China Set for Goldilocks Landing?

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China Set for Goldilocks Landing?

China will likely manage a soft landing in 2012. But economic imbalances in the Year of the Dragon will challenge the Chinese Communist Party.

In the Chinese Zodiac, China is now entering the Year of the Water Dragon, marking a year of transition, uncertainty and change.

The Year of the Dragon is indeed set to be a critical year for political change in China – at the very highest levels of the national government. This autumn, the 18th National Congress of the Communist Party will elect the new Central Committee and Politburo Standing Committee members.

Current President Hu Jintao and Premier Wen Jiabao are due to step down from the Standing Committee to make way for the new generation of leaders, from amongst whom the new Chinese president and premier will be appointed in March 2013.

In the Year of the Dragon, China – which is now the world's second largest economy – is also facing considerable economic uncertainty. There’s clear evidence that Chinese economic growth momentum has moderated during the second half of 2011. The eurozone, still a major market for Chinese exports, is already sliding into recession, while the momentum of U.S. economic recovery, although encouraging in recent months, remains moderate at best.

Latest GDP growth data released for Q4 2011 showed that Chinese GDP growth had moderated to a pace of 8.9 percent year-on-year, the slowest in ten quarters. This reflects various factors, including weakening EU demand for Chinese exports, as well as the impact of significantly tighter monetary policy in order to curb inflation pressures.

There are signs that the Chinese government’s monetary policy tightening in 2011 has been successful in curbing inflation, with the year-on-year CPI inflation rate slowing from 6.5 percent in July 2011 to 4.1 percent by December.

However, the recent growth slowdown has heightened concerns about whether the Chinese government can successfully engineer a Goldilocks scenario – a “not too hot, not too cold” – of moderate inflation and a soft landing for the economy, or if China will face a hard landing with growth slowing sharply.

IHS Global Insight's central case forecast for the Chinese economy in 2012 is for a soft landing, with GDP growth moderating from 9.2 percent in 2011 to 7.9 percent in 2012. This forecast is based on the central case scenario for the world economy, which assumes the eurozone will only have a mild recession in 2012, with eurozone GDP declining by 0.7 percent, while the United States is forecast to have positive growth of +2.0 percent.

A number of factors are expected to support the resilience of Chinese economic growth in 2012.

First, although Chinese exports to the EU are clearly slowing rapidly, overall Chinese export growth is still positive. In December 2011, Chinese exports were up 13.4 percent on a year ago, despite weaker EU orders, since the U.S. market has remained stable while exports to the rest of Asia and other emerging markets has continued to grow strongly.

Second, domestic demand measures still show considerable momentum, with December industrial production up 12.8 percent on a year ago, while nominal retail sales were up 18.1 percent on a year earlier.

While fixed asset investment moderated in Q4 2011, it’s still up 20.4 percent on a year ago. Although private residential construction slowed significantly in Q4 2011, this is a deliberate objective of government monetary policy tightening, to cool down an overheated residential property market in the large cities. Meanwhile, the Chinese government has also taken measures to mitigate this construction slowdown with a program to build 36 million affordable homes for low-income households over the five years starting in 2011. Work started on 10 million of these last year, but the bulk of construction work on this first batch of homes will take place during this year. Meanwhile non-residential construction, which accounts for the largest share of total construction, has been supported by large-scale infrastructure development programs, particularly in the relatively underdeveloped central and western provinces.

So, could China have a hard landing?

In the Year of the Dragon, we forecast the Chinese economy to have a soft landing, but it still faces significant downside risks and vulnerabilities. Due to these risks, a downside scenario with a hard landing for the Chinese economy sometime in the next three to four years is a significant risk, with a probability of 20 to 25 percent.

A key risk comes from imbalances in the structure of the economy, which has been excessively reliant on exports and investment as growth engines over the last three decades. This has created a lopsided economy in which private consumption only accounts for one third of GDP, a very low share by international standards. This heavy reliance on the export growth engine makes China vulnerable to external shocks.

A second key vulnerability stems from the 50 percent expansion in bank credit in 2009 to 2010, which was also linked to rapid growth in local government borrowing, much of which was for uneconomic projects that will eventually become bad debts on banking sector balance sheets.

Yet the Chinese government still has substantial flexibility, due to its foreign exchange reserves which exceed $3 trillion, as well as a moderate government debt to GDP ratio estimated at around 50 percent after including contingent liabilities from local government borrowing. This gives the Chinese government leeway to use further fiscal stimulus measures should growth slow more sharply than expected. With inflation already falling, monetary policy easing through reductions in the reserve requirement ratio is also expected to support growth in 2012.

And in the long term? The outlook for Chinese economic growth is still favorable, with average GDP growth of around 8 percent per year expected over the next decade. This will continue to drive the global shift of economic power from West to East, with China forecast to become the world's largest economy by 2020.

However, the Chinese economy also faces key risks and vulnerabilities, and the new leadership will face a difficult task of either taming the Dragon economy or facing the threat of a hard landing that could derail China’s economic development.

Rajiv Biswas is the Asia-Pacific Chief Economist for IHS Global Insight. He previously worked as Southeast Asia director for The Economist Group and as Executive Director for Asia-Pacific Country Risk for UBS. He has also worked as Senior Economist for the Commonwealth Secretariat and as a consultant for the United Nations.