The World Bank has damned the lifeboats in its China Quarterly Update and called out multiple risks including a housing bubble, inflation and external imbalances. Here is the money excerpt:
Inflation is unlikely to escalate but there are risks. Food price increases seem to have slowed for now, sequentially, and the (yoy) rate of increase in food prices is likely to diminish later in the year (Figure 8).
Upstream price pressures maycontinue to build because of the hikes in oil and industrial commodity prices. Importantly, however, so far core inflation pressures remain in check. Based on the above global price outlook, we expect the moderation in food price inflation in the coming 12 months to more than offset the rise in non-food inflation, resulting in a slowdown in headline CPI inflation, with the pace of deceleration in part depending on factors such as the possible adjustment of some utility prices.
Meanwhile, we have revised downwards our projection for the current account surplus because of the higher commodity prices, which affect China’s terms of trade substantially. Domestic risks add to the global ones noted above. Downside risks to growth stem from possibly weaker corporate sector investment or household consumption. However, both also carry upward risk. Higher raw commodity prices pose a risk to the inflation outlook.
The property market is a particular source of risk. With tension between the underlying upward housing price pressure and the policy objective to contain price rises, interaction between the market and policy measures could lead to a more abrupt than planned downturn in the real estate market. In the medium term, the widespread use of property as investment vehicle and the role of local governments add to the risks. Property construction is an important part of the economy, directly and in terms of impact on large sectors such as steel and cement. Thus, shocks to the property sector that would slow down construction significantly could have a large impact on the economy and on bank balance sheets, taking into account bank exposure to construction and other sectors dependent on the real estate market.
Moreover, a property downturn could affect the finances of local governments, which do a lot of the infrastructure investment and are important clients of the banking system. Looking further ahead, whether the recent trend towards a lower external surplus and lower dependence on external trade will be sustained remains to be seen. The fall in the external surplus and the relative importance of exports since 2007 was in no small part because of the global crisis.
Whether the domestic economy and imports will outpace exports in the coming five years depends on China’s policies, including progress with rebalancing, and other domestic and international developments. If China’s domestic demand growth remains much stronger than elsewhere and significant rebalancing takes place, the external surplus may remain contained and the economy may continue to become less dependent on exports. The importance of exports may decline especially if domestic prices continue to rise much faster than tradable prices, as in 2005-10. This would over time change the nature of China’s economy, making it increasingly domestic demand driven. It would also facilitate a broadly benign further integration of China’s economy in the global economy. However, the tentative results on the pattern of investment across sectors suggest such a scenario is not yet entrenched (see below charts). With less progress on rebalancing, less benign scenarios are also possible.
The macro stance needs to be normalized fully to address macro risks including on inflation and the property market. Even though our baseline inflation projections are not particularly worrying, the risks, including from further global commodity price shocks, call for vigilance. Also, inflation expectations are high, and there is little spare capacity in the economy, overall. Macroeconomic policy remains key in limiting the spill-over of higher prices of food and other raw commodities into other prices and wages and containing other risks, including in the property market and with respect to bank balance sheets. To address such macro risks, macroeconomic policy is typically better placed than moral suasion and administrative measures.
Recent economic policy has largely been moving in this direction. Fiscal policy appears not to provide stimulus anymore and the monetary stance has moved towards normalization. The government has recently also limited the transmission of higher oil prices in domestic fuel prices used moral suasion. Such measures could create distortions and are unlikely to be effective for a long time. With the central inflation outlook manageable, it may not be necessary for concerns about inflation to hold up for long price changes needed for the transformation of the growth pattern such as price increases for resources and utilities.
Looking ahead, it is too early to stop the macro tightening, while, with risks both ways, fiscal and monetary flexibility is key. The strong recent growth has shown the resilience of the economy to the policy normalization. If the slowdown materializes and inflation eases, the case for further overall monetary tightening weakens. However, even then room remains for interest rates to play a larger role, relative to quantitative targeting.
On the property market, market-related risks require one set of policies and social concerns another. After the 2008-09 stimulus, the authorities rightly reined in liquidity, flanked by specific measures, to stop housing prices from surging. However, in general, given robust income growth and urbanization, housing prices should rise over time and empirical research is inconclusive as to what extent prices are systemically out of line with fundamentals. The role of economic and financial policy is to prevent different types of economic and financial risks from building up in the housing sector, including those discussed above, and to make the economy and the financial system robust to a potential property downturn, rather than focusing mainly on containing overall prices. In any case, if overall prices are considered to be systematically too high from a market perspective, macroeconomic levers are most obvious; administrative measures are less obvious, especially locally administered ones. On the other hand, making housing more affordable for targeted groups requires sustainable rules based arrangements, almost unavoidably explicitly subsidized by the government. The planned scaling up of social housing discussed below is in this direction. As elaborated below, a transpartant, rules based, financing model is key.
What will be the focus of structural reforms? The 12th 5YP discussed below has 2 overall objectives: transforming the pattern of growth towards more emphasis on consumption and services and moving up the value chain in manufacturing. What the 12th 5YP implies for the way China will grow in the medium term will in part depend on the relative emphasis on these 2 objectives.
Really, the only criticism I have of the report it’s proposed remedy for inflation. If the major source of inflation is rising commodity prices then, as I’ve been saying for quite some time, the best solution is to raise the currency, not interest rates. Conversely, if they don’t raise the yuan then ipso facto inflation will keep rising as commodities do (thankee Bernankee). Maybe the refusal to mention the currency is the World Bank’s one sop amidst a tough report for it’s China client
There’s a lot more in the report and a brilliant collection of charts here.
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal.
He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.
