Behind the "High" Growth

While it was generally anticipated that the Chinese economy would slow down, the third quarter GDP growth reported reached 9.4%, bringing the average growth of the first three quarters also to 9.4%. Apparently, there are no "cool down" symptoms and the economy is still on the "upward" cycle. Looking into the expenditure items, fixed investment and retail sales grew by 26.1% and 13% respectively in the first three quarters, while exports soared by 31.3%, boosting the trade surplus to a historical high of $68.3 billion, being 17 times of the surplus for the same period last year. In light of the high growth in the three major areas, the growth momentum appeared quite strong.

Nonetheless, this is by no means optimal. The divergence in the pace of growth among consumption, investment and exports is noteworthy. Though consumption registered double-digit growth, it was still far behind investment and exports. This indicates that domestic demand relies more on investment, and, amid the relatively weak consumer demand, the robust growth in investment is increasingly reliant on external demand, i.e. exports. Such growth pattern has become more notable.

Excessive Capacity and Rebound in Investment

Excessive capacity, and the resulted deflationary pressure, was once a major problem faced by China. Though prices had rebounded and even fuelled worry over inflation last year, this was only due to the volatile food prices, which occupied a large share in the CPI. The source of deflationary pressure - excessive capacity, has remained unresolved. Take the highest CPI increase of 5.2% in September last year as example, while the cereal and food components rose by 31.7% and 13% respectively, prices of industrial products continued to fall, particularly the durables. The report by the Commerce Bureau also indicated that among the 600 major commodities, there were no signs of "shortage", of which 154 items were roughly in equilibrium and the rest with excessive supply. Particularly, the excessive supply of those related with daily consumption reached 84%. Such a situation has little changed so far, though the downshift of CPI inflation brought about by food prices has made it more notable. In other words, the Chinese economy has not been freed from the potential threat of deflation.

Apart from the global manufacturing excessive capacity developed since the 1990s, there are domestic reasons for China's situation. The immature investment and financing systems in the Mainland have given rise to a tendency to expand investment in the economy. For example, quite a number of regional administrations and state enterprises tend to expand the scale of the cities or production capacities. At the same time, the traditionally high propensity to save, as well as the uneven distribution of income and uncertainty related to the transformation has restrained consumption growth. While these have to do with the economic system and culture, little change can be expected in the near term. Consumption growth can hardly catch up with the expansion of investment and production capacity.

The Chinese economy can be characterised by a high susceptibility of overheating in investment but stable consumption. Though the macro control measures last year have curbed the robust investment growth since 2003, the current growth rate of near 30% is still excessive. As fixed investments normally take a number of years to complete, the pressure on market supply from the investments in the past two years can be expected to unfold gradually. In addition, current figures are suggesting the revival of fixed investment growth, with city fixed investment growth reaching 29.4% in September. Should this imply a new wave of acceleration in investment growth, it would no doubt support economic growth, but the situation of excessive capacity would worsen, increasing the risk of potential downturn and deflation.

Key Areas Affecting Growth

Judging from the above, it would be more appropriate to describe the current situation as the deadlock between "cold" and "hot" forces in the Chinese economy. This situation would probably remain in the near term. Economic growth for 2005 can be expected to stay above 9%, but uncertainty would probably increase for the coming year. The relative performance of investment and consumption would play a more and more decisive role.

The following three areas should be crucial for assessing the future economic performance.

1. Policy Focus - As reflected in the past two years, the policy factor has been crucial to the Chinese economy, particularly investment performance. For example, as the state government clarified its macro control measures last year, growth of fixed investment sank rapidly. With the control measures less tight this year, investment growth, as well as money supply and loan growth, shows signs of reacceleration. Similarly, the shift of policy focus, or merely inclination, between cooling investment and sustaining growth, would be a significant factor that affects the economy.

2. Corporate Profits - Excessive capacity and relatively weak demand have already added much pressure on company profits. The rise in energy and raw material prices brought about by high investment, together with soaring global oil prices, have further boosted the cost of production, eating into the profits. The overall corporate profit growth has stayed at high levels, but divergence among enterprises has also increased. In the first three quarters, realised profits of large industrial enterprises (all state enterprises and non-state enterprises with annual sales of over RMB5 million) amounted to RMB988.3 billion, increased by 20.1% from a year ago. However, those with losses were mainly "lower-stream" processing firms, and their total losses reached RMB153.2 billion, increased by 57.6% from a year ago. Should the situation worsen, these enterprises may inevitably cut back production and investment, giving rise to lower economic growth and employment. Therefore, corporate profit growth should be a major reference in assessing the economy.

3. Exports Momentum - As domestic consumption can hardly pick up substantially in the near term, external momentum has become more crucial. In the first three quarters, China's exports and net exports occupied 42% and 5% of GDP respectively, indicating their increasing significance. As China's trade surplus grows but remains concentrated with a few markets, including the U.S., trade frictions are bound to intensify. External economic performance in the coming year, particularly the U.S., together with potential trade disputes, may become more significant to the Chinese economy than before.

In conclusion, while China's economic growth performance has been remarkable, the risks and hidden problems should not be overlooked, including the imbalances between consumption and investment, and between domestic and external demand. In the near term, the developments of investment and exports are noteworthy. In the long term, the ability to boost domestic consumption would be important for the restoration of China's economic balance and the sustainability of economic growth. It is note worthy that the Chinese government has gradually put more emphasis on reform to resolve the consumption problem, e.g. the series of measures to support farmers and the lift of tax allowances. It takes time for reform to bear fruit, but with state policy objective more clarified, residents' income expectations and confidence may improve earlier than expected, adding momentum to the economy. For investors, this may imply new opportunities.