansion, more assertive measures to trammel investment growth are expected. Concurrently, imports are expected to slow again, implying a lagged deceleration in manufacturing output growth, amid renewed speculation over further appreciation in the yuan. Finally, infrastructural bottlenecks, particularly in the energy sector, may impinge on growth. Reflecting the balance of these forces, our current 2006 growth forecast stands at 9.5%. A delicate path needs to be trodden to ensure that growth maintains at sufficient levels to absorb necessary restructuring, while containing the risks that unbridled expansion may pose over the medium term.

Contact: Raul Dary

24 Hartwell Ave.
Lexington, MA 02421, USA
Tel: 781.301.9314
Cel: 857.222.0556
Fax: 781.301.9416
raul.dary@globalinsight.com

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