Is China's Economy Really Slowing Down?

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Craig Stephen's This Week in China

June 13, 2010, 7:59 p.m. EDT · Recommend (1) · Post:

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HONG KONG (MarketWatch) -- As China delivered its latest economic report card last week, authorities were quick to say policy will stay on course. That means interest rates will be left unchanged, even as the dangers of a cheap-money policy look to be rising.

We are now almost six months into China's apparent tightening, yet the data out for May point to a rising inflation trend, rather than much of a slowdown.

China's consumer price index in May accelerated to 3.1%, a 19-month high, and the producer price index rose to 7.1%. While bank lending has been slowing, money-supply growth is still running at over 20%, and retail sales grew by 18.7% year-on-year. ( See full story on Chinese economic data.)

May exports rebounded reaching a record high of $136 billion, and the monthly trade surplus jumped to $19.5 billion. ( See full story on Chinese trade data.) To find evidence of a slowdown it was left to fixed-asset investment, which grew 25.9% in the January-May period, down from 26.1% in the January-April period.

Everything is relative when it comes to China, but this looks to be a textbook case of an overheating economy in need of higher interest rates. The surprise is a number of economists reviewing the new numbers say not so.

Credit Suisse conclude "overall this data indicates the economy is experiencing a slowdown," and further, "we do not think these numbers justify a change in Beijing's macro policy stance."

The economists at Standard Chartered Bank are in agreement: "We see China's economy shifting to a lower gear. We expect no interest-rate increases in 2010."

For any economist to explain China's command-style economy, successfully second-guessing government policy is a big part of the puzzle. However, it still looks a stretch to argue these numbers justify keeping interest rates unchanged.

They were at least in agreement with mainland Chinese officials, who were quick to downplay inflation risks, despite the CPI breaching the stated 3% target.

Yet back in the real world, inflation is clearly a growing problem. Factory workers striking for wage increases due to the spiraling cost of living are spreading across China, despite reported news blackouts by authorities. While not all workers will get the 70% pay rise recently awarded at Foxconn /quotes/comstock/22h!e:2038 (HK:2038 5.53, -0.04, -0.72%) /quotes/comstock/11i!fxcnf (FXCNF 0.75, -0.01, -0.67%) , wage growth is accelerating, and will inevitably fuel inflationary pressures and expectations.

The recurring fear of many institutional investors is that China is going to face a painful reckoning to rein in its overheating economy. By avoiding the medicine of higher interest rates, the pain will be that much worse later.

So far tightening has come through increased reserve ratio requirements for banks and slower lending, but no rate increases. JP Morgan's head of China equities, Jing Ulrich, describes current policy as "China switching from an ultra-expansionary policy to a tightening bias."

Asia markets will look toward the release of a new lending plan by the Bank of Japan as well as an interest rate decision in the coming week. MarketWatch's Steve Gelsi reports.

That may be so, but as inflation increases, "real interest rates" are now negative and continue to fall, with interest on bank deposits just 2.25%. The dilemma of hiking interest rates is its impact on China's increasingly important property market. Beijing wants to avoid tipping an overheated housing market into a potential collapse.

While mainland banks may have limited their exposure to property, the weak link could be home owners. In many parts of China, home prices are now up to 15 times average incomes, and households can be paying 60% of their income on mortgages. No matter what affordability models might tell you, households will struggle if interest rates go up.

This is one explanation for authorities' reluctance to use orthodox rate hikes and instead to favor a patchwork of administrative measures to slow growth.

The risk is that this refusal to raise the price of money will perpetuate the bubble economy, as excess money resurfaces somewhere else where there are fewer controls.

If gambling enclave Macau is a barometer for tightening, it is not working. Gaming revenues are making fresh records, and some analysts now forecast a massive 50% gain for 2010. Elsewhere, excess money is pouring into luxury items such as wine, high-end watches or Chinese art, exacerbated by a lack of investable options for Chinese savers. There is little incentive to keep money on deposit.

Beijing clearly has a difficult balancing act, having put itself in a position of needing low interest rates to manage asset prices and the economy.

Investors will note this looks like a shaky foundation for price stability and sustainable growth.

The mystery of who's running Sara Lee Corp. is solved -- at least for now.

17 min ago12:50 p.m. June 14, 2010 | Comments: 3

As long as the military is paid on time, and they have enough ammunition, the communist dictatorship will survive. China has had no problem in murdering millions of its own citizens in order to maintain the political 'status quo.'"

- ProfitB4People | 9:22 a.m. Today9:22 a.m. June 14, 2010

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