SOLID FOUNDATION

China’s first-quarter economy continues to grow but challenges lie ahead By Hu Yue

COVER STORY

SOLID FOUNDATION

China’s first-quarter economy continues to grow but challenges lie ahead By Hu Yue

The Chinese economy remains on solid footing, though a string of economic indicators have brought back talks of a downturn.

Its GDP grew 8.1 percent year on year to reach 10.8 trillion yuan ($1.71 trillion) in the first quarter of 2012, slowing from 8.9 percent of the fourth quarter of 2011 and 9.2 percent of the whole year of 2011, said the National Bureau of Statistics(NBS).

“China has left the worst of liquidity shortages behind it, and there is a time lag before the pro-growth policies gain traction,” said Ba Shusong, Deputy Director of the Research Institute of Finance at the Development Research Center of the State Council.

“The economy is likely to bottom in the second quarter before rebounding in the fourth quarter this year,” said Ba.

BUILDING SPREE: A low-rent housing project in Jinjiang,southeast China’s Fujian Province. China is accelerating the pace of affordable housing construction. Those investments are expected to help shore up the slowing economic growth

“Renewed concerns of an economic hard landing in China are unjusti fi ed, as the country’s service sector remains quite resilient,” said Lu Ting, an economist with the Bank of America Merrill Lynch. “The faltering manufacturing industry is part of the whole economy and susceptible to changes.”

The manufacturing sector accounted for 47.6 percent of the fi rst-quarter GDP, while agriculture and services accounted for 6.4 and 46 percent, respectively, according to the NBS.

While export growth is expected to further decelerate, China’s consumption will remain relatively resilient, driven mainly by stable income growth, stable con fi dence in domestic demand and an increase in pension payouts in 2012, said a report by Bank of America Merrill Lynch.

Lian Ping, chief economist with the Bank of Communications Ltd., said the Chinese economy is set for a bright future due to deep growth potential.

“Massive urbanization, industrialization and market reforms will continue injecting fresh life into the economy,” he said.

“Meanwhile, the less-developed central and western regions are catching up quickly by receiving industries transferred from east coastal regions,” he said.

Inflation eases

Now it seems that inflation is no longer an acute headache for the Chinese economy as the consumer price surge has showed signs of cooling down, but the possibility of a comeback in in fl ation cannot be ruled out.

The consumer price index (CPI), a barometer of in fl ation, grew 3.6 percent year on year in March, 0.4 percentage points higher than in February. But the figure represented a remarkable decline from 5.4 percent for the entire year of 2011.

The biggest driver of CPI was still food prices, up 7.5 percent from a year ago in March. Pork prices, in particular, skyrocketed 11.3 percent.

The producer price index (PPI), an effective gauge of inflation at the wholesale level, declined 0.3 percent in March, hitting a 28-month low. The index climbed 6 percent last year.

“Inflation will surely taper off markedly this year as powerful government measures to increase food supplies and reduce market speculation are taking root,” said Zuo Xiaolei, chief advisor to president of the Beijing-based China Galaxy Securities Co. Ltd. “The CPI is expected to stay at 3.5 percent this year, well below the government-set target of 4 percent,” she said.

But Cao Fengqi, Director of the Finance and Securities Research Center at Peking University, said China will face long-term in fl ation pressures due to land and labor cost inflation. “In addition, a short-term factor pushing up CPI is rapid increase in international crude oil prices,” he said.

In line with international market development, the National Development and Reform Commission in March raised the retail gasoline and diesel prices by 600 yuan ($95) per ton, the second hike this year.

Though fuel only takes a small weight in the CPI basket, the pass-on effect may filter through consumer prices by forcing up logistics costs.

Zhao Xijun, Deputy Director of the Financial and Securities Institute at the Renmin University of China, said the ripple effect will soon be felt when squeezed enterprises begin to pass the increased logistics costs onto consumers.

Zhao also struck a note of caution about possible risks of imported inflation, adding that the biggest uncertainty lies in oil prices if the situation in the Middle East worsens.

Zhao Qingming, a finance professor of the University of International Business and Economics, raised worries about falling PPI. “The PPI declines re fl ect fragility of the real economy as many domestic enterprises, especially smaller ones, leave their machines idle.”

Growth incentives

To provide a floor under the slowing economy, policymakers have cautiously handed out pro-growth incentives on a selective basis,including favorable policies for small enterprises in terms of taxation and credit support.In December 2011, the Ministry of Finance announced to cut corporate income tax by half for small and micro-enterprises from January 1, 2012 to December 31, 2015.

On February 24, 2012, the central bank decreased the reserve requirement ratio by 0.5 percentage points, following the reduction in December 2011, which was the first cut since November 2008. It also required commercial banks to bump up lending to cash-starved smaller businesses and the weak agriculture sector.

“Since in fl ation is not a main concern at the moment, the policy stance could be more pro-growth than 2011. But it could be quite incorrect to assume that China is facing strong headwinds similar to the collapse of exports at end of 2008 and then to predict a massive stimulus,” said Lu.

“The central bank may further cut the reserve requirement ratio in the rest of this year,but we see no chance for interest rate cuts unless the European debt crisis worsens,” Lu said.

“We expect no major easing on property tightening, but Beijing could allow eased enforcement of home purchase restrictions in lower-tier cities,” he said.

“As inflation pressures continue to ease,weaker export growth is likely to prompt further easing measures,” said Qu Hongbin,a Hong Kong-based economist for HSBC Holdings Plc. “Once the easing measures fi lter through, growth is likely to rebound.”

Qu added that he expects further efforts to stimulate the economy through tax breaks.Government spending and eased credit would help the economy to rebound in the second half of the year after “bottoming out” in the April-June quarter.

Lian suggested China retain the current prudent monetary stance and closely monitor the external economic environment.

The central bank could encourage lending to SMEs, affordable housing projects and strategic emerging industries, and further lower the reserve requirement ratio, said Lian. “But there is no need to lower the interest rates, and the economy would otherwise suffer negative interest rates in real terms,” he said.

Paul J. Heytens, country director for China of Asian Development Bank (ADB),said China’s GDP growth in 2012 is forecast at 8.5 percent, with the priority of macropolicy expected to shift from fi ghting in fl ation to stabilizing growth.

China’s fi scal policy is expected to remain broadly expansionary, with higher spending on social security programs like education,health care, pensions and public housing, said the ADB in a recent report.

The bank said the Chinese Government may carry out further fiscal and financial reforms to ease the tax burden on consumers and small and medium-sized enterprises.

The main risks for China would be uncertainty over external demand among the country’s largest trading partners, and potential increases in non-performing loans of local government.

But it pointed out that progress in diversifying export markets and re-balancing sources of growth toward domestic demand should help maintain economic growth momentum, and that the country’s fi nancial sector is sound overall.

Risks remain

While an overall weakness in the world economy drains steam out of China’s export sector, domestic worries proliferated about withering real estate investments and fi nancial woes of small businesses.

During the January-to-March period,China’s exports totaled $430.02 billion, up 7.6 percent year on year, while imports edged up 6.9 percent to reach $429.35 billion. The trade surplus stood at $670 million.

“The trade data show the global economy is recovering, albeit slowly,” said Zhou Hao, an economist with ANZ Bank in Shanghai.

LABOR SHORTFALL: Recruiters of many small and medium-sized enterprises wait for job hunters at a job fair in Yiwu, east China’s Zhejiang Province. Labor shortage has become an acute concern for small businesses in the country

“Given that China had a trade surplus in the first quarter versus a deficit in the same period of last year, it indicates a positive contribution to GDP growth.” he said.

“But the export prospect looks dim due to clouds gathering over the world economy and souring domestic business environment,”Zhou said.

Meanwhile, uncertainties are hanging over the cooling property markets, with home price growth softening and developers offering discounts to bump sales.

“The nation’s home prices may decline 10 percent by June from a year earlier, while sales volume is expected to be little changed or may even slip in 2012,” said Bei Fu, a Hong Kong-based analyst with the S&P.“Many developers may be at increased risk of re fi nancing due to weaker property sales, high funding costs and tightened liquidity.”

“A major cause for the ongoing slowdown is a stringent clampdown on the real estate industry,” said Ba.

“But policymakers are less likely to take their foot off the brake as they attempt to bring soaring house prices back to a reasonable level,” he said.

Slower property investment is likely to cut into growth for 2012 in the world’s second biggest economy, Bei said.

Industrial enterprises above designated size—sales revenue exceeding 20 million yuan ($3 million)—generated 606 billion yuan ($96.2 billion) in pro fi ts for the fi rst two months of 2012, dropping 5.2 percent year on year, said the NBS.

Woes of small businesses are no less acute,as capital strains, labor shortages and lackluster demand make a dent to their competitive edge.Newspapers are constantly filled with reports of factories in Guangdong and Zhejiang provinces operating on slim pro fi t margins or failing to hire enough workers.

“The small and medium-sized enterprises may face more daunting challenges than in 2008 when China felt the ripple effect of the fi nancial crisis,” said Zhu Baoliang, a research fellow with the State Information Center.

“In addition to that, the country will have to properly deal with simmering dangers of waning property investments, piling debts of local governments, as well as financial risks caused by private lending,” he said.

Bank of America Merrill Lynch expects China’s economic growth to slow from 9.2 percent in 2011 to 8.6 percent in 2012.

The major risks are the euro-zone debt crisis and the falling property fixed-asset investment under the current tightening measures, said the bank in a recent report.

“Over the long-term, China could experience a gradual slowdown due to an aging population, falling returns on capital investment and lack of gains from institutional reforms,” it said.