The pace of economic growth in China has been scorching. But there are signs that it has started to slow down, finally
Rohit Chawdhry

Is the Chinese slowdown finally occurring? Having registered the longest and the fastest growth in world's economic history (of over ten per cent per annum over the last several years), this may be finally happening.

The broad macro theme is seemingly straightforward. Every broad economic indicator in China slowed again in October last year. Real investment spending, in particular, has now slowed down to single-digit level, and monthly credit flows are slowing down. Clearly, macro policy tightening has had its intended effect, and it is expected that growth indicators will continue to slow gradually even further over the next quarter or two.

The most recently released data set appears to suggest a smooth and gradual deceleration just as policy makers have wanted:

* Urban fixed asset investment growth decelerated for the fourth straight month, to 26.8
per cent year-on-year (YoY) in January-October, (+28.2 per cent in January-September).

* Loan creation dipped to Rmb17bn in October, a pleasing 36 per cent YoY decline.

* Export growth proved resilient (+29.6 per cent YoY vs +30.6 per cent in September), cont-rary to the disappointing data out of Korea and Taiwan earlier in the month, with shipments to the US (+22.1 per cent), EU (+31.4 per cent) and Japan (+15.4 per cent) still expanding at a robust pace.

* Retail sales growth was also resilient, picking up for the third straight month in October to 14.3 per cent YoY (+13.9 per cent in September), reaching a new monthly record of Rmb699.8bn.

* Subdued inflationary pressure, with CPI inflation easing to 1.4 per cent YoY in October from 1.5 per cent in September, and PPI inflation dipping to 2.9 per cent from 3.5 per cent, helped by the correction in energy prices of late.

GDP data for 3Q shows slowdown
China's economic growth slowed during the third quarter, meeting expectations that had been raised by signs of weakening activity in lending and investment. China's economy expanded 10.4 per cent, compared to 11.3 per cent growth in the previous quarter. The slower growth was in part attributable to a deceleration in investment in August and September amidst measures by the central government to cool the economy. Money and credit growth also showed signs of moderation for the same reason. Export growth remained buoyant: the third quarter trade surplus totalled US$48.7bn. The economy now seems to be on course for a soft landing as a result of Beijing's administrative tightening and attention has switched to the policy outlook for the years ahead.

Investment deceleration slows growth
Because of slower fixed-asset investment (FAI), third-quarter real GDP growth was 10.4 per cent YoY – in-line with the consensus forecast and below the second-quarter YoY figure of 11.3 per cent. It is now expected that real GDP growth would slow further to 9.5 per cent YoY in the fourth quarter, resulting in full year 2006 growth of 10.5 per cent. The forecast is for nine per cent growth in 2007, which takes account of a slowdown in the global economy.

The most widely watched indicator, real FAI growth, has declined to 17.5 per cent YoY from a 30.2 per cent in June. Investment slowed drastically in ferrous metals but remained strong in transportation, coal mining, non-ferrous metals and real estate.

Several pointers have emerged to suggest a possible slowdown in real estate. For example, a rising number of senior government officials and company executives have been arrested in connection with Shanghai party chief Chen Liangyu's alleged use of city pension funds to invest in real estate. This incident is likely to dampen provincial leaders' enthusiasm for participating in state-sponsored investment schemes, and so help to keep activity in check. The market for land has become tougher, with Beijing tightening transaction rules and increasing taxes on sales. Indeed, the growth in floor space in both under construction structures as well as land under development has already shown a sustained slowdown since the middle of the year. Expect the slowdown in construction to continue.

...but consumption stays firm
Consumer spending and net exports remained strong during the quarter, but with a limited upside. Real growth in retail sales has been running at a steady 11.5 per cent to 12.5 per cent YoY for the past two quarters. Expected increases in civil servants' pay will be important factors in underpinning consumer spending growth next year, but a major boom remains unlikely in the foreseeable future without reforms of the pension system, healthcare or education to free up savings for consumption.

The other issue, excess external surplus, still remains a problem. China's trade surplus has grown rapidly this year, and was 70 per cent higher in the third quarter than in the same period a year ago. That said, the US$15.9bn rise in foreign exchange reserves to US$988bn in September was nearly half the US$30bn peak recorded in May. This reflected the fact that speculative inflow has more or less disappeared, which in turn means that the growing trade surplus now accounts for the entire build up in reserves. Nonetheless, external inflow remain the main cause of China's expanding domestic liquidity. So while the People's Bank of China may feel under much less pressure to hike interest rates to dampen end-user credit demand, it is unlikely that it would relax its sterilisation efforts too quickly.

But related macro indicators are suggestive of stabilisation this year. Even though the slowdown is gaining momentum in China, there are now advance signs of stabilisation. To begin with, since the data began to slow in the summer, the PBC and the government have been relatively quiet, and it is unlikely that any significant new tightening measures will go forward – ie, this could be the end of macro tightening. Of course, with domestic currency credit growth still running at around 15 per cent, don't expect the authorities to take their foot off the brake any time soon.

And sure enough, the construction data, the best leading indicator of the macro and profit cycle, already shows a recovery in October from the Q3 lows, with domestic steel and materials demand recording a relative upturn as well. In this environment, expect overall growth to stabilise at a rate of around nine per cent in 2007.

Financial markets have jumped onto the policy agenda. One of the biggest near-term issues on the agenda is the sudden jump in financial markets. In the past few weeks, the domestic A-share market has seen near-vertical gains. Indeed, rising more than ten per cent in a few short trading sessions in November; at the same time, short-term money market rates shot up by more than 100 basis points, reflecting speculative activity as well as the impact of the latest required reserve ratio hike. The authorities are naturally concerned about these events, and the market is full of discussion about possible policy actions.

Here is the most important event which this column has covered in previous issues. As expected, Chinese currency (renminbi) has been appreciating. But this not the end of the road. More renminbi appreciation is expected ahead. Meanwhile, the one remaining medium-term macro policy issue is the continued rapid increase in the trade surplus as a share of GDP. This prevents the authorities from dampening demand growth too aggressively, as this would push the surplus up even further and bring a flood of new liquidity into the banking system. Recently, markets have witnessed moves away from endless sterilisation, in favour of reserve requirement hikes to help manage domestic monetary policy. Finally, the rising external surplus means that the authorities should continue the pace of renminbi exchange rate appreciation; the renminbi is already streng-thening at a five per cent YoY annualised pace against the dollar, and at a minimum expect a similar pace through the first half of 2007.

To conclude, there is ample evidence of a slowdown in the broad macro numbers. The renminbi strengthening continues unabated (at approximately five per cent per annum). The financial markets have suddenly become a serious issue. However, construction and policy indicators now point to stabilisation next year. Though this soft patch may persist for some more time, it is more likely that the pace of economic growth may pick up in mid 2007.

On balance, the growth in China is likely to be around nine per cent in 2007. However, this slowdown may have serious implications for global stock markets in the short-term, as the biggest contributor to global growth slows. On balance, cash still remains attractive in the short-term. Attractive opportunities, in both India and China, may present themselves once this correction is over.

But this slowdown does not imply that the China story is over. It merely implies that the economy is now growing at a measured pace; a pace which is still the highest in the world. Over the long term, the Chinese economy will provide, perhaps, the best opportunities both in terms of projects and indeed financial markets. Stay tuned.