China in Transition

Chinese Economy will Enter a Gradual Adjustment Phase in 2007

Chi Hung KWAN
Consulting Fellow, RIETI

The Chinese economy continued to boom in 2006, and economic growth for the year is projected to have reached 10.4%, marking the fourth straight year of double-digit growth. The high growth so far has been supported on the supply side by an increase in input, notably investment, and on the demand side by both investment and exports. However, amid excessive production capacity and intensifying trade frictions, the economy is poised to enter an adjustment phase.

Due to the investment boom since 2003, excess production capacity has become conspicuous in many industries, including steel. Although this does help hold down prices, for processing industries, which cannot translate the higher costs for materials such as oil into higher output prices, profits go down and companies must cut back on new investment. On the other hand, because domestic production exceeds domestic demand, the export drive launched by Chinese firms is aggravating trade frictions and placing upward pressure on the yuan through the expansion of the trade surplus.

In response to the excess production capacity, the Chinese government has implemented a series of policies to rein in new investment. First, on the monetary policy front, the benchmark lending rate was hiked twice in 2006 for a total rise of 0.54%, while the deposit reserve ratio of banks was raised three times during the year for a total 1.5 percentage point increase. In addition, the central government dispatched surveillance teams to the regions and has taken strict measures against investment projects that were not in line with industrial policy and involved illegal land transactions. Against such a backdrop, Chen Liangyu, the top official in Shanghai, was in September dismissed as secretary of the Communist Party's Shanghai Committee for his alleged involvement in misappropriating money from the city's social insurance funds, but this has also been viewed as an attempt to serve as a lesson to regional leaders who resist economic tightening policies mapped out by the central government. The effects of such policies began to appear in the latter half of 2006 through such trends as a slowdown in the number of investment projects being launched.

The Central Economic Work Conference that convened in early December agreed on an economic policy platform for 2007 that places more emphasis on improving the quality, rather than speed, of economic growth. In order to correct external-internal imbalances, on the demand side, the conference called for (1) rational restraint of investment increases and efforts to make adjustments in the investment structure (2) accelerating adjustments in the income redistribution system by focusing on private consumption, especially increasing consumption by farmers, and making efforts to raise the income levels and purchasing power of farmers and low-income urban residents (3) actively expanding imports and investment cooperation overseas (outward direct investment). On the supply side, the conference renewed its calls for the implementation of measures already included in the 11th Five-Year Plan draft, namely such steps as (1) the overall implementation of a scientific approach to development, (2) acceleration of the establishment of a harmonious society, (3) efforts to make adjustments to the country's economic structure and shift its economic growth model, (4) efforts to conserve resources and protect the environment and (5) promotion of market-opening reforms and independent innovation.

The National Congress of the Chinese Communist Party (the 17th such meeting) is to be held in the autumn of 2007 for the first time in five years. The season for personnel changes is approaching, not only for central government officials but also those at the local level. Because the economic growth rate and the amount of foreign investment in their areas of jurisdiction have traditionally served as the most important benchmarks for the promotion of senior regional officials, the years that the National Congress is convened often see an investment boom. However, this time, the standards by which personnel evaluations are made have changed from "quantity" to "quality" in line with the Central Economic Work Conference, and we can expect investment to be restrained.

On the other hand, the global economy, including that of the United States, is expected to gradually slow in 2007. When acceleration in the yuan's appreciation is also taken into account, exports, which have so far been robust, will inevitably slacken. Amid forecasts of a deceleration in investment and exports and with a surge in private consumption unlikely, growth in 2007 will probably slow to a level between 8% and 9%.

December 27, 2006

December 27, 2006