China in Transition

Short-term Outlook for the Chinese Economy

Chi Hung KWAN
Consulting Fellow, RIETI

(Published in the October 25, 2011 edition of the Allatanys Newspaper Guide)

Since the beginning of 2010, the Chinese government has adopted a tight monetary policy, centering on a hike in interest rates and reserve requirements, to cool the overheated economy. Thanks also to weakening demand overseas, the Chinese economy is decelerating, and the inflation rate, hitherto consistently on the uptrend, is also beginning to fall from its July 2011 peak. The inflation rate is set to fall further going forward along with the economic growth rate, and this is likely to expand the room for monetary easing. In the wake of these developments, the Chinese economy should bottom out in the spring of next year and begin to recover in the run-up to the National Congress of the Chinese Communist Party scheduled for the fall.

From overheating to stagflation

In China, the reserve requirements were raised 12 times since January 2010 for a total of six percentage points, to 21.5%, a record level. The benchmark one-year base lending rate was also hiked five times, for a total of 1.25 percentage points, since October 2010. Following these increases, the rate of growth in the money supply has declined from 29.7% in November 2009 to 13.0% in September 2011. With the economy slowing down on the back of monetary tightening, inflation has also begun to ease.

GDP growth in China has been trending downwards, from a peak of 11.9% in the first quarter of 2010 to 9.1% in the third quarter of 2011, the lowest level since the second quarter of 2009. Growth in exports has also been slowing because of the weakness of overseas economies, especially in Europe, in addition to domestic factors such as consumption and investment, and this is pushing down the growth rate.

Although inflation rose to 6.3% in the third quarter of 2011, higher than 5.7% in the second quarter, it has been falling on a monthly basis, from a peak of 6.5% in July to 6.2% in August and 6.1% in September. For the following reasons, it looks likely that inflation will continue to fall in the months ahead. First, the upward pressure on prices is easing because of improvements in the market supply-demand balance, as economic growth eases. Second, market liquidity is tightening, as symbolized by slower growth in the money supply. Third, China looks set to have a good grain harvest this fall, which will serve as a brake on the rise in food prices. Fourth, given the high inflation rate in the fourth quarter of 2010, the figure in the fourth quarter of 2011 is likely to be low because of the high comparison base. Finally, as international commodity prices have fallen, this is likely to lessen the pressure of imported inflation. In fact, the year-on-year rate of increase in the producer price index (PPI), regarded as a leading indicator of the consumer price index (CPI), has been declining, to 7.3% in August and 6.5% in September, after peaking in July at 7.5%.

While the current growth rate is below 9.5%, the average value since the collapse of Lehman Brothers, the inflation rate still exceeds the average value of 2.5% in the same period. In terms of the business cycle, the Chinese economy has moved from a phase of overheating (from the second quarter of 2010 to the second quarter of 2011), with high growth and high inflation, to a phase of stagflation, with low growth and high inflation. The economy is likely next to enter a recessionary phase of low growth and low inflation at the beginning of next year, with the effects of the tight monetary policy becoming even more pronounced.

Monetary easing

In the market, expectations of rate hikes and higher reserve requirements have been receding significantly, reflecting the slower economic growth and lower inflation in China, as well as turmoil in the global financial markets associated with the downgrading of U.S. treasuries and the sovereign debt crisis in Europe. Instead, expectations are mounting for an easing of credit.

At the third quarterly meeting in 2011 of the People's Bank of China Monetary Policy Committee, which was announced on September 30, 2011, the expression used to describe inflationary pressure was toned down somewhat from "remained high" to "moderated but remaining high" (the website of the People's Bank of China, September 30, 2011). More "forward-looking" macroeconomic management was also emphasized for the first time in the context of monetary policy. This implies that the Chinese authorities may ease their monetary policy by making preemptive moves to prevent a major economic slowdown if concerns arise that the monetary tightening measures adopted to date have already gone too far.

The tight monetary policy since 2010 has been centered on hikes in the reserve requirements rather than in interest rates. In fact, the reserve requirements were raised for the first time in January 2010, while the first rate hike was implemented nine months later. In the coming shift to an easy monetary policy, the reserve requirements are likely to be lowered before interest rates are cut, and its timing is likely to be at the beginning of next year when the economy is expected to enter a recessionary phase.

Economy to recover in the run-up to the Party Congress next fall

For the first time in five years, the National Congress of the Communist Party of China (Party Congress) is scheduled to be held in the fall of 2012. It is a golden opportunity for the Communist Party to appeal to the people for support based on China's economic achievements under its rule, and for the next generation of leaders to move into the central government, leveraging their accomplishments in the local governments. For this reason, the congress tends to be accompanied by expansionary fiscal and monetary policies, and the growth rate tends to be higher in the years when it is held. While the average growth rate in China from 1981 to 2010 is 10.1%, it is 11.3%, or 1.2 percentage points higher, for the six years in which Party Congresses were held (1982, 1987, 1992, 1997, 2002, and 2007). As an extreme example, growth reached 14.2% in 2007 when the previous Party Congress was held. Given that expansionary fiscal and monetary policies are also likely to be pursued next year, the Chinese economy is expected to enter a recovery phase characterized by high growth and low inflation once again as the Party Congress approaches.

The original text in Japanese was posted on October 26, 2011.

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October 26, 2011