China Quarterly Update, August 2005

34459 World Bank Office, Beijing China Quarterly Update August 2005 The World Bank quarterly update intends to provide an update on recent economic and social developments in China, and present findings from ongoing World Bank work on China. The update is produced by a team from the Beijing Office. Questions and feedback can be addressed to Li Li (lli2@worldbank.org)  China Quarterly Update--August 2005 2 OVERVIEW China's domestic demand is slowing down. GDP growth remains high due to a large contribution of external trade as exports continued to power ahead while imports decelerated significantly. Net of external demand, the GDP numbers suggest that a slowdown in domestic demand is under way. Slower credit and profit growth, lower FDI and modest growth in machinery and equipment imports are pointing to a further slowdown in investment to a more sustainable pace in the period ahead. Signals are that the government's measures to slow the real estate sector are also starting to work. The debate on the direction of the economy and the desired stance of economic policy is to some extend clouded by headline monthly activity indicators. Continued overheating, a soft landing, and the risks of deflation are all subject of recent debate. Indeed, growth in fixed asset investment and retail sales do not signal much of a slowdown. However, these numbers tend to overstate growth in investment and consumption, which are likely to have grown significantly less rapidly. The change in the exchange rate system and the accompanying revaluation may further slow domestic demand. The impact on the trade balance is likely to be limited, but some of the capital flows associated with an expected revaluation could moderate in the months ahead, and therefore give the authorities more independence in conducting monetary policy. Development of forward markets to allow for hedging of trade and investment related capital flows is now a priority, as is close monitoring of short-term capital flows and exposure of domestic institutions to foreign exchange rate risk. Over time, more clarity on how the authorities will use their increased autonomy in monetary policy will become desirable. China's macroeconomic outlook remains favorable, with some softening of growth expected this year, and some more in 2006. Risks have become more balanced. Downward risks include lower than expected export demand. A two-way risk is formed by the considerable uncertainty on the extent to which domestic demand, notably investment, is slowing. While macroeconomic policymakers should remain alert to the possibility that risks materialize, for now the focus could be more on the structural issue of rebalancing growth. The rebalancing would be away from the relatively volatile export and investment-based growth to more stable consumption-based growth. Measures in social security and shifting government spending away from investment towards health, education, and social safety could help increase consumption's share in GDP, policies that would also help in redressing the surpluses on the current account. To maintain growth and employment creation as consumption increases, however, more efficient investment as well as a shift of investment to services is needed. Financial sector reforms, better corporate governance, and a dividend policy for state enterprises could be measures towards that goal.  China Quarterly Update--August 2005 3 RECENT ECONOMIC DEVELOPMENTS: DOMESTIC ACTIVITY SLOWING DOWN National accounts and customs data suggest a slowdown in domestic demand in the first half of 2005. GDP growth remained high because of a large contribution of external trade. While it is hard to detect a domestic demand slowdown in the monthly activity indicators, these should be interpreted with care. Leading indicators point to a slowdown in investment growth to a more sustainable pace in the period ahead. Real GDP grew a stronger than expected 9.5 percent in the first half. Nominal GDP growth slowed from 16.4 percent in 2004 to 14.2 percent in the first half of 2005. A strong contribution of net trade to GDP growth suggests a sizable slowdown in domestic demand in the first half.1 Although agriculture showed a strong 5 percent growth on the back of government subsidies and lower taxes, industry continued to outperform other sectors. Industrial value added rose by 11.2 percent in real terms in the first half of 2005 (year-on-year, (yoy)), which is consistent with strong external trade and moderating domestic demand. The rising share of industry in GDP to an unprecedented 59 percent raises concerns about environmental and resource constraints on growth as well on the sustainability of the current pattern of growth. Fixed asset investment (FAI) growth, the target of the tightening measures in 2004, remained robust. It grew 25.4 percent (yoy), in nominal terms, in the first half of the year, more than in the second half of 2004, although significantly less than in end-2003 and the first half of 2004 (Figure 1). Based on recent experience, gross fixed capital formation, the internationally comparable national accounts measure of investment, is likely to have grown significantly less (Box 1). It is not easy to interpret the decomposition of nominal FAI growth in a volume and a price component.2 Key determinants of investment have slowed down, suggesting investment is heading for a more sustainable pace. Our econometric estimations indicate that FAI can be well explained by profits and credit growth, and both measures show signs of more moderate growth. M2 and credit, which decelerated during 2004, grew broadly at pace with nominal activity in the first seven months, suggesting a neutral monetary setting (Figure 4). Moreover, profit growth in industry has decelerated from 38 percent in 2004 to 19 percent in the first 6 months (Figure 5), reflecting strong competition and divergences between upstream and downstream price developments. Average profitability has leveled off across most industries, including in light manufacturing.3 In addition, utilized FDI has declined somewhat this year,4 and measures introduced to affect real estate investment appear to have had effect (see below). 1 Assuming a large increase in the discrepancy between GDP data from the production and expenditure sides of 2 percentage points in the first half, and with a conservative estimate on the contribution of net trade in non factor services, nominal domestic demand growth would have declined from 15 percent in 2004 to 10.4 percent in the first half of 2005, more than what could reasonably be explained by price movements and distortions in the trade data stemming from over- and under invoicing. 2 The reported rise in the FAI deflator of 1.7 percent (yoy) in the first half compares to increases in import prices, the PPI, and real estate prices of 8.2, 5.6, and about 9 percent. 3As defined by the NBS: profit over costs. 4Although there may be an issue in accounting for re-invested profits of foreign invested profits,  China Quarterly Update--August 2005 4 Real retail sales growth accelerated from 10