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Government Documents
Government Documents
UPDATED: June 20, 2011 NO. 23 JUNE 9, 2011
China Quarterly Update
World Bank Office, Beijing, April 2011
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Overview

China's economic growth has remained resilient as the macro stance moved towards normalization. Both fiscal and monetary policy contributed to the normalization. Consumption growth slowed in early 2011. But overall domestic demand held up well, supported by still strong investment growth. Real estate investment has so far remained robust to measures to contain housing prices—a policy focus. Reducing inflation is the other policy priority, after inflation rose to 5.4 percent, largely on higher food prices.

The economic outlook remains broadly favorable. The global growth outlook has so far been little affected by the higher raw commodity prices and the earthquake in Japan. Domestically, headwind from a normalized macroeconomic stance, inflation, and somewhat slower global growth is likely to be partly offset by solid corporate investment and a still robust labor market. An expected slowdown in mainstream housing construction should in part be compensated by the government's ambitious social housing construction plans. With a broadly neutral contribution of net trade, we now project China's real GDP growth at 9.3 percent in 2011 and 8.7 percent in 2012. The surge in raw commodity prices means we expect another decline in the current account surplus this year. However, whether the trend towards a lower external surplus and lower dependence on external trade will be sustained to be seen.

A fully normalized macro policy stance is key to address the macro risks with respect to inflation and the housing market. With food price increases slowing, sequentially, and core inflation still in check, inflation should moderate eventually. However, much of the impact of the higher oil and industrial commodity prices is still in the pipeline, inflation expectations are high and there is little spare capacity in the economy, overall. To address the risks on inflation and the property market, macro policy is typically better placed than moral suasion and administrative measures. It is too early to stop the macro tightening. Two way risks are better dealt with by maintaining fiscal and monetary flexibility.

While the macro and financial risks on the property market require macroeconomic measures and reforms, social concerns require a different policy response. Macro and financial policy is supposed to prevent different types of risks from building up and make the economy and the financial system robust to a possible property downturn, rather than mainly focus on containing overall housing prices. If housing prices are considered systematically too high from a market perspective, macroeconomic levers are more obvious than administrative measures, especially locally administered ones. On the other hand, making housing more affordable for targeted groups requires sustainable rules-based arrangements, almost unavoidably explicitly subsidized by the government. The scaling up of social housing is in the right direction. However, finding a transparent, rules based financing model is key.

The 12th Five-Year Plan can provide direction for reform. Its two key overall objectives are rebalancing and industrial upgrading and moving up the value chain in manufacturing. Policy-wise, it is important to find the right balance between these two. With regard to the Five-Year Plan's growth targets, the challenge is to make them binding and consistent nationwide. The targeted 4 percentage points of GDP increase in the share of services is ambitious but supported by fruitful policy proposals. The targeting of wage growth at or above GDP growth is new. Reforms of inter-governmental fiscal relations will be crucial for achieving meaningful progress on a range of other policy priorities. Barriers to labor mobility may require more attention.

Recent Economic Developments

Economic growth remained resilient as the macro stance moved towards normalization. Sequential GDP growth eased from 10 percent in the last quarter of 2010 to 8.7 percent in the first quarter of 2011 at a seasonally adjusted annualized rate (SAAR), according to the new estimates of the National Bureau of Statistics (NBS), leaving output up 9.7 percent on a year ago; our estimates suggest somewhat faster sequential growth. The overall fiscal stance implies some withdrawal of stimulus in 2010 and 2011. The monetary stance was normalized through the first quarter of this year, with higher interest rates and reserve requirement ratios and, most importantly, reinforced quantitative guidance on bank lending. As a result, credit and money (M2) growth slowed in early 2011, although overall financing conditions remained accommodative (Figure 1).

Domestic demand held up well in early 2011, supported by investment, even as consumption slowed. Reflecting the still accommodative financing conditions, reported real fixed asset investment growth rose to 25 percent in the first quarter (y.o.y) (Figure 1).[1] Real estate investment remained resilient to several rounds of measures to contain housing prices. Reflecting those measures, housing prices in large cities softened on average in the first quarter, according to data of the NDRC and Soufun.com. However, housing market activity remained buoyant in tier 2 and 3 cities, where nowadays the bulk of housing construction takes place and which have been less affected by the measures.[2] In the first quarter, economy-wide real estate investment, floor space under construction, housing starts, and property sales all still continued to post robust growth. However, retail sales decelerated in the first months of 2011 as inflation affected purchasing power and consumer confidence (Figure 2). Car sales decelerated particularly rapidly, after surging in recent years, as several incentives expired.

Exports slowed down in late 2010 but continued to expand in early 2011. As world trade rebounded in the first half of 2010, China's exports surged 39 percent (SAAR) in real terms (Figure 3). In the second half, amidst slower world trade growth, exports rose only 7 percent on this sequential metric, but in the first quarter of 2011 they expanded 10.6 percent (SAAR), to a level up 11.4 percent on a year ago in real terms.

Reflecting the still robust overall domestic demand, imports held up well early this year, especially those of manufactured goods. Overall import volumes rose 14 percent in the second half of 2010 (SAAR), with growth particularly strong in the fourth quarter (Figure 3). They broadly kept that pace in the first quarter, growing 13 percent (SAAR) to a level up 14.5 percent on a year ago. Processing imports volumes continued to track processing export volumes, while growth of "normal" imports—used in the domestic economy—slowed from 22 percent to a still solid 15 percent (y.o.y.) in the first quarter, in real terms. As in most of 2010, manufactured goods imports outpaced raw material imports substantially (y.o.y.), in real terms.

Falling external terms of trade combined with the volume developments to lower the trade surplus. For much of 2010, net external trade contributed positively to GDP growth. The NBS estimates this contribution at 0.8 percentage points (pp) for the whole year; our estimate is 2.5 pp (see Table 4 below). However, a large decline in the external terms of trade—as global commodity prices recovered much faster than those of manufactured goods—kept the trade surplus broadly unchanged in 2010, in US dollar terms (Figure 4). Nevertheless, the current account surplus rose, largely because of higher income on China's rapidly rising foreign assets.[3] In the first quarter of this year, with export volumes slowing more rapidly than import volumes, the contribution of net trade to real growth declined—we estimate it was slightly negative (y.o.y). On the back of further raw commodity price hikes in the first quarter, the terms of trade were down another 3.8 percent on a year ago and the (customs data based) trade balance shifted to a small deficit, although the seasonally adjusted trade balance remained positive.

Inflation has risen to a 32-month high on higher food and other raw commodity prices.[4]Consumer price inflation rose to 5.4 percent (y.o.y.) in March, mainly driven by higher food prices caused by problematic weather domestically last year and hikes in international food prices (Box 1 discusses longer term trends in food prices). Vegetable prices, the key driver in 2010, have come down recently, sequentially, after peaking in February. Retail prices of other food products, such as meat, rose in the first quarter, probably driven by higher feed costs.[5] Grain retail prices have also risen, in line with adjustments in procurement prices. However, overall, pressure from food prices may have peaked for now, with sequential increases having slowed since early 2011. In the absence of significant spill-over into other prices and wages, underlying inflation pressures have so far remained low. Core inflation was 2.3 percent in March (y.o.y), although much of the impact of higher raw commodity prices is still in the pipeline.

The government has taken several steps to contain inflation. In addition to normalizing the overall macro policy stance it took some measures to boost food supply and reduce the cost of production and logistics, including releasing grain from China's large reserves, increasing subsidies to farmers, exempting transport of vegetables from road toll, and boosting food imports. More recently, this was followed by limiting the increase in domestic fuel prices arising from higher oil prices and applying moral suasion on manufacturers of food and consumer products. Also, after being de facto pegged for almost 2 years, since June 2010 the RMB has appreciated 4.6 percent against the US dollar, although it depreciated in nominal effective terms.

Foreign reserves continue rising rapidly. The rise in foreign reserves in 2010 was at US$448 billion broadly unchanged from 2009 as a higher current account surplus and higher net FDI were offset by a switch from valuation gains to valuation losses and lower net financial flows (which include "hot money" flows) (Table 1). The US$197 billion increase in foreign reserves in the first quarter, despite a trade deficit, suggests a surge in net financial commercial inflows and/or one-off transactions. Given that China's capital controls are considered to have been reasonably effective in recent years, a surge in net financial commercial inflows would be remarkable.[6]

Some medium term trends

With strong real growth and substantial real appreciation, China's share in the world economy has surged in recent years. China's continued strong growth in 2008-2010 contrasts with weak or no growth in other parts of the world. In addition, with substantial price increases and some nominal exchange rate appreciation, in the last five years China's prices rose faster than elsewhere, measured in common currency (Figure 5). This is especially so for the GDP deflator (Table 2).[7] GDP deflator-based real appreciation against the US dollar averaged 6.6 percent per year in 2005-10 and annual (trade-weighted) effective real appreciation on this basis averaged an estimated 5.5 percent. It is not fully clear what the main reasons are behind these rapid relative price increases and whether they will be sustained. Nonetheless, they have been a major factor in China's catch up in recent years. China's share of global GDP rose from 6.3 percent in 2007 to an estimated 9.5 percent in 2010, in current prices and market exchange rates, with around one third coming from higher relative prices.

During this time, China's exports rose rapidly. They strongly outpaced partner countries' imports on the basis of rising competitiveness in an increasing array of manufacturing sectors, and their global market share rose from 7.4 percent in 2007 to an estimated 9.6 percent in 2010 (Figure 6). Moreover, the value added content of exports continued to rise because of (i) deeper supply chains in the processing sector that raised the value added content of processing exports from 40 percent in 2007 to 43 percent in 2010; and (ii) a rising share of normal (non processing) exports, which have a higher value added content. Thus, in terms of value added, export growth was even somewhat faster than headline export growth (Figure 6).

Nonetheless, because of strong domestic demand and relative price changes, the relative importance of external trade has declined. China's domestic economy grew even faster than exports in those 3 years and China's imports surged alongside domestic demand—outpacing exports, in real terms (Figure 7). This lowered the current account surplus from 10.1 percent of GDP in 2007 to 5.1 percent in 2010, leading to some external rebalancing simply because China grew much faster than the rest of the world.[8] At the same time, the relative importance of exports in the economy declined because of these trends and the fact that domestic prices rose much faster than export prices. Having peaked at 39 percent in 2006, the share of exports in GDP was an estimated 29 percent in 2010 (in value added terms the reduction was somewhat less). These developments are of course influenced by the global crisis, which depressed global demand and led China's government to implement a large and effective stimulus. Looking ahead, whether these trends will be sustained depends on China's policies, including the progress with rebalancing, and other developments domestically and globally.

Economic prospects

The global growth outlook remains broadly favorable despite recent shocks. After a period of upgrades to growth forecasts in 2010, the global outlook has recently been challenged by high prices of oil and other raw commodities and the terrible earth quake and tsunami in Japan. Overall, though, global growth prospects remain robust. Recent downward revisions to growth have generally been modest and the April Consensus Forecasts suggest global GDP growth of 3.4 percent this year, after 3.8 percent in 2010, at market exchange rates (Table 3). This incorporates a downward revision of the forecast for Japan's GDP growth by 0.9 percentage points, with the forecast for next year up by 0.8 percentage points, although the damage to society and physical assets is of course much larger than those numbers suggest. Although the oil price has continued to rise since early March, in large part because of turmoil in the Middle East and resulting supply concerns, most of the oil price increase since early 2010 took place before the outbreak of that turmoil, apparently largely because of improved global demand prospects instead of supply concerns.

International raw commodity prices more generally have risen. Since early summer 2010, international raw commodity prices have risen strongly across the board, largely because of strengthened global demand prospects but also, such as in the case of food, because of supply factors. More recently, international prices of most raw commodities, including oil, metals, and food, have halted their ascent, sequentially, presumably in large part because global demand prospects have stopped improving. However, the higher raw commodity price levels are pushing up (y.o.y) inflation, especially in emerging markets, and much of the higher raw commodity prices still needs to feed through into consumer prices, globally. At the same time, low core inflation in high income countries, especially the US, means it is likely to take a while before global interest rates will rise substantially.

Risks to the global growth outlook remain. In high income countries, high public debts and weak real estate markets continue to pose risks, especially in some euro area countries, while financial risks stem from high funding requirements of banks and sovereigns. In emerging markets, risks include overheating and booming asset markets. Also, raw commodity prices including oil may rise still further.

Domestically, growth is likely to ease somewhat this year and next to a still healthy rate. This year, headwind from a normalized macroeconomic stance, inflation, and somewhat slower global growth should be partly offset by solid corporate investment and a still robust labor market.

l Investment growth is likely to slow down somewhat. It should be affected by the monetary policy normalization. Overall financing conditions should remain reasonably supportive because of robust financing via the capital market and generally healthy profit prospects and balance sheets in the corporate sector. This is so even though higher commodity prices may put downward pressure on profits in sectors that find it difficult to pass on higher input costs because of strong competition, such as in core manufacturing, or administratively-set output prices. However, the rapid expansion of infrastructure investment in recent years reduced the room for it to further drive investment growth.[9] This is even though investment should benefit from the start of the 12th Five-Year Plan, including through its emphasis on "industrial upgrading". Real estate investment is also expected to slow down in response to several rounds of property tightening measures, although the government's ambitious plans for social housing construction are likely to keep overall property construction growing this year. In all, despite significant stock building, we project growth in gross capital formation to come down from an estimated 11.6 percent last year to 10.7 percent this year and 9 percent next year (Table 4).

l Consumption should remain supported by a robust labor market, but inflation creates headwind. Household income should benefit from solidly rising wages and employment, although this is likely to continue to be tempered, especially in the second and third quarter, by substantial inflation which reduces real income growth and consumer confidence.[10] We expect total consumption (including government consumption) to grow 8 percent this year, as in 2010.

l Net trade should be broadly neutral with respect to growth. With global imports expected to rise 7.4 percent in 2011, in real terms, and global market share gains expected to moderate, we project China's exports to rise 12.4 percent this year, in real terms. With domestic demand growth remaining steady, we expect imports to outpace exports somewhat, growing 13.2 percent in real terms.

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