Monday, March 21, 2011

The slowdown in China

The People’s Bank of China (PBOC) has announced a further increase in the Required Reserve Ratio (RRR). This is the third increase this year. From March 25th the ratio for the major banks will be 20% and 18% for the small and medium-sized banks.

The authorities have been tightening monetary settings on three fronts: increases in benchmark interest rates, a (modest) managed appreciation in the exchange rate and the increases in the RRR. This has been in response to inflation that has been hovering around the 5% mark in recent months, largely on the back of higher commodity (food and energy) prices. However, core inflation has also been drifting higher.

This three-pronged strategy appears to be having some impact on key growth indicators. In particular, money supply growth is slowing. M2, the broadest measures of the money supply rose 15.7% in the year to February. This is down from a peak of 29.6% in the year to November 2009.

The Performance of Manufacturing Index is heading south. The index has now fallen for 3 consecutive months. However, at 52.2 this is still consistent with robust growth, although most likely at a lower rate than the 9.8% GDP growth rate achieved in calendar 2010. We don't put too much weight in the more volatile non-manufacturing index at this point.

This slowdown is coinciding with the recent release of China’s 12th 5-Year Plan. The plan had a number of important elements. Firstly, my reading of it suggests authorities are putting greater weight on the “quality” of growth rather than the “quantum”. By quality, I mean more equal sharing of the benefits of growth, especially between the fast growing coastal areas and the slower growing internal regions.

Secondly, and perhaps more importantly from the perspective of reducing global imbalances, this Plan also has a focus on building a stronger social safety net via improved pensions, enhanced medical coverage in rural areas and social housing programs. These sorts of measures will reduce the need for precautionary household savings and boost domestic consumption.

The 12th Plan is targeting growth of 7.0% per annum. That’s a long way from where we are now, but then the 11th Plan targeted growth of 7.5% per annum, well below the average outcome over the period of just under 11% which included the Great Recession.

In the short-term, we think it is prudent to lower our expectations for China GDP growth this year. That’s based on the view that with key growth indicators already turning down and with further tightening likely, our previous forecast of 9.5% growth looks a tad optimistic. I’m more confident with 9.0%, although that still leaves the risks biased to the downside.

The PBOC has relied on the RRR and other quantitative lending controls to do most of the tightening work thus far. A more balanced approach is desirable. In particular, further appreciation in the Chinese Yuan would take some of the heat out of imported inflation while at the same time aiding the rebalancing of the economy away from the tradeable to the non-tradeable sectors. A more flexible approach on the exchange rate would also allow further increases in benchmark interest rates.

While the recently-reported February China trade deficit might take some heat out of the CNY appreciation argument, we see the monthly deficit as more of an aberration than the beginning of a trend.

While we thing more tightening is likely, it’s also important the PBOC doesn’t overdo the job. The economy is clearly slowing which will relieve capacity pressures. And as we know, much of the recent high headline inflation is due to commodity prices. It is most likely the case that some of the increase in core inflation is due to the second round effects of those higher prices, as we are seeing in Europe currently. It is indeed the second round effect of higher commodity prices that has the European Central Bank trigger-happy.