Mostly: Classical

[Frank Pembleton]

China's economy -- Still roaring

http://www.economist.com/daily/news/displaystory.cfm?story_id=8406955

China's economy grew by a dramatic 10.7% last year, but this year will be slightly quieter

ROSS PEROT, a populist American politician, predicted in the early 1990s that a trade pact with Mexico would create a ‘‘giant sucking sound’’ as jobs headed south. Instead, America experienced full employment. So giant-sucking-sound detectors turned to China. In time, China became the workshop of the world, although by then America had long hollowed out much of its manufacturing.

Now there really is a giant sucking sound—not one made by the flight of jobs, but by China ferociously hoovering up commodities and raw materials. Although it accounts for roughly 4% of global GDP (measured at market exchange rates), China consumes 30% of the world’s supply of minerals and other raw materials. This time around, the world has not only heard the sucking sound, but has also felt its effects, as the prices of commodities such as iron ore, copper and zinc have soared, doubling or tripling in just a couple of years.

How has China suddenly developed such a big appetite? The economy has been growing at a dizzying rate, recently by double digits. Much of this growth is driven by fixed-asset investment, which now accounts for more than 50% of GDP a year—a higher proportion than that of any other country at any time in history. This relentless capacity for expansion has created an insatiable demand for raw materials.

China also wastes a lot. Take energy consumption. China required 4.3 times as much energy as America in 2005 to produce one unit of GDP, up from 3.4 times in 2002. It can be argued that much of China’s new investment has not yet reached optimal efficiency. That may be true, but it does not explain why things are getting worse: China consumed 15% more energy per unit of GDP in 2005 than it did in 2002. India, also a rapidly expanding economy, consumes only 61% as much energy as China per unit of GDP.

China’s wasteful growth has brought joy to commodity producers and their bankers and shareholders worldwide. With rising profitability and stock prices, they have been happily expanding mining operations and acquiring or merging with rivals. But there are reasons to believe that the surge in commodity prices worldwide has run out of steam.

There is strong evidence that the current cycle of China’s investment-led growth has peaked. A clear sign of overheating is the increase in accounts receivable. Although sales appear robust, Chinese firms are beginning to find it difficult to get paid in cash, either because their buyers cannot turn over their own stocks fast enough or because they have trouble borrowing money to finance their purchases. The receivables of the 166 largest state-controlled Chinese firms rose by 14% in the first half of 2006 from a year earlier. For over a third of these firms, receivables now account for more than 30% of total sales, which is twice as high as the average gross margin for Chinese firms. It was the escalating volume of ‘‘triangular debts’’ or receivables between different domestic firms that led to the overheating and consequent severe austerity programme in the mid-1990s.

China’s growth has become too expensive in many ways. Overinvestment pulls up prices of raw materials but, simultaneously, overcapacity depresses the prices of finished products. Whereas prices of imported raw materials rose sharply between 2003 and 2005, those of Chinese exports to America fell by 5.2%. As a net importer of raw materials and a net exporter of finished products, China is paying a high price for its growth, particularly to commodity-producing countries.

China needs a break to catch its breath, in more ways than one. As anyone who has been to the mainland in recent years knows, all the major cities are choking with smoke and environmental damage has reached appalling levels. The government knows this and during 2006 tightened the screw on the economy several more turns. Interest rates will continue to rise. The trouble is that much of the liquidity comes from hot money, which finds its way into China around foreign-exchange controls in anticipation of a yuan appreciation. Each rise in interest rates only encourages more speculative inflows. This means that China will inevitably allow the yuan to appreciate further in 2007 (though not as sharply as worriers in Washington, DC, would like), while also further relaxing capital controls, to keep the growth of money supply at least partly in check. The central bank has taken other measures to reduce liquidity, including telling banks not to lend to ‘‘overheated sectors’’ such as steel, cement, coal and power, and forcing them to buy central-bank bills.

These measures are already checking investment growth. The economy will grow more slowly in 2007. This will help the country make the transition from investment-led growth to expansion led by private consumption. The slowdown of the American economy, China’s largest export market, will further force China to focus on stimulating domestic demand.

All this suggests that the good times for commodity producers are about to come to an end. Although commodity producers will mourn it, a quietening of China’s roar will help sustain its growth. And, for the health of China and its neighbours, a pause for breath—of cleaner air, one hopes—will definitely be welcome.