May 11, 2012

China Economic Review: Growth and Currency Considerations
Did domestic consumption play its role in supporting economic growth in the first quarter? Which factors pulled the headline figure down? How will this affect the yuans movement going forward?

by iFAST Research Team

China Economic Review: Growth and Currency Considerations

Key Points

China’s first quarter gross domestic product (GDP) figures disappointed markets, growing just 8.1% year-on-year, slowing dramatically from the 8.9% seen in the fourth quarter of 2011. Did domestic consumption play its role in supporting economic growth in the first quarter? Which factors pulled the headline figure down?

On top of that, earlier in April, the People’s Bank of China (PBoC) widened the Chinese currency’s trading range, allowing the Chinese yuan to trade up to 1% above or below the daily official rate against the US dollar. How will this affect the yuan’s movement going forward?

In two parts, we will address both China’s growth and currency outlook in this review.

Implications of 8.1% GDP Growth

Looking at the trend of the three crucial economic indicators in Chart 1, we can see that these three factors have all slowed in the first quarter of 2012. Investments in fixed assets grew 20.9% in the first quarter, slowing from the 23.8% growth last year. On the other hand, retail sales grew 14.8% in the first quarter, slowing less dramatically than investments did. More severely however, although exports growth is typically volatile, it has been trending downwards in the past two years and in the first quarter, grew just 7.6% year-on-year.

Chart 1: Retail Sales, Investments and Exports Growth

Nonetheless, the bright spot amidst the disappointing data is that if we consider the three main contributors to China’s GDP in Chart 2, we can see that consumption (private and public) played a particularly astonishing role to the economy in the first quarter. In the previous article (China: What are the implications of a 7.5% Growth Target?), we noted that investments’ contribution to GDP and the GDP growth rate has risen dramatically in the past decade, putting the economy in jeopardy of an unsustainable economic growth model. At the same time, we stressed the importance for China to switch focus towards boosting domestic consumption. In the first quarter, investments’ contribution to GDP declined to 33.4%. At the same time, consumption’s contribution increased to 76% from 51.6%.

Chart 2: Consumption, Investments and Net Exports Contribution to GDP

Looking at the situation from a different point of view, consumption became the core driver of China’s economic growth in the first quarter, contributing 6.2pp (percentage points) to the 8.1% GDP growth rate, compared with a 4.8pp contribution to the 9.2% GDP growth rate for the whole of last year. Notably, looking at Chart 3, consumption has not played such an important role to economic growth in any of the past ten years. The economy had previously been predominantly driven by growth in investments. The spike in contribution coming from consumption is definitely a positive sign which reassures us that China is making progress in transforming its economy, moving onto a path of sustainable growth.

Chart 3: Components’ Contribution to GDP Growth Rate


Although we saw disappointing growth figures and evident signs of an economic slowdown in the first quarter, we also noted that some indicators, such as retail sales and industrial production, rebounded in March. This suggests that figures may have already bottomed out in the first quarter. As for investments, first quarter figures were mainly affected by a slowdown in property investments. Real estate investments growth slowed significantly to 23.5% year-on-year; the figure is 4.4pp below the growth rate seen in 2011 and 10.6pp below the growth rate we saw in the same period last year. But given that the real estate market will receive support from the government’s initiative to build 36 million units of subsidised apartments by 2015 as part of the social housing program, we are not too pessimistic on the investment front.

In conclusion, though the headline growth figures are slightly disappointing, the bright spot for China is that it appears to have made progress towards becoming a consumption-driven economy. Nonetheless, since the transition is obviously not something that will happen overnight, we remain cautious in analysing the GDP figures above, and would not jump to the conclusion that China has "succeeded" in its quest for domestic consumption growth. We would not rule out the possibility that the unexpectedly large contributions coming from consumption represent volatility in the growth of the three factors. On the other hand, going forward, we expect growth figures to show improvement and believe that the worst is passing us by. We will continue to closely monitor China’s economic data in the coming months to get a clearer picture of where the economy is headed.

Implications of Currency Trading Band Doubling

Earlier this month, the People’s Bank of China (PBoC) widened the Chinese currency’s daily trading range, allowing the RMB to trade up to 1% above or below the daily official rate against the US dollar; the range is now double its previous range of 0.5%.

We do not think the policy move itself will have any fundamental effects on the long term movement of the RMB. However, as we mentioned previously, we do expect the RMB to move onto a different appreciation roadmap, which involves a slower pace of appreciation with increased two-way volatility. That is to say, contrary to some popular beliefs, the RMB is not a one-way investment, there are also downside risks. The widening of the RMB’s trading band is definitely a move that will help shift the currency onto this path.

On the other hand, China has clearly demonstrated efforts to liberalise and internationalise its currency, embarking on a road towards a fully convertible currency, this policy move was definitely an important sign. Widening the trading bands will effectively open the doors for more market participation in determining the value of the RMB. In fact, the trading band widening comes hand-in-hand with the liberalisation of the onshore capital markets we saw in the first quarter. Looking at Chart 4, we can see that the approved Qualified Foreign Institutional Investor (QFII) quotas in the first quarter have already exceeded the total amount approved of in the whole of 2011. Furthermore, earlier this month, the China Securities Regulatory Commission announced that the cap on the amount of QFII quotas a fund manager may be granted will now increase from US$30 billion to US$80 billion.

Chart 4: Qualified Foreign Institutional Investor (QFII) Quotas Approved

As for the outlook for the RMB, we do not see the policy move having any major impact on the currency’s direction. Despite liberalisation, at the end of the day, the central bank is still playing the role in fixing the daily rate, still grasping the inter-day movement of the currency.

If we take a look at the RMB non-deliverable forward contract (NDF), a proxy of the currency movement, we can see that especially after the equity markets selloff (or Chinese equities selloff) last year, the markets’ view on the appreciation of the RMB has shifted. In Chart 5, we can see different lengths of the RMB NDF contract at different points in the past year. An upwards sloping curve indicates that investors expect an appreciation of the RMB. Since the start of last year, the expectation of an appreciation has steadily declined. In fact, after the selloff last year, markets now expect a slight depreciation of the RMB in the coming 3 years. But since the NDF contract merely reflects market expectations, it cannot be treated as a crystal ball and in the long run, we actually still expect a moderate appreciation of the RMB at an annual average rate of 2%. Nevertheless, we stress that investors should remember that there are downside risks to the RMB.

Chart 5: Historical CNY-USD Non Deliverable Forward (NDF) Contract Price to Spot Price

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