China's transition from a rural to an industrial economy has generated immense demand for raw materials. The production facilities currently being built could shortly result in unsustainable overcapacity. The financial markets, meanwhile, are having to contend with a weak banking sector saddled with a mountain of bad debt.
The Chinese central bank is beginning to pull on the monetary reins in order to temper economic growth. All the same, our basic scenario anticipates a soft landing for the Chinese economy, thanks in part to recovery in the United States and Japan.
Pace of growth undiminished
Reforms necessitated by China's desire to join the World Trade Organisation (WTO) have led to the huge expansion of the country's economy, bolstered by large-scale foreign investment. Low Chinese labour costs prompted a wave of outsourcing, whereby companies from all over the world have shifted production capacity to China.
Corporate investment rose no less than 42% in the first quarter of 2004, compared to 17% in the final quarter of last year. In February, the Chinese government announced investment restrictions for rapidly growing sectors like steel, aluminium and the car industry.
Industrial production grew 16.6% last year and a similar pace of growth has continued in the first quarter of this year. Production at foreign-financed businesses rose almost 20% last year, and firms like this already account for more than 25% of total industrial output.
Exports were 34% higher in the first quarter of 2004 than a year previously, having levelled off only slightly relative to the 40.6% growth recorded in the final quarter of 2003. There is no sign, therefore, of an end to this strong export growth. Production growth has, however, eased from an extreme of 23.2% in February to 17.5% in May. Private consumption likewise remains strong, thanks to growing employment, higher pay and easier borrowing.
Increased likelihood of soft landing
The Chinese economy is plainly overheating: industrial production and exports cannot go on growing at their current rate. The key question now is whether there will inevitably be a sharp downward correction, or whether a soft landing is still possible.
At first sight, current extreme growth figures suggest a hard landing is unavoidable. There are plenty of reminders of the Asian crisis of the 1990s.
On that occasion, too, excessive lending and a fragile banking sector were the main culprits. Yet China is not in the same position as the Asian countries then.
In the 1990s, excessive demand sparked high inflation, enormous current-account deficits and a surge in real estate and equity prices. In today's China, by contrast, there is no sign of any such bubble. Although it is argued that property prices are far too high, this is at worst a local problem.
China has a current-account surplus and immense currency reserves, while inflation generally remains extremely modest. Taking everything into account, the current situation represents a break with the trend of violent economic shifts to which China has hitherto been subject.
Tighter profit margins
The monetary authorities have only limited scope to intervene because of the yuan's peg with the dollar. This is unlikely to change, despite international pressure.
Consequently, an interest-rate hike - standard action in developed economies - will have little impact. The central bank has now ordered that lending to certain sectors should be curtailed, while increasing reserve requirements.
A soft landing is possible provided that the Chinese government does not make a hash of the tightening process. Ongoing restructuring of the banking sector, higher reserve requirements and some additional interest-rate increases on bank loans will rein in vigorous credit growth.
As profit margins narrow, this will also put an end to the unbridled growth of the industrial sector. Finally, the recent decline in commodity prices will reduce the investor fever centring on Chinese basic industry.
The result ought to be an easing in Chinese GDP growth this year to 7.5%.
