China Had a Good 2010 but Risks Leave Future Uncertain

by: Carnegie Endowment

China ended 2010 with a bang, growing an astounding 12.7 percent in the last quarter and 10.3 percent over the year as a whole. But massive credit expansion has left the economy with a potentially dangerous overhang of liquidity and China’s GDP growth will likely slow somewhat in 2011. A number of domestic and international risks — most significantly among them, inflation — leave its longer-term future more uncertain than usual.

An Impressive 2010

Following the global financial crisis, China experienced the shortest and shallowest recession of any of the major economies, posting particularly impressive growth in 2010. According to the government’s provisional estimates, China’s GDP grew by 10.3 percent in 2010, compared to 8.7 percent in 2009. In the fourth quarter alone, GDP increased by an astounding 12.7 percent (q/q, annualized), or a more "modest" 9.8 percent in quarter-over-quarter terms, once again raising the specter of overheating.

As a result, China made an outsized contribution to the global recovery — accounting for about half of global growth in 2009 and 2010. The Conference Board, for example, expects China’s role in boosting the global economy to continue, estimating that China will contribute about 40 percent to global growth in purchasing power parity terms over the next decade — about 10 times the projection for the U.S. contribution during that period.

At the same time, it is not yet clear whether China’s current account surplus as a percentage of GDP — a critical metric of imbalance, which fell from a peak of 10.6 percent in 2007 to 9.4 percent in 2008 and about 6.0 percent in 2009 — continued its decline in 2010. The IMF and World Bank’s most recent projections (made in October and November, respectively) expect a decline to 4.7 and 5.5 percent, respectively, but China’s strong export recovery suggests that the external balance may have changed little, if at all, in 2010. [1]

In addition, while China’s growth remains impressive, it appears to be slowing somewhat. The composite manufacturing Purchasing Managers Index remains well above 50 (the line between expansion and contraction), but turned down a little in December while the composite manufacturing output growth index remained stable. As the government phases out stimulus programs, growth in 2011 is likely to slow to a still-high 8.5–9 percent.

The Biggest Risk

Although the consumer price, food price, and producer price indices all fell a little in December, inflation poses the biggest near-term risk to the economy, particularly given China’s overhang of "excess money."

Though this concept of "excess money" is imprecise and difficult to quantify because of variations in the velocity of money, [2] China’s monetary overhang is large by any standard. In China, M2 normally grows at about the same rate as nominal GDP. Had that been the case in 2009 and 2010, M2 would have been about RMB12 trillion — $1.8 trillion, or about 30 percent of GDP — lower than it was at the beginning of 2011.

What caused this large monetary overhang in China?

According to China, the U.S. Federal Reserve’s quantitative easing policy is a source of inflationary pressures in China. There is some merit to this complaint: U.S. monetary policy has turned the dollar into something of a "carry-trade" currency, [3] which likely contributed indirectly to commodity price increases and some "hot money" inflows into China.

However, excessive domestic monetary expansion — specifically, the extraordinary growth of bank credit in 2009 and 2010 to support the government’s huge stimulus program, is undoubtedly the most important source of inflationary pressure in China at the moment. International commodity price increases (e.g., wheat, soya beans, non-ferrous metals) and domestic cost-push factors (wage, utility, and land price increases) are also contributing pressure.

China’s central bank (PBoC) is very aware of the inflation risks facing the country, as evidenced by its efforts to gradually tighten monetary policy. However, in spite of the fact that it raised benchmark interest rates by 25 basis points in February — the third such increase since October 2010 — deposit rates remain negative in real terms and lending rates are barely positive. The PBoC’s job is admittedly very difficult, but it may be erring on the cautious side. Further increases in the policy interest rate and tightening of minimum reserve requirements are likely.

At the same time, China’s decision to once again delink the RMB from the dollar last June may slightly offset some of the inflationary pressures. Since June, the nominal RMB/USD exchange rate has appreciated by about 3.6 percent, and, with inflation in China far exceeding that in the United States, the real RMB/USD exchange rate has appreciated much faster. According to the U.S. Treasury Department, China’s real exchange rate appreciated at an annual rate of 10 percent in the second half of 2010, rising almost five percent (y/y) in December.

If not carefully managed, China’s monetary overhang could lead to financial instability in China, with negative spillover effects on the rest of the world. Most dangerously, given the excess liquidity in the economy, inflation expectations could become a self-fulfilling prophecy, triggering higher inflation and negative social and economic consequences across the world.

Another significant risk comes from the possibility of continued inflation in commerical real estate markets in Tier 1 cities, such as Beijing — where a typical apartment now costs more than 30 times the average annual salary of a mid-level government employee [4] — as well as Shanghai, Hangzhou, and Shenzen. If China fails to cool these urban property markets, the growing unaffordability of commercial housing for ordinary people could lead to social unrest.

Conversely, if China succeeds in cooling the real estate markets in Tier 1 cities, land prices will probably fall and this will undermine the value of collateral for hundreds of billions of loans to local-government-owned investment companies, which have been used to finance stimulus infrastructure projects in recent years.

Other Risks and Uncertainties Ahead

In addition to inflation, a number of uncertainties — which, unlike risks, often remain unidentified and cannot be quantitatively measured — are converging in China, making any precise projections for more than one year out more questionable than usual.

Some of the risks are domestic: corruption and nepotism — sources of growing public discontent in China — could push the limits of social tolerance with little warning.

Other risks have to do with the interactions between internal policies and the global economy. For instance, if China were to continue or even intensify World Trade Organization-inconsistent statist and mercantilist trade and industrial policies — including preferential treatment of domestic enterprises — it could provoke or reignite international tensions. Though China is keenly aware of international complaints about certain aspects of its trade and industrial policies, it has made only minimal corrections so far.

Finally, several risks outside of China’s control could have a substantial effect on the economy. Drought in China’s major grain-producing areas could continue, for instance, compounding the effects of global food price increases. [5] World oil prices could also spike as a result of ongoing political turmoil in the Middle East, or the European debt crisis could deteriorate. In the longer term, the United States could suddenly see a sharp increase in domestic interest rates amid problems in the bond market, potentially even triggering a dollar crisis.

Pieter Bottelier, former chief of the World Bank’s resident mission in Beijing, is a nonresident scholar in Carnegie’s International Economics Program and senior adjunct professor of China Studies at the School of Advanced International Studies at Johns Hopkins University.


1. China’s Ministry of Commerce expects a trade deficit for the first quarter of 2010, and the trade surplus fell in November and December 2010, but it held strong in other months in 2010. It fell again in January 2011, reaching a 9-month low of $6.46 billion.

2. The ratio of money supply to GDP in a normal year differs from country to country. When M2 grows faster than nominal GDP, prices tend to rise, unless money "velocity" — the rate at which money circulates through the economy — drops.

3. Since current monetary policy is keeping short-term interest rates in the United States extremely low, it is very possible that cheap dollar loans are being used to "invest" in commodities and certain other assets.

4. In Beijing for example, it is now almost impossible to find a decent apartment within the 5th Ring Road below RMB30,000 per square meter. That means that a typical 100-square meter apartment costs RMB3 million (or $455,000 at the current exchange rate) which is over 30 times the average annual salary of a mid-level government employee.

5. The current drought in northeastern China, the country’s main wheat growing area, is reported to be the worst in 60 years.