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China's Economic Slowdown, Policy Challenge and Impacts on Hong Kong

1. Slowing trade and economy with high inflation

According to the latest figures from China Customs1, China's exports rose 17.6 percent over the previous year to USD 121.53 billion, tumbled from 28.1 percent in May. For the first half, value of exports increased 21.9 percent year-on-year to USD 666.6 billion, 5.7 percentage points lower than that in the same period last year. The export slowdown led the trade surplus in June fall 20.6 percent or USD 5.54 billion from a year earlier, marking the third straight month of declines. If counted by first six months, the surplus narrowed 11.8 percent or USD13.21 billion from the same period last year.

Note that these figures are expressed in U.S. dollars and in nominal term, the export growth in real terms may be even slower after netting out the effect from currency appreciation and inflation. The real export growth looks to have dipped to single digit appreciation in the first half, should we take RMB's 6.0 percent appreciation against the dollar and consumer inflation of 7.9 percent into account.

China's export remained the major driver of economic growth, its recent slowdown has weighed on the broader economy. China's annual GDP growth eased to 10.1 percent in the second quarter from 10.6 percent in the first three months, and slowed from 11.9 percent in the second quarter last year.

Accompanied with economic slowdown, the inflation climbs up. The consumer price index (CPI), the main gauge of inflation, was up 7.1 percent in June over the same month last year, 3.7 percentage points higher than the same month of pervious year, if measured by the first half, it risen to 7.9 percent, up by 4.7 percentage points.

table

2. Inflation remains a major concern to be addressed

China's macro-economic policy is on horns of dilemma amid slowdown economic growth and rising inflationary pressure. Markets pay close attention to the possibility of some 'fine-tuning' on the tightening-biased monetary policy. On the one hand, growth in export and overall economy was slowdown noticeably in recent months, ongoing tight monetary policy could push economy over the edge. On the other hand, inflation has stayed high, the relaxation of monetary policy may threat to aggravate it. Currently, there are voices advocating to relax tight monetary policy and to hold it up, some experts urge China to strike a balance between pursuing economic growth and curbing inflation.

Economic slowdown is unfavorable to labor market while inflation would affect people's livelihood, both are associated with social stability, and need to be carefully addressed. It would be ideal if China's macroeconomic policy can get the economy on track and keep inflation in check at the same time. However, these two mandates are usually incompatible and quite difficult to compromise. The Nixon Administration and Federal Reserve Chairman Arthur Burns2 ad ever tried to curb inflation without denting the job market during the oil crisis in early 1970's, by capping unemployment rate and interest rate. However, the Fed failed to take care of inflation and economic growth at the same time, leading inflation climb up from 6 percent in 1970 to12 percent in 1974 and economy fall into a "stagflation" predicament. If history is of any guide, it would make sense to argue that China will treat inflation as a higher priority at this juncture although its economic growth and employment shall not be ignored. We believe China's monetary tightening stance will not be shifted fundamentally before inflation return to a moderate level (2-3%) by the following reasons:

(1) Inflation would largely affect people's livelihood, and is still of higher priority to fight. The mass population of China, with grass-root people still accounting for a large proportion, has long time adapted to a low inflation environment. Since the implementation of economic reform, periods of significant economic instability in China have always been prefaced by sustained inflation, demonstrating the importance of price stability. Therefore, combating inflation should be the top priority for China's policymakers.

Central bankers of major economies have arrived at a clear view of the benefits of price stability since the 1970s stagflation era. Paul Volcker3 appointed as Chairman of the U.S. Federal Reserve in 1979, determined to tackle inflation by accepting short-term recessions in the early 1980's. Price stability has become an increasingly popular monetary policy target since the last decade4. Central banks among advanced economies have widely considered an inflation rate of around 2% as the critical threshold and anti-inflation has become their major, or even sole, objective. Central bankers will not allow a reprise of the stagflation era. Bringing down inflation remains a top priority for policymakers.

(2) The threat of inflation still looms high. Though china's consumer price index remained subdue in June, skyrocketed commodity prices, upward adjustment of domestic retail oil prices and rising import price of primary commodities like iron ore are adding fuel to the inflation fire. Producer prices are now rising at a faster pace compared to consumer prices5, signaling the potential upward pressure for consumer prices. Looking at the external environment, the us Producer prices grew at a pace of 9.2 percent in average over the last twelve months, the highest since 1981. Consumer prices jumped 1.1 percent over the prior month in June, the second-sharpest jump since 1982. Producer prices in the Euro-zone gained 7.1 percent also. China is suffering from imported inflation caused by higher global commodity prices.

Furthermore, the current inflation is a global phenomenon, and soaring food and oil prices are widely blamed as the major drivers. However, if viewing the inflation from the monetary perspective, it roots in US lax monetary policy. The global excessive liquidity has been generated amid US lower interest rate and cheap credit in recent years, and prolonged weakness of the dollar. Globalization has accelerated the transmission of anticipated inflation across different countries. The proportion of global exports to output expanded from 21 percent in 1980 to 32 percent in 2007, according to official data from the World Bank. Should the Fed be reluctant to reverse its lax monetary policy, China, the world's third largest trading power, could find it very difficult to solve the problem on her own.

(3) More evidence suggests that China's economy is feeling a stronger pinch of export slowdown. (1) Surging labor cost, raw material price, environment cost, reduction of export tax rebates together with RMB appreciation have hurt the competitiveness of low-end products from China ; (2) slowdown in external demand ; (3) recent intensification by regulatory authorities in the monitoring of cross-border capital flows may have squeezed out the "hot money" hidden in external trade, reducing the export growth.

Therefore, a looser monetary condition may offer little help to sustain the export industry, given the current situation in China. As slowdown in external demand is due to cyclical factor, recovery would largely depend on when the cycle reverses. Furthermore, even though export momentum of low value added manufactured goods like garment, textile and shoes has been weakened notably, outlook of high-tech products remains intact. The dichotomy suggests domestic manufacturing is climbing up the value-added ladder, alleviating the pressure for outright relaxation in monetary policy.

(4) Slower pace of currency appreciation and expansive fiscal policy can help sustain growth and exports. Arguably, the low-skilled labor-intensive industries remain the backbone of the Chinese manufacturing industry, in view of its role as the major employers of low-skilled labor. The policymakers have voiced the concern over the hollowing out of industry. While monetary policy can be of little assistance, export-oriented friendly measures, like upsurge of export tax rebate, slower pace of currency appreciation and fiscal assistance, may help to address the problems faced by those low value added manufacturers.

In view of those factors, the Mainland economy is still expected to grow on solid footing in 2008. Trade surplus has shrunk to USD 99.03 billion in the first half as external demand weakness becomes more widespread. If external weakness persists, the estimated trade surplus will likely narrow 40 percent over the previous year to about USD 150 billion in 2008. Domestic consumption in the near term is likely to be restrained by the lackluster securities and property markets. Yet, the post-quake reconstruction spending will give a strong impetus to fixed asset investment. The enormous reconstruction spending is expected to largely offset the negative impacts from moderated export and domestic consumption. We expect the possibility of an abrupt slump in China's economy in the second half would be rather low, despite the investment-dependent growth pattern may not be the most desirable in long run.

Merchandise Trade Surplus in China

Year

Trade Surplus
(USD Billion)

2002

30.4

2003

25.5

2004

32.1

2005

102.0

2006

177.5

2007

262.0

2008.1-6

99.0

Source: Ministry of Commerce of the People's Republic of China


3. Implications for Hong Kong

Hong Kong's stock corrected severely and the active property markets also calmed down since the beginning of May on the concern over the marked slowdown in the Mainland's economic growth and rising recession threat in the US. Albeit Hong Kong's exports are expected to suffer from the slowdown in external demand, the softening HKD is good for tourism and retail industry, and thus helpful to buffer this negative impacts. Separately, Hong Kong's consumer inflation reached an 11-year high of 6.1%, after hitting 5.7 percent in May. There is no sign of improvement for the import-induced inflationary pressures in sight for the near future. In view of these, we decide to maintain the full year forecast of Hong Kong's real GDP growth at 5 percent, down from 6.3 percent in 2007. As for inflation, it should hike from 2 percent in 2007 to around 4 percent this year. The underlying inflation rate is expected to rise from 2.8 percent to 6 percent6.

The impact of industry amalgamation and transformation in the Mainland should be carefully considered also. In recent years, Hong Kong enterprises with China production line have been facing tremendous hardship due to rising labor cost, land price, less tax rebate etc. We wouldn't say that these are sudden changes. In 2006, Mainland authorities began to execute its Eleventh Five-year Plan, implementing the measures to improve pollution and production technology. On June 2007, Standing Committee of National People's Congress enacted the Employment (Amendment) Ordinance7, effective on January 2008. Then, on January 2008, a joint announcement by five government ministries to cut the tax rebates8 on highly polluting and highly energy-consuming export products. Furthermore, the Ministry of Commerce declared to implement the deposit account system9 included in "Restricted Catalogue for Major Adjustment over Processing Trade Policies" on July 2007. Manufacturers should be aware the impacts from these policies coming out one by one and take pre-emptive measures to buffer them. Nonetheless, a substantial number of SMEs and even conglomerates are still facing deep trouble.

Considering the facts the labor cost and land cost in Pearl River Delta and Yangtze River Delta have soared up substantially, it is widely recognized that the regions' processing factories need to transform themselves and manufacturers should move up their value chain ladder. However, if restructuring goes too haste, there has a risk of old model collapse without new one emergence, then hollowing out of industry in consequence. Hong Kong enterprises parked in Pearl River Delta have so far been well integrated into the global supply chain and established a solid linkage with overseas markets. If Guangdong Province can strategically help those enterprises transform production model, or relocate them, especially help them to build up product brand, it would be meaningful to Guangdong's indigenous economy, employment and exports.

Separately, a series of macro-control measures by the Mainland authorities has changed the capital environment in Hong Kong. The amount of deposits in local banking system has reversed its uptrend and posted modest decline since November 2007. On the contrary, loans by financial institutions once again enter an uptrend this year. The amount of deposits from customers slid 2.4 percent or HKD 138.0 billion over the end of 2007. Of which, the amount of customer deposits denominated in HKD dropped 4.6 percent or HKD 140.3 billion. The amount of customer deposits denominated in foreign currencies shed HKD 2.24 billion or 0.08%. The outstanding amount of total loans and advances increased 10.7 percent or HKD 317.3 billion. Of which, loans and advances denominated in HKD added 6.5 percent or HKD 141.9 billion. Loans and advances denominated in foreign currencies jumped 22.6 percent or HKD 175.5 billion. The "decoupling" between the growth paths of deposit and loan can be explained by the widening negative real interest rate and a weakening HKD, which reduce the incentive for people to bring new deposits into the banking system. Faster pace of RMB appreciation has also greatly increased the appeal of RMB denominated assets, domestic residents are thus rushing to exchange foreign currencies and HKD on hand into RMB on the expectation of further RMB appreciation. China's RMB deposits continue to accumulate at a quite substantial pace recent months, suggesting capital inflow may have accelerated. At the same time, SMEs strive to explore external capital raising channel under the shadow of tightened credit in the Mainland. Surge in the amount of loan denominated in foreign currencies in Hong Kong may merely mirror the capital needs of the enterprises from China.

As we stand by our call for that monetary policy will have to remain tight in coming months, enterprises from China may continue to be hamstrung by a shortage of capital, especially those from the property sectors. Accordingly, demand for offshore loans in Hong Kong is expected to remain robust in the second half year. However, it is noteworthy that such offshore loans will take higher policy risk, moreover, China have already taken numerous measures to tighten capital account control10. The loan-to-deposit ratio for different HK local lenders has almost reached the upper limit, without the back of renewed capital inflow from abroad, total loan and advances shall grow at a moderated pace in the second half. In addition, since interbank interest rates are still edging up, there will be a greater chance for banks to promote different products like Certificate of Deposits, in order to expand their deposit-taking means.

In the meantime, both the Mainland and Hong Kong appear to be maintaining steady growth momentum in spite of global slowdown and financial turmoil, characterized by high inflation (inflation rise above 2%) and solid economic growth (above trend growth for GDP). But should western nations head into a deep recession and inflation remains high in the Mainland, Hong Kong will suffer from the fire and ice of high inflation and low growth, and may end up with stagflation at worst.


Tse Kwok Leung
Senior Economist

1 The total trade volume in June stood at USD 221.71 billion, a year-on-year rise of 23.3 percent. Exports in June grew 17.6 percent over the prior year to USD 121.53 billion, whilst imports in June climbed 31 percent to USD 100.18 billion. The trade surplus in June alone fell 20.6 percent or USD 5.54 billion over the previous year. The total trade volume in the first half hit USD 1,234.17 billion, up 25.7 percent on year-over-year basis, of which, exports rose 21.9% percent to USD 666.6 billion, imports surged 30.6% to USD 567.57 billion, bringing the trade surplus down by 11.8 percent or USD 13.21 billion.
2 Arthur Burns served at Federal Reserve Chairman during 1970-1978.
3 Paul Volcker served at Federal Reserve Chairman during 1979-1987. He took emboldened move on the rate front to tackle the inflation head on by accepting short-term recessions in the early 80's. The bold rate movement finally brought the inflation down to 3.2% after hitting 13.5%. He is widely credited with ending the United States' stagflation era.
4 According to the data from Wikipedia, inflation targeting is now in use by the central banks in Euro-zone, UK, Australia, Canada, New Zealand, Sweden, Norway, Chile, South Africa, Turkey and Poland. Although the Federal Reserve does not have an explicit inflation target, investors widely recognize the Fed has indeed set its inflation target in terms of core inflation of 2%.
5 Producer price gained 8.8 percent in June, 1.7 percentage points higher than the consumer price inflation in June.
6 The underlying inflation rate is not subject to the effect of one-off government measures, including rates concession and the waiver of public housing rentals
7 Investors estimate the labor cost could be increased by 30 percent or total production cost increased by 10 percent, after the implementation of the Employment (Amendment) Ordinance.
8

According to a joint announcement by five government ministries including the Ministry of Finance, the State Administration of Taxation, National Development and Reform Commission, the Ministry of Commerce and China Customs, China cut tax rebate on several industries in an effort to encourage industrial restructuring.

9

The ledger deposit is collected according to the comprehensive tax rate and based on total value of all imported materials under the deposit account system. Over 7,000 Hong Kong companies with production line located at China are expected to face hefty pressure from rising capital cost.

10 If the advance settlement of exporters included in the short term debt item, FX inflow through the channel of trade financing could be controlled.
Content provided by Bank of China (Hong Kong)
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