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Time to RegroupChina must use 2004 to put its growth on a solid foundationby Isaac Cheng and Virginia Hulme 
China's impressive economic growth over the past 30 years continues to draw the world's attention. In spite of the outbreak of severe acute respiratory syndrome in spring 2003, GDP last year officially grew 9.1 percent, the highest rate since 1997, to ¥11.7 trillion ($1.4 trillion). Many independent analysts put growth even higher, in the double digits, pointing to large increases in domestic freight and production of such key goods as electricity, steel, and cement. Per capita GDP passed the $1,000 mark for the first time, a positive sign for Chinese living standards and maturation of the consumer market. Judging by these numbers, China is doing very well indeed. But questions about the sustainability of China's growth persist. One set of immediate concerns--among them inflation, overproduction, and loose capital controls--centers around managing the current boom cycle. Unusually large increases in bank lending and investment in sectors such as steel, real estate, and autos have convinced many analysts and government officials that the economy is overheated. China has started to apply the brakes, but worryingly high investment rates in early 2004--and GDP growth of 9.7 percent--indicate that further measures are needed. A clampdown on lending, added to the effects of a recent tax rebate cut on exports, may yet rein in GDP in 2004. But growth will still come in above the government target of 7 percent. Another set of concerns centers around serious, long-term threats to sustainable economic development. Inequalities between rich and poor, coast and interior, and rural and urban areas have developed into chasms that the PRC leadership can no longer ignore. The severe environmental degradation stemming from economic development is also catching the leaders' attention. A series of bank, state-owned enterprise, land, tax, and investment reforms are expected over the next few years. A "Revitalize the Northeast" campaign may also get under way as China tries to breathe life back into a former powerhouse of industry that now accounts for only about 5 percent of China's total trade. Investment and output: Too much of a good thingThe government's first urgent task is to slow the extraordinarily high levels of investment, especially in sectors such as steel, autos, aluminum, real estate, and consumer goods. Despite initial moves to slow investment in late 2003, investment in fixed assets such as buildings, machinery, and vehicles grew 43 percent in the first quarter of 2004 over the same period last year. China's fixed-asset investment last year as a proportion of GDP, at more than 47 percent, ranked among the world's highest. Inequalities between rich and poor, coast and interior, and rural and urban areas have developed into chasms that the PRC leadership can no longer ignore. Indeed, the government's new steel policy and the auto policy currently being drafted are aimed, in part, at cooling off investment in these sectors. Investment in steel, textiles, and chemicals continued at a furious pace in January and February, growing 176 percent, 144 percent, and 153 percent, respectively, year-on-year. The effect of heavy investment is becoming visible in output levels. Value-added industrial output rose 17 percent in 2003 and 17.7 percent in the first quarter of 2004. With so much new capacity being built, output growth will likely jump even higher in the next two to three years. Weak consumption undermines growthDemand continues to be investment-driven; domestic consumption is still a relatively small contributor to GDP. Private consumption in China accounted for 45.1 percent of GDP in 2002, whereas it accounted for 70.5 percent in the United States and 64 percent in the European Union. Consumption in China, as measured by retail sales, rose 9.1 percent in 2003 and 10.7 percent in the first quarter of 2004--not enough of an increase to draw down inventory stockpiles. Retail sales have strengthened slightly so far this year, but the consumer mini-boom analysts expected is nowhere to be seen. Possible reasons? Household savings rose 19.2 percent to ¥10.4 trillion ($1.26 billion) at the end of 2003, perhaps signaling that consumers feel a need to save for healthcare, education, housing, pensions, and other services no longer provided by the government. Private consumption in China accounted for 45.1 percent of GDP in 2002, whereas it accounted for 70.5 percent in the United States and 64 percent in the European Union. Supply is projected to exceed demand even for some industrial inputs where demand is currently high. Take steel: investment in steel doubled last year, and output is accordingly expected to nearly double, from 182 million tons last year to 330 million tons in 2005. But domestic demand is not expected to match this level of supply until 2010. Investment in the property sector grew more than 41 percent year-on-year in the first quarter and accounted for more than one-fifth of total fixed-asset investment. But according to the Economist Intelligence Unit, of the 550 million m2 in new construction last year only 330 million m2 was sold. Mismatched input and output prices further squeeze producersChina's consumer price index (CPI) confirms these trends. Although the CPI rose 3 percent in the last few months of 2003 and 2.8 percent in the first quarter, non-food prices held steady with only a 0.3 year-on-year increase for January and February. Demand for consumer goods is not broadly rising. The spike of inflation is almost entirely due to a rise in food prices: China had a bad crop last year and trouble transporting food to markets. With rural and urban families spending 46 and 38 percent, respectively, of their incomes on food, rising food prices may in fact be biting into consumption of other goods. Yet energy, iron ore, cement, and some other raw material prices have risen, some to record highs, putting pressure on producers. Global commodity prices have jumped, driven in large part by rising Chinese demand. And producers continue to stockpile raw materials, belying government projections of slower growth in commodity prices for 2004. Shipping prices have also shot through the roof. The Baltic Dry Index, a common average of global freight-shipping fees, is more than triple its 20-year average, and the price of freight exceeds the value of the ore itself on some routes, according to the chair of Baosteel, China's largest steel producer. The government plans to invest more in transportation and logistics this year (see China's Evolving Transportation Sector). The shortage of energy, which hampered production all of last year and is expected to intensify this summer as demand rises, further aggravates producers' difficulties. As of April, anecdotal evidence indicates that much of eastern China is already on a shortened workweek because of power shortages, and in some locations power has been cut without warning, bringing production to a sudden halt. Significant new generating capacity is expected to come online in 2005, which should ease power shortages. Relatively flat prices for end products and high production costs crimp manufacturers' already-tight profit margins, and the coming production surge, indicated by high investment rates, will apply even more pressure. Monetary policy still too looseChina needs to restrict lending and money supply growth, which exceeded the government's 17 percent target last year by three percent. According to economist Nicholas Lardy, China's credit growth last year was the highest in 25 years. Late last year China's central bank, the People's Bank of China (PBOC), raised bank reserve requirements by 1 percent, increased scrutiny of loans, and raised rates for loans to property developers and on some mortgages. Expansion of currency in circulation, including cash and holdings in savings and checking accounts (M2), was down slightly from last year in January and February at 18.1 percent and 19.4 percent, respectively, although lending continued at 21.3 percent year-on-year for the first two months (compared to 2003's 21.4 percent growth). PBOC Governor Zhou Xiaochuan has indicated that interest rates will remain stable for the time being, but if inflation rises above 5 percent, PBOC will likely raise rates slightly to cut lending and maintain a positive real interest rate on bank deposits. Two back-to-back increases in bank reserve requirements in March and April indicate financial authorities favor mild measures but are tracking liquidity closely. A fundamental obstacle in the central government's efforts to restrict lending is its lack of control over local governments. The same investments that PRC Premier Wen Jiabao brands as haphazard and redundant, local governments view as desirable, in part because they provide employment. In 2003, the great majority of fixed-asset investment was spent on local government projects, while such spending by the central government actually fell, indicating that overinvestment is occurring largely at the local level. And despite warnings from the top to curb spending, state-owned enterprises (likely with the aid of local bank loans) contributed almost two-thirds of total fixed-asset investment in January and February.
Forex reserves jump again; RMB holds firm--for nowThe government is also focusing this year on unfunded pension debts and the nonperforming loans of the state banks, estimated by official sources at about $447 billion and $241 billion, respectively, but by foreign analysts as up to $600 billion and $500 billion, respectively. Foreign exchange reserves hit $403.3 billion at the end of 2003, up more than 40 percent from year-end 2002. The amount would have been even larger if the Ministry of Finance had not used $45 billion from the forex reserves to shore up two state banks in late December. Rapidly accumulating forex reserves are one sign of upward pressure on the RMB--exporters earning forex and foreigners buying goods and services valued in RMB both need to exchange their foreign currency for RMB. In other words, strong demand is putting upward pressure on the RMB. But the PRC has not given in to strong pressure from the United States and other trading partners to revalue the RMB, which trades in a narrow band of 8.276-8.28 to the US dollar. Though outside political pressure for revaluation seems to have eased in the last few months, China has its own reasons to consider revaluing the RMB, namely the threat of inflation and overheating (see China's Exchange Rate and US-China Economic Relations). Inflows speculating on a revaluation of the RMB have also increased pressure on the currency. China took several steps to ease pressure on the RMB, such as allowing Chinese travelers to purchase more foreign exchange, simplifying foreign exchange procedures, and reducing value-added tax rebates on exports--which will cut the volume of exports in 2004 and the associated forex inflow. It has also placed limits on the amount of forex individuals can convert to RMB. These tweaks around the edges are not enough to reduce the pressure significantly, however, and most analysts are predicting that within two years China will widen the trading band gradually and tie the RMB's value to a basket of up to 10 currencies. Bankrolling financial reformsThe government is also focusing this year on unfunded pension debts and the nonperforming loans of the state banks, estimated by official sources at about ¥3.7 trillion ($447 billion) and ¥2 trillion ($241 billion), respectively, but by foreign analysts as up to $600 billion and $500 billion, respectively. International attention has focused on banking reforms because of the immediacy of the situation and the recent bailout and planned listing of two of the Big Four state banks (see Bank Reform: How Much Time Does China Have?). But the pension deficit, which is already at ¥200 billion ($24.2 billion) and growing rapidly, may prove to be the bigger long-term problem, both in complexity and in its direct implications for social stability. Huge government resources will be necessary to clean up these gaping holes in the country's financial system. Is the government's ledger up to the challenge? Here the news is good. Analysts note that China's debt situation is relatively benign, and that given its large foreign exchange reserves and strong economy, China can afford to (and perhaps should) expand its debt in external markets. The budget deficit will remain the same absolute size in 2004 as in 2003, but is forecasted to shrink to 2.5 percent of GDP because of economic growth. The total explicit official debt is low, at 25 percent of GDP compared to 60 percent or more in some developed countries. The government is also limiting its Treasury-bond offerings; it released only ¥140 billion ($16.9 billion) of new domestic bonds in 2003 and plans to issue ¥110 billion ($13.3 billion) in 2004, according to Ma Kai, minister of the National Development and Reform Commission (NDRC). PRC officials have indicated that from 2004, bonds will no longer be used to stimulate the economy; this is a prudent move, given the current government deficits and incipient strength of private investment, although the lack of fiscal stimulus may be a factor in the government's reluctance to tighten monetary policy. In a side note, the government has started selling two- and five-year T-bonds to create a yield curve--the first step in establishing a dynamic and rational debt market. Taken together with the State Council's January policy paper on corporate markets, the move makes this year look encouraging for the development of a corporate bond market. Rural issues unresolvedThe other major priority for the government is addressing slow rural development, an issue linked closely with rising inequality, persistent unemployment, and low domestic consumption. Wen promised at the March session of the National People's Congress to eliminate central-level agricultural taxes within five years and to reduce the system of arbitrary charges levied on farmers by local government officials. PRC officials also budgeted a large 20 percent jump in spending on agriculture and rural investment in 2004. The measures are sorely needed to close the developing income gap. Rural income per capita, which grew 4.3 percent to ¥2,622 ($317) in 2003, still lags behind urban income, which rose 9.3 percent last year to ¥8,500 ($1,028). The Chinese Academy of Social Sciences reportedly estimates that migrant workers, who are responsible for 40 percent of rural income, are owed $12 billion in back wages, mostly by construction companies. The central government is encouraging local governments to pressure construction companies to pay all back wages within three years by making it difficult for recalcitrant companies to win contracts. Many rural issues are at the heart of conflict between the central and local governments. Illustrating this conflict of interest is the high-profile case of Sun Dawu, who built up a small family farm into a successful agricultural company employing more than 1,000 people. His success drew the attention of several universities in Beijing, who invited him to speak. What he had to say regarding local corruption, the impossibility of obtaining a loan without paying bribes and kickbacks, and government rural policies--information he also made available on the company's website--did not go down well with local officials, who imprisoned him. After five months, a local court convicted him of setting up an independent rural credit cooperative without permission. (He had collected deposits from employees, paying them a higher interest rate than local banks, in place of the loans he could not get from state banks.) He was released with a suspended sentence and a fine. Ironically, soon after his release the Chinese Communist Party (CCP) School in Beijing awarded him a prize for his efforts to bring economic growth to rural areas. Sun's case may have accelerated government plans to strengthen rural access to credit. In January, the government started a program in eight provinces to overhaul rural credit cooperatives and to write off up to 50 percent of their nonperforming loans, currently at $61 billion by official estimates. To qualify for the program, credit cooperatives must improve governance and risk-management goals according to a set schedule. Part of the solution will be further liberalization of interest rates. Without compensation for the higher risk of lending to farmers, the rural credit cooperatives have little hope of achieving good health, a precondition for expanding credit. Job growth: Racing to keep upThe ultimate goal for Chinese economic policy, of course, is social stability. The official estimate of urban unemployment was 4.3 percent, or 8 million, for the end of 2003, but this figure omits workers furloughed from state-owned enterprises and migrant laborers seeking work in the cities. Nor is surplus rural labor included. Furloughed workers numbered 18.6 million at the end of October 2003--leading most independent analysts to put real urban unemployment between 10 and 20 percent. The CCP's Central Institute estimates that unemployment in small and medium-sized cities is about 18 percent. Making matters worse, job creation apparently slowed in 2003. Morgan Stanley's Andy Xie has calculated that half as many jobs were created in the most recent five years as in the previous five years. In fact, official statistics show that in spite of China's vaunted growth in industrial output, net manufacturing employment has decreased steadily since 1992, with state-owned manufacturing units shedding over two-thirds of their workers. Official statistics show that in spite of China's vaunted growth in industrial output, net manufacturing employment has decreased steadily since 1992. PRC officials expect official urban unemployment to reach 4.7 percent by year-end; NDRC chief Ma explained that the restructuring of inefficient state companies and the shutdown of small producers will continue with an emphasis on rationalizing industry and creating stable jobs. To cope with the layoffs, the government is allocating ¥8.3 billion ($1 billion) for reemployment training this year and aims to create 9 million new urban jobs. What to look for in 2004
China will still vigorously pursue economic growth, but with close attention to shoring up the strength of the underlying financial system and more consideration for rural stability, health, welfare, education, and the environment. This strategy possibly explains the government's surprisingly low 2004 GDP and investment growth targets of 7 and 12 percent, respectively. Although analysts unanimously judge those numbers to be too low, the coming year should show a slight slowdown. The degree of that slowdown is of keen interest to global investors. China is the second-largest engine of world economic growth after the United States and accounted for half of last year's 37 percent increase in global trade. If China's current officials muster the political power and discipline to put their economic house in order, the results will affect global growth, forecast at 4 to 5 percent this year. China's economy, for better or worse, is now an integral part of the global economy. Businesspeople--Chinese and international--who are patient and look beyond the horizon will recognize that a short-term correction is a small price to pay for long-term, sustained growth.
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