BEIJING - The Chinese dragon is a difficult beast to tame. At 2006's meeting of
the National People's Congress (NPC) in March, Prime Minister Wen Jiabao
outlined a new national economic model based on greater resource efficiency and
"balanced" growth. Wen told delegates that the blind pursuit of high gross
domestic product (GDP) growth for its own sake should be abandoned: instead,
China should slow annual growth to a modest 7.5 % through 2010.
Clearly, no one decided to tell the nation's exporters, investors and -
increasingly - shoppers about the new plan. Despite
government belt-tightening, the economy roared ahead in 2006 and fears of a
hard landing were proved unfounded. Real GDP growth was 10.7% in the first
three quarters of the year, after hitting a jaw-dropping 11.3% in the second
quarter. Although July's monetary-policy tightening measures began to bite in
the second half, full-year growth is forecast to gallop in at 10.5% - well
above last year's predictions.
China's economy is growing quickly, but not wildly. Fears of overheating have
been exaggerated. Inflation pressures are muted, and the only medium-term risk
is that the US suffers a severe recession, which could knock a point or two off
GDP growth in 2007. An easing of investment growth and a slightly slower rate
of increase in the ballooning trade surplus will bring GDP growth down
marginally below 10 % - but still higher than the 9% growth China has averaged
over the past quarter century.
Much of the talk about overheating has focused on fixed-asset investment, which
is expected to rise by a whopping 23% in real terms this year, about the same
as 2005. Over-investment is only a problem if there is not enough demand to
soak up supply, but there is little evidence that this is happening - witness
the robust property prices across the nation. Both construction and industrial
investment should remain strong in 2007, although a slowdown in local
government investment in the run-up to the autumn 17th National Congress of the
Communist Party will ease overall investment growth.
Agriculture
The one area where growth remains much slower than the party's leaders would
like is the agricultural economy. One of the key policy initiatives at this
year's NPC - and a central plank of the the administration's plan to create a
"harmonious society" - was the so-called building of "a new socialist
countryside". Addressing the growing inequalities between China's booming
cities and the impoverished countryside, Wen argued, would also "encourage
consumption in rural areas" - an important consideration if China is to shift
to more environmentally sustainable, consumption-led growth.
Agriculture may only account for a measly 12% of GDP these days, but it retains
huge symbolic value for China's leaders. The government had predicted a bumper
harvest of 518 million tons of grain this year, but forecasts were revised down
when a two-month summer drought affecting 15% of the nation's grain-producing
farmland resulted in a loss of at least 40 million tons of grain.
Nevertheless, the revised forecast of 491 million tons is still higher than
2005's, making 2006 the third year in a row that grain output has risen since
2003's low of 431 million tons. Barring disastrous weather in 2007, greater
agricultural productivity should see the harvest rise again.
Bumper harvests are not necessarily good news for farmers, however. A
government report released at the end of July predicted that falling grain
prices and higher production costs would reduce farmers' average net income by
30-50 yuan (US$3.8-6.3). Although average rural cash income grew 11.9%
year-on-year to 1,797 yuan in the first half, there are signs that the rising
cost of farming materials - diesel, pesticides and fertilizers - is hitting
farmers.
The surest way for the government to raise rural incomes is to continue pushing
farmers into manufacturing and construction work in the cities. Although
China's migrant workforce reached 150 million this year, the growing gap
between city and rural dwellers will continue to expand in 2007.
Consumption
Consumption figures show that wealthy urbanites living on the east coast are
becoming enthusiastic shoppers. Consumption - the holy grail of the Chinese
economy - increased by about 12% in real terms in 2006, up from 11% last year,
and should rise again slightly in 2007.
But as Arthur Kroeber writes in the latest China Economic Quarterly: "The truth
is that the retail market in China is only about half as big as commonly
reported, and the so-called 'Chinese middle class' is smaller, more scattered,
and has far lower purchasing power than many hopeful salesmen imagine. For the
most part, China remains what it has long been: a large country, inhabited by
many people, most of whom do not have any money."
There are plenty of city folk with fat wallets, however, to continue China's
new love affair with the private car. China should overtake Japan as the
world's second-largest vehicle market in 2007, with sales of domestically
manufactured vehicles expected to surpass 7 million units, according to the
China Association of Automobile Manufacturers. Sales in the first 10 months of
2006 soared to 5.8 million units, up 25.7% for the same period in 2005, with
growth in car sales particularly strong.
The top-end foreign carmakers, such as Volkswagen and General Motors, are
making tidy profits after a difficult couple of years. But price slashing at
the crowded, lower end of the market is squeezing margins and affecting
quality. Defects were found in 77% of domestically made cars during the first
six months of use, according to the China Automobile Customer Satisfaction
Index survey, as manufacturers bought cheap parts to offset lower sales prices
and profits. Competition and razor thin margins will remain the name for many
domestic carmakers in 2007.
Over-capacity, rampant small-scale production and falling profits are all
familiar to observers of China's steel, copper and cement industries. Profits
in 83 major steelmakers fell by 30.4% year-on-year in the first half, with
crude steel output growing faster than consumption throughout the first three
quarters. Output hit 308.4 million tons, up 18.5% year-on-year, while
consumption grew by 10.5% to 287.3 tons, according to the China Steel and Iron
Association.
Commodities
Overproduction and falling profits at home, where prices for steel products are
much lower than on the international market, pushed exports of steel products
up to 28.6 million tons, a huge climb of 81%, stoking the wrath of US
steelmakers. The American Iron and Steel Institute submitted a written
statement in October to the US government asking for limits on imports of
Chinese steel products, despite an attempt by China to control exports by
slashing the tax rebate for steel shipments from 11% to 8%. If a tightening of
investment in fixed assets next year slows demand for steel at home, growing
export pressure will likely lead to further trade frictions.
The China Iron and Steel Association expects imported iron ore prices to level
off next year as increased domestic iron ore output slows Chinese demand for
imports - though analysts predict a modest international price rise of around
5%. Chinese demand helped push global prices up 71.5% in 2005 and 19% in 2006.
But import growth slowed by seven percentage points on last year during the
first nine months, at the same time as domestic iron ore production rose by
92.9 million tons, up 36.1 %. Output in 2007 is expected to continue climbing
to meet domestic demand - though questions remain about the quality of domestic
ore.
Copper demand in China is picking up after a flat year. Macquerie Research
estimates total demand for 2006 at 3.8m tonnes, a growth rate of just 0.5 %.
High copper prices saw demand fall in the first half, while domestic scrap
recovery rose. Growing demand for refined copper in the second half of the
year, however, raised prices; Jiangxi Copper, the mainland's largest copper
producer, said third-quarter net profit surged four times as third quarter
sales rose by 125% year-on-year to 7.3 billion yuan. All the evidence suggests
a strong bounce back in Chinese demand next year.
One commodity China cannot get enough of is oil, with demand for both crude and
refined products growing strongly. Crude oil imports reached 109 million tons
in the first three quarters, up 18.5%; this looks set to top 180 million tons
by year end, with a total crude import bill of around $60 billion - equivalent
to total foreign direct investment (FDI) for the year. If demand continues
unchecked, imports of crude in 2007 may approach the 215 million-ton mark.
Real estate
In the world of real estate, government measures to cool the market in May and
July failed to prevent the inexorable rise in property prices. Prices in
China's 70 large and medium-sized cities rose 5.5% in the third quarter, with
Shenzhen outpacing all other cities; Beijing, Dalian, Hohhot and Xiamen also
enjoyed a strong year. Demand for luxury residential apartments remains strong
in both Beijing and Shanghai, despite July's measures aimed at curbing
speculative foreign investment in the two cities - although Shanghai was the
only city in China to record negative growth in both the second and third
quarters.
The central government is now targeting real estate enterprises in its efforts
to cool the market. Investigations of more than 300 Beijing property companies
are ongoing, with a separate probe being launched in Shanghai. The
investigations aim to crack down on illegal acquisitions of land and tax
evasion. The Ministry of Finance recently audited 39 real estate developers and
found all of them cheating in their financial records. In total, the 39
developers underreported 3.3 billion yuan of profits, amounting to over 1
billion yuan of evaded taxes. Nevertheless, property prices look set to rise in
2007.
Information technology
China's technology sector is having a tougher time. After several years of
rapid growth that saw Baidu, Sina, Netease, Soho and Ctrip all list on the
Nasdaq stock exchange, China's Internet sector is going through a period of
adjustment, with many companies failing to translate impressive hit rates into
profits. Baidu, China's most popular search engine with nearly a 60 % share of
the search market, closed down its enterprise software unit on July 10,
dismissing 40 staff as a part of a "strategic adjustment" to focus on its core
business. Despite this setback, the company now has an ambitious plan to enter
the Japanese market in 2007.
Baidu would do well to note the foreign tribulations of TCL, the world's
biggest television maker. In October, the Guangdong-based company announced a
Euro45m restructuring plan to close down most of the European TV business it
bought from France's Thomson three years ago. TCL will sell its factory in
Poland and close five of its seven European offices, including the regional
headquarters in France and six sales and marketing subsidiaries. TCL struggled
to make the Thomson brand profitable, losing 203 million euro (US$268
million)on its European business; the saga remains a cautionary tale for
Chinese manufacturers ignoring their domestic position while trying to buy
their way into foreign markets. A renewed emphasis on the domestic market,
where TCL's sales fell this year, will be the name of the game for 2007.
Foreign investment
The outlook for foreign investors in China is far rosier - despite
well-publicized warnings to the contrary, including a recent editorial in The
Wall Street Journal suggesting that a "reversion to economic nationalism [in
China] remains a worry". Citing China's new "Rules on the Merger with and
Acquisition of Domestic Enterprises by Foreign Investors", which came into
effect on September 8, the Journal wondered whether we are seeing "the start of
a broader anti-foreign backlash".
Certainly a number of high-profile foreign acquisitions of Chinese companies
have recently come to a halt. These include the long-running saga of Carlyle, a
US private equity group, and Xugong, a state-owned machinery company from
Jiangsu province. Last October, Carlyle agreed to buy 85% of the company, but
the deal was recently watered down to a 50% joint venture after rival
construction group Sany Heavy Industry launched a political campaign to scupper
the takeover. "Selling anything is fine, but selling out the country is wrong!"
wrote Sany's chief executive in a fiercely nationalistic weblog.
In addition, the National Reform and Development (NDRC) recently published its
11th Five Year Projection (2006-2010) for using FDI, which criticizes local
governments for "blind seeking" FDI at any cost and says priority will be given
to the quality rather the quantity of foreign investments. The document notes
that emerging monopolies by foreign businesses in certain industries pose a
potential threat to China's economic security.
So are we witnessing a backlash against foreign investment? The short answer is
no. The NDRC plainly states that it expects no reduction in FDI: "During the
11th five-year-plan period, the domestic and international environment
affecting foreign investment in China will generally improve, making it
possible for China to improve the quality of investment while maintaining
quantity," the document states. Moreover, September's new regulations do not
apply to foreign investment in general, only to mergers and acquisitions.
There is no evidence for a concerted government effort to stymie foreign
investment. Rather, the reforms have two aims. First, to centralize control
over foreign mergers and takeovers in the hands of the Ministry of Commerce
(Mofcom). Second, to shift foreign investment away from labor-intensive
manufacturing into higher value-added industries. By giving Mofcom the power to
prevent all mergers or acquisitions that involve core industries or famous
domestic brand names, or which threaten "national economic safety", the central
government now has greater leeway to direct investment towards priority
industries.
According to Lynne Yang, a lawyer at Allen & Overy in Shanghai, the
regulations mark a response to lobbying from certain industrial sectors, as
well as political concerns. Protectionist sentiment is certainly alive and
kicking in China, just as it is in the US or France - but there is not a scrap
of evidence that this signals either an anti-foreign backlash or the beginning
of a closed-door policy to foreign investment. The environment for foreign
investors in 2007 will likely be no different from 2006's.
A policy of economic nationalism would be sure to stir further protectionist
sentiment in the US, China's largest single export market, and would be
self-defeating. After the bra-wars and dumping disputes of the past couple of
years, it is inconceivable that 2007 will not see further trade disputes
between China and the US and European Union, especially as China's trade
surplus continues to swell.
The customs trade surplus will come in at $160-170 billion in 2006, rising to
an enormous $220 billion in 2007. China has now entered a period of sustained
high structural trade surpluses, which will put increased pressure on the
People's Bank of China to let the yuan rise against the dollar.
Helpfully, China's $1 trillion and counting foreign exchange reserves are now
largely a function of trade flows rather than speculative capital flows. Now
that hot money inflows betting on a one-off revaluation of the yuan have melted
away, the government's tolerance for currency appreciation should rise. When
the reserve surpluses were driven by volatile capital flows, it was safer to
stick with a fixed exchange rate against the dollar - but now that they reflect
stable movements in the real economy, appreciation is a more sensible
proposition.
Today the yuan is rising at an annualized rate of around 6%, up from the 3%
that prevailed after China ditched its fixed peg to the dollar in July 2005.
This rate of appreciation should continue through next year, yielding an
end-2007 rate of 7.5 yuan to the dollar. With greater exchange rate movement,
there is less chance that the government will have to contain investment by
raising interest rates - good news for exporters both at home and abroad.
Tom Miller is the Beijing-based deputy editor of the China Economic
Quarterly.
