Will China be able to regain two-digit growth? By AXA IM strategist Hervé Liévore

The announcement by the National Bureau of Statistics that economic growth in China in the second trimester had reached 7.9 percent probably did not come as a surprise to anyone.
China's economy undoubtedly touched bottom at the beginning of the year when growth slumped to 6.1 percent before regaining its upward path. This extraordinary recovery, aided by considerable sums of public money and measures designed to stimulate the economy has also rekindled the debate about decoupling and the possibility that China could offer a real alternative to the distressed American consumer.

According to Hervé Liévore, strategist at AXA Investment Managers, an analysis of the workings of the Chinese economic engine over the past ten years will help determine if the country will be able to regain the two-digit growth rate it achieved in the years leading up to the financial crisis. From what he has observed, the answer is likely to be a no.

An economy strongly dependent on foreign investment and trade

Up until the end of the 1990s, China's economic growth seemed to follow a trajectory typical for a developing country, characterized by sudden peaks followed by gradual cooling off. From 1992 to 1994, production volumes maintained a steady growth of over 13 percent, then slowed down to 7.6 percent in 1999, before settling at 8.3 percent in 2000 and 2001. At the end of that year, the People's Republic joined the World Trade Organization and from 2002 to 2007, China's economy continued its upward climb, peaking at 13 percent in 2007.

National accounts statistics leave no uncertainty as to the significance of foreign trade in driving China's economic growth. From a purely statistical point of view, it can be said that net exports contributed to an average of 1.6 percent of the GDP between 2000 and 2004, and for 20 percent between 2005 and 2007.

But this phenomenon clearly demonstrates the influence global demand has on economic activity. In fact, a growing share of Chinese production output ends up being sold abroad, generating in turn a rise in imports. In certain sectors, such as textile, electronics and capital goods, foreign demand absorbs more than 30 percent of the nation's industrial production.

Capital spending has constituted another major driver for economic growth in the last decade. Since 2004, the ratio of investments to GDP has remained at 40 percent, which is six percent higher than in 2000. A number of factors have contributed to the rise in capital expenditure, including the construction of urban centers, considerable direct foreign investment and the restructuring of large state-controlled enterprises in the second half of the 1990s. The last one in particular constitutes an interesting point, as it helps to understand why China was able to deflect the worst of the internet bubble in 2001 and 2002 with a relatively modest action plan. Following the restructuring of the public sector (eliminating non-viable enterprises), overproduction was brought in check and the profitability of the society was considerably improved. As a result, countercyclical stabilization policies gained efficiency. Between 2002 and 2007, foreign trade and investment generated between 50 and 65 percent of growth. In the ten preceding years, they only contributed an average of about 40 percent.

Unsurpassed spending needed to jump start the economy

The Chinese stimulus plan (7 percent of the 2008 GDP in 2009 and 2010) was formulated to boost the spirit on the market and in many ways it has succeeded in doing so. But the current financial crisis is much more complex than its predecessors and the government is facing a number of obstacles that could hinder the efficiency if its actions.

First of all, it is not at all certain that enterprises really have the capacity to back the stimulus efforts. In contrast to what happened in 2001 and 2002, this time around profits declined significantly throughout 2008 and in the first trimester of 2009. Industrial figures for 2008 show that at the beginning of the year, profit-making companies saw their gains fall by about 41 percent (data with seasonal adjustment) before settling at 36 percent in the second trimester and at below 26 percent in the third trimester. Thus, companies lack an impetus for increasing production capacity. Nevertheless, increased public spending, namely in infrastructure projects, price adjustments and easier access to loans contributed to the revival seen in the third trimester.

Secondly, the demand for Chinese exports is still down. This said, after the nose dive of foreign trade at the end of 2008 and the beginning of 2009, exports did pick up finally in March. But this was not to last, and soon after, demand dropped. Data with seasonal adjustment shows the figures for June to be below those of March. In the manufacturing sector, SMEs have reported of a slight improvement in their business data due to increased internal demand spurred by the stimulus efforts.

These reports indicate a sharp rise in the number of new orders while new demands for export products have at best remained steady. The slump in foreign trade is a reflection of the weakness in final demand in developing economies, namely in response to a rise in the savings ratio. In the Euro-zone, imports from outside the European economic and monetary union dipped in April to their lowest level since May, 2005. In the United States, imports, with the exception of petrol, stagnated in May, remaining at their lowest since April 2004.

Thus it is possible that global trade will linger below the levels of the period prior to the Lehman bankruptcy because of the relatively low import content of growth fueled by public spending (protectionism).

Beijing has already taken considerable action to support the ailing exports sector (export tax cuts, currency revaluation against the dollar) but remains quite powerless in the face of the massive challenge. In order to have some real effect on the economy, the Chinese government has to find a way to compensate for the decline in foreign demand as well as for the impact of lower margins. In this sense, the 4,000 billion yuan stimulus package is probably not enough and other funds have had to be raised. This explains why the amount of credit soared so fast: the country was (and still is) in dire need of huge amounts of liquidity. But unfortunately these kind of policies also often have negative side effects.

New sources of instability

Chinese countercyclical policies rely in essence on bank loans. The 4,000 billion yuan plan makes it possible to launch new projects, the financing of which will need to be completed. At the beginning of the year, Premier Wen Jiabao urged banks to make efforts to exceed their annual goal of 5,000 billion yuan in new loans. And the banks, most of which are owned by the state, have complied. In the six first months of this year, they lent more than 7,400 billion yuan, which is more than in the two previous years combined. Even if the banks are now becoming more cautious about lending, they would still need to approve about 10,000 billion yuan worth of loans this year, which equals to nearly 30 percent of the GDP. This enormous amount of money will fuel what seem to be bubbles, especially in the property and stock markets (excluding raw materials). It is also worth noting that bank lending took off rapidly following the loosening of the monetary policy at the end of 2008.

Rapid rise of lending in China

Since the end of June, Beijing has quickly shifted from an extremely accommodating policy to a more cautious one that takes into account the negative effects of such money creation measures. One of the most evident signs of this shift came on July 8, when the central bank recommenced the sales of one-year bills, just eight months after suspending them. These bills are an important tool for the central bank in regulating the amount of liquidity on the interbank market. In addition, in mid-June, the banking regulatory commission backtracked in the subject of housing loans for secondary residences by reimposing a loan limit which allows people to borrow 60 percent of the value of the house or less, and by raising the benchmark interest rate. Analysts now expect to see a certain tightening of the monetary policy (even if it is unlikely that the base interest rate would be raised) in order to prevent new instabilities.

The rebound in growth in the second trimester confirms that the Chinese economy touched bottom at the beginning of the year. The reprise is explained by the inflation base effect and by the stimulus package. Nevertheless, the outlook looks uncertain and in our opinion, the GDP will likely not reach two-digit growth within the next two years. China's leadership is aware that their countercyclical policies, which, although necessary, have their limitations and which could soon become apparent, particularly in terms of money generation and in the form of an increased risk of inflation. It is almost certain that China's monetary policy will be put in check in the second semester, most likely via more securities issuances by the central bank (to reduce interbank liquidity) and by a tightening of loan requirements. A rise in interest rates in unlikely. We anticipate the economy to grow by about 8.5-9 percent by mid-2010, assuming that domestic demand will remain robust. But given that the global economy is still in a slump, it is highly unlikely that China would be able to achieve a growth rate in excess of ten percent.