Where Will China Move as the Global Economy Dims?

August 10, 2011 Posted by China Briefing Reading Time: 4 minutes

By Vivian Ni

Aug. 10 – Tightening or easing – it is the main question now facing Chinese policymakers. In China’s July economic statistics, the county’s elevated price index seems to be calling for a new round of tightening measures, but the stable yet decelerating industrial and investment growth has also been interpreted as a warning sign for a looming economic slowdown. What may also darken the Chinese economy outlook is the decreasing external demand caused by the recent global financial turmoil. While it seems unlikely that China will make a U-turn in its fiscal policy to allow another spending spree as it did after 2008’s financial crisis, it is widely believed it may adjust its current tightening policy and hold off a new interest rate hike.

China’s July economic statistics issued by National Bureau of Statistics on Tuesday have brought the global financial markets a break from the bad news comprised of the worsening European debt crisis and U.S. credit downgrade. The country’s industrial production rose by a steady 14 percent from a year earlier, urban investment surged by 25.4 percent, and retail sales grew by 17.2 percent, showing strong economic momentum and solid domestic demand.

However, the world’s growth engine is somewhat showing signs of a slowdown compared to its performance in June, when its industrial output jumped 15.1 percent, investments soared 25.6 percent, and retail sales gained 17.7 percent.

Meanwhile, China’s consumer price index (CPI) growth rate for July reported a surprising new high of 6.5 percent, while most experts believed it would slide slightly after hitting a 36-month high of 6.4 in June. High food prices turned out to be the primary culprit behind July’s high inflation rate, climbing by 14.8 percent from a year earlier.

The producer price index also increased faster than expected at a rate of 7.5 percent, suggesting the country’s industrial production will still likely suffer from rising costs, and such inflationary pressure may be transferred to CPI performance, which matters considerably to Beijing’s social stability.

China’s high inflation is – among other reasons – a hangover from the country’s stimulus policies implemented in 2008 in a bid to boost the economy in the global gloom. The government poured some RMB4 trillion into the economy and local governments borrowed heavily from banks to realize their development goals.

The stimulus package had won China great opportunities for development and contributed to the country’s strong economic growth over the last few years while the West was largely struggling to recover from the global recession, but it has also caused a great deal of problems that are still lingering today. In addition to facing the soaring prices that have placed the People’s Bank of China (PBC) into a tough position, the country is also getting a headache from its local government debt which has stacked up to a massive amount of RMB10.7 trillion, nearly 27 percent of China’s total annual output. A Reuters report yesterday even cited some economists warning that as much as one-quarter of that debt total could end up in default.

Pressure from inflation and bad loans is believed to stop the PBC from announcing another round of stimulus policies, even if it may be able to afford to do so with US$3.2 trillion in foreign reserves and relatively low public debt.

“It’s unrealistic to hope that China will come to the rescue of the global economy this time… [since] we are still digesting the mess of the 2008 stimulus package,” said Yu Xuejun, local head of China’s banking regulator in Jiangsu Province.

However, a number of experts predict that instead of major fundamental changes, a moderate adjustment to the current monetary policy is likely to take place. Since last October, China has started to tighten its monetary policy – lifting interest rates five times and reserve ratio requirement nine times – to curb inflation. Although the market was still expecting another interest rate raise, Standard & Poor’s downgrade of the U.S. credit rating on Friday has impacted economists’ predictions on the PBC’s policy outlook. The confidence loss in the West may decrease China’s external demand and harm the country’s export performance, and such consequence will especially bring a nightmare to China’s small and medium-sized enterprises (SMEs) that are already struggling to survive in a tight lending environment.

“Another rate hike can be pretty much excluded given the possible fall-out in external demand has increased,” said a UBS analyst Wang Tao when commenting on the July statistics.

Kevin Lai, an economist at Daiwa, also indicated a potential policy about-face, pointing out “China is likely to become more cautious in terms of its tightening policies.”

China may resort to more modest fiscal measures if the global economy deteriorates. It may choose to give more incentives to SMEs, cut their taxes, offer them more loan issuance, and/or even lower interest rates.

In addition, if export growth decelerates significantly in the coming months, the Chinese government will likely allocate more funding towards the expansion of affordable housing, infrastructure and water systems, according to Lu Ting, an economist at Merrill Lynch.

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