Mainland China's economy in 2007

Mainland China's economy remained strong in the first nine months of 2007. Although real GDP growth moderated slightly to 11.5% year-on-year in 3Q from 11.9% year-on-year in 2Q, real GDP for the first nine months of the year still grew by 11.5% year-on-year, up from real growth of 10.7% for the whole of 2006 (Exhibit 1).

Growth was mainly fuelled by strong domestic and overseas demand. In the first 10 months, fixed asset investment grew 26.9% year-on-year while retail sales of consumer goods increased 12.3% in real terms (Exhibit 2).

In the external sector, exports grew by a strong 26.5% year-on-year, mainly because of strong demand from the European Union (EU), whose imports from the Mainland grew 36.9% year-on-year in the first three quarters. Exports to North America, however, grew by only 16.5%. The EU and North America are the Mainland's biggest export markets, each accounting for over 20% of total exports. As export growth again outpaced that of imports, the Mainland recorded a record trade surplus of USD212.3 billion for the first 10 months of the year.

A rapidly expanding economy raised inflation risks. Consumer price inflation on the Mainland accelerated to an 11-year high of 6.5% in October and averaged 4.4% in the first 10 months of 2007, compared with 1.5% for the whole of 2006. While a substantial part of the inflation was caused by the surge in food prices, soaring prices of inputs such as fertilisers and feeds as well as strong domestic demand in the period also played a role.

Abundant liquidity as a result of the Mainland's large current account surplus and capital inflows drove asset prices sharply higher. The A-share index in Shanghai rose 81.6% between the end of 2006 and the end of November 2007. Property prices in major cities continued to follow an upward trend.

Alerted by increasing signs of overheating, the central bank has intensified monetary tightening since 2006. It has raised the required reserves ratio 10 times so far this year to 14.5%, the highest level since the government reformed the required reserves system in 1998. It had also increased the benchmark 1-year lending rate for banks five times to 7.29% by September.

To limit the growth of money supply as a result of the surge in foreign exchange reserves, the government has been taking measures to limit the growth of exports, including the reduction and removal of export rebates for a series of export products.

So far, these various measures have had little observable effect. Money supply (M2) still grew strongly by 18.5% year-on-year in October, up from 16.9% in December 2006 and well above the government's 16% target (Exhibit 3). Lending by banks also rose strongly by 18.0% year-on-year in October, up from 16.3% in June and 14.6% in December 2006.

China's economic outlook in 2008

While the strong economic momentum of 2007 is expected to continue in 2008, the global economic outlook, changes in domestic demand and the government's monetary stance will determine whether or not this momentum can be sustained.

Most agree that the global economy led by the US will slow in 2008 due to the sub-prime turmoil. The recent announcement of sub-prime-related losses by some large financial institutions indicates that total losses in the financial industry from the crisis may be much higher than initially believed.

Due largely to concerns about the US sub-prime crisis, the IMF cut its forecast in October for global economic growth in 2008 to 4.75% from the 5.25% that it forecast in July (Exhibit 4). The greatest revision was made to figures for the US, which is now projected to grow by only 1.9% in 2008, down significantly from the IMF's earlier forecast of 2.9% in July.

Financial market turbulence and slower growth in the US are also influencing the outlook for economic performance in Europe. The IMF is now forecasting that the Euro area will grow by 2.1% in 2008, down from a projected growth of 2.5% for 2007. The situation for the rest of the world is similar, with the only real difference being the extent of the slowdown.

However, despite a gloomier outlook for the global economy and a strengthening renminbi, the Mainland's exports of goods are not expected to be significantly affected in 2008. The Mainland's diversification of exports into increasingly sophisticated products in the past 10 years has greatly increased its immunity to fluctuations in export demand. Between 1997 and 2007, the share of machinery and transport equipment in the Mainland's exports rose from 24% to 47% (Exhibit 5). Export growth of close to 20% in 2008 is still expected, slightly down from the 26% projected growth for 2007.

Domestically, strong consumer demand has been driven largely by concrete growth in household income. Exhibit 6 shows the close relationship between disposable income in urban areas (as a proxy for national disposable income) and retail sales of consumer goods. In the first nine months of 2007, real urban household income per capita grew by 13.2% year-on-year, up from 10.4% for the whole of 2006. The real growth of rural household income per capita was even stronger, rising to 14.8% year-on-year from 7.4% for the whole of 2006.

Barring a sharp drop in stock market prices that would significantly dampen consumer sentiment or the emergence of other adverse factors that would drive up unemployment, household income, and hence consumer demand, is likely to continue to grow at double-digit pace in 2008. However, the positive impact of the 2008 Olympic Games on consumption is not expected to be significant at the national level. Any such impact will likely be confined to the few major cities hosting the Games.

With economic growth remaining the government's policy priority, the growth of fixed-asset investment is also unlikely to slow much in the year ahead. Although the government has raised concerns about possible overheating in the property market, prevailing negative real deposit rates continue to support a strong demand for property development.

Overall, real GDP is forecast to grow by about 10% in 2008, slightly lower than the 11.5% growth projected for 2007 (Exhibit 7). CPI inflation is expected to ease to about 3-4% in 2008 from the 4.5% projected for 2007, which is still slightly higher than the government's 3% target.

Persistent and above-trend growth, abundant liquidity and rising inflation suggest that monetary policy is likely to retain its tightening bias. The People's Bank of China is expected to further increase interest rates, probably to levels at which real deposit rates become positive (Exhibit 8).

While room for significant increases of the required reserve ratio is limited given that major banks are already close to their lending capacity after the series of ratio hikes that began in 2006, the central bank could still raise the ratio if the Mainland's foreign exchange reserves continue to soar. The excess reserves ratio of the big four commercial banks, which is a measure of banks' lending capacity, has already dropped from 6.6% in 2001 to 2.0% by September 2007. While the drop for the smaller banks is even greater, they still have an average reserve ratio of 4.1% (Exhibit 9).

The renminbi exchange rate will continue to be the focus of attention. In addition to increasing external pressures, the domestic costs of maintaining a relatively rigid exchange rate policy are also on the rise, as witnessed in the need for sterilisation and asset price bubbles. The renminbi exchange rate is therefore not only expected to continue marching higher against the US dollar, but the pace of appreciation could accelerate, as it has in the past several months.