China’s economy grew by 7.7% year over year (yoy) in the first quarter of 2013, against the market expectation of 8.0% yoy and a prior quarter’s 7.9% yoy. Gross domestic product (GDP) expanded 1.6% quarter on quarter (qoq), with an annualized growth rate of 6.6%, a step down from the 2.0% qoq and 8.2% annualized growth seen in 4Q 2012. Drivers of the weaker than expected growth include:
- Industrial production is slowing, with March growth at 8.9% yoy, compared to 9.5% in January-February.
- Consumption-related light manufacturing was surprisingly weak, especially in food & beverage and catering services. This was probably driven by the new government’s promotion of frugality, a curb on official spending and renewed bird flu concerns.
- Heavy manufacturing sectors such as steel, power and cement were also weak seemingly due to the lack of inventory restocking.
- Fixed asset investment maintained at a relatively high level at 20.9%.
- Retail sales increased by slightly above 12%, a slowdown from the 14.9% yoy in prior quarter, partly due to government’s frugality campaign and likely the impact of slower income growth by 6.7% yoy vs. above 9% in the past.
- The government’s new property tightening measures led to a significant drop in March property construction and new starts as developers adjusted construction in progress and delayed new starts.
This data set is disappointing. Many expected that the government’s public investment and accommodative credit policy would stabilize the economy and jump-start general private investment. So far, the gradual pickup in final demand is not strong enough to drive continuous inventory restocking in the downstream industries. Private investment appears to improving only modestly if the lack of growth of medium- to long-term bank loans is an indicator. This reflects some structural challenges that China’s economy is facing after years of high investments and growth. Over-capacity in the economy and persistent wage inflation have been capping corporate profitability growth. In addition, real borrowing costs remained high for small- and mid-sized private corporations even after the government improved liquidity conditions. Financing costs in China inherently favor large corporate borrowers. The above factors likely explained the slower than expected growth in general private investment.
The weak 1Q GDP was in stark contrast with recent credit expansion. The Total Social Financing program has been growing above 20% in 1Q. We suspect that some of the new credit facilities are being used to roll over and service legacy debts which resulted from the large stimulus programs in 2008-2009 and the money is not being channeled to invest in new projects. Consequently, the effect of credit expansion on real economic growth has been less than expected.
Our view is that the new government has an increased tolerance for lower growth recognizing the urgency to push structural reforms due to the decreasing effectiveness of government stimulus and credit expansion on stimulating economic growth. Recent reforms include steps to deepen the financial markets by deregulating interest rates and internationalizing the currency. This should help improve capital allocation in the economy and drive capital efficiency in the long term. An early example may be the break up of the state monopoly railway system with an aim to make the railway sector run on a commercial basis. This in turn will serve as a pilot project to eventually open up more state run services sectors to private investment.
China’s new government still targets GDP growth between 7%-8%. The moderate inflation picture with a more modest food price cycle and subdued non-food price pressure offers some opportunity for policy flexibility. At the moment, we don’t think the government will launch any further government fixed investment. If economic growth continues to moderate, some recently implemented tightening measures such as those in the property market could be reversed.
It is likely that the sources of economic growth in China will continue to transition. That path will be long and winding, and it will have significant impact on commodity demand/pricing and broader financial markets globally.
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