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Monday, June 06, 2005

State of Play With The Chinese Economy

Oxford Analytica had a reasonable piece in Forbes recently. I pretty much agree with what they argue:

However, there is more of a risk that the enormous over-capacity built up over the last three years of breakneck investment growth will spark a return to deflationary pressure sometime next year.

A short-term consequence of the current combination of excess industrial capacity and declining domestic demand will exert further upward pressure on the trade surplus, as manufacturers seek to clear inventories by exporting what they cannot sell at home. One sector where this effect is almost certain to show up is steel. China is likely to add 65 million tons of new steel capacity this year, while domestic steel demand on current trends is likely to rise by only 30 million tons......

The implications of this are that a modest revaluation of the renminbi--by say 5% to 10%--would have no impact on the trade surplus, which is determined by two structural factors: a surplus of domestic savings over investment and industrial overcapacity.

As the government tries to head off overcapacity by restraining investment, the savings surplus--and hence the trade surplus--will increase. Any renminbi revaluation large enough to counteract these forces--40% is a minimum estimate--would probably plunge the economy into serious deflation. Beijing will not take such a dramatic step. Instead, it is likely to pursue greater exchange rate flexibility by switching to a trade-weighted basket peg within the next six to 18 months in an effort to minimize the shift in the yuan-dollar exchange rate.

The short-term consequences as the economy comes off the top of its investment-driven business cycle and moves toward a position of substantial overcapacity will be a continued slowdown in investment growth, a modest rise in consumer-price inflation and a tripling of the trade surplus as the economy relies more on external sources of demand. Next year, inflation could give way to deflation, and the trade surplus will continue to grow as manufacturers try to clear inventories by exporting. However, Beijing is unlikely to bow to pressure to substantially revalue its currency, preferring a more modest move in the direction of exchange rate flexibility.

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