Finance Blog number 1

China’s stimulus-induced lending binge probably propelled growth in the third quarter to its fastest pace in a year. Now, policy makers have to figure out how to wean the economy off state support.

The country’s rebound has been powered by 4 trillion yuan ($586 billion) of spending on railways, roads, power plants and public housing. The program ends next year, forcing Premier Wen Jiabao to find new ways to sustain the expansion with increased consumer spending and the financing of small businesses.

“This has been growth on steroids,” said Michael Pettis, a Peking University finance professor and former head of emerging markets at Bear Stearns Cos. “The question now is how to stop pumping so much money into the system without a sharp reduction in growth.”

State-directed support will make up more than four-fifths of growth this year, says the World Bank, spurring record iron- ore production at Rio Tinto Group and car sales in China at Volkswagen AG. An exit from the stimulus won’t be easy without unnerving investors: A plunge in July loan growth sent the Shanghai Composite Index down more than 20 percent in August.

Extending the stimulus for too long risks the diversion of funds into stocks and real estate, an erosion of bank asset quality and inflationary pressures, the Asian Development Bank said in a report last month.

‘Severe’ Reaction

“Such a scenario might trigger a round of severe monetary tightening in the medium term that would pull growth down again,” the lender said.

China’s cabinet late today said that it will continue with monetary and fiscal stimulus measures even after the economy exceeded officials’ expectations for the first nine months of the year. At the same time, the State Council signaled that inflation concern will be an increasing focus of policymaking as the rebound strengthens.

The recovery remains at a “critical stage” and China will “maintain the continuity and stability of macro-economic policies,” the State Council said in a statement on a government Web site. “The policy focus of the next few months is to balance the need to maintain stable and relatively fast growth, the need to adjust the economic structure and the need to better manage inflationary expectations,” it also said.

Policy Shift

“They are cautious about the speed at which inflation will return,” said Ben Simpfendorfer, an economist with Royal Bank of Scotland Group Plc in Hong Kong. “It’s not a change of policy tone yet, but I think we will get that change in the first quarter of next year.”      The state-driven credit boom, which led to a record $1.27 trillion in new loans in the first nine months, the stimulus plan and resulting growth in car and property sales will help the economy expand 11.2 percent in the fourth quarter, according to Frankfurt-based Deutsche Bank AG. That follows a 7.9 percent expansion in the second quarter of this year, the first acceleration in growth since the last three months of 2006.

The benchmark Shanghai Composite Index of stocks reached a two-month high today before tomorrow’s economic data releases, including gross domestic product. The gauge rose as high as 3,105.51 before trading at 3,087.84 as of 2:03 p.m. local time.

Industrial output probably grew 13.2 percent in September and investment in properties and factories surged 33.1 percent in the first nine months, pushing GDP growth to 9 percent in the third quarter. It was the fastest pace since the third quarter of last year, according to the median estimate of 34 economists surveyed by Bloomberg News. The data will be released tomorrow.

Inflation Gauge

Figures this week will probably show no signs of inflation, allowing the People’s Bank of China to keep in place what it calls its “moderately loose” monetary policy. China will stick to that policy, guide reasonable loan growth to boost domestic demand and further cement the nation’s economic recovery, the central bank said Sept. 29.

Consumer prices dropped an estimated 0.8 percent in September, according to the survey.

Retail sales rose 15.5 percent last month, the fastest pace since January, according to the data survey. Car sales surged 84 percent to more than 1 million units for the first time, putting China on course to overtake the U.S. this year as the biggest market for sales of new cars.

The stimulus, record lending, tax cuts and subsidies may help push China’s imports 30 percent higher to $313 billion this quarter, according to Zurich-based Credit Suisse Group AG payday loans with low fees. Iron ore imports jumped to a record 64.6 million metric tons last month while copper imports rose 23 percent.

Global ‘Locomotive’

China’s demand for goods from overseas can play “a critical role in some locomotive way for the world,” Jim O’Neill, chief economist at Goldman Sachs Group Inc. in London, said in a Sept. 2 research note.

The lending boom, equivalent to about 50 percent of China’s GDP in the first half, drove public and private investment in factories and properties 33 percent higher in the first eight months, helping restore investor confidence in stocks and property after the start of the financial crisis.

The Shanghai index has soared 70 percent this year as government-influenced spending helped growth rebound from 6.1 percent in the first quarter, the slowest pace of expansion in almost a decade.

Volkswagen Sales

Wolfsburg, Germany-based Volkswagen, the biggest overseas carmaker in China, sold 150,000 cars last month, a monthly record, as sales for the first nine months surged 37 percent. Car sales were buoyed after the government halved sales taxes and announced 5 billion yuan in subsidies to help rural residents to buy vehicles. Volkswagen is investing 4 billion euros ($5.9 billion) to expand capacity in China through 2011.

“China is the steam engine of the world economy,” Volkswagen sales chief Detlef Wittig said in a Sept. 25 interview in Frankfurt. “The lust for mobility there seems almost bottomless. We’re very well positioned there and will keep investing to secure our share of the market.”

Iron-ore production at London-based Rio Tinto, the world’s third-largest mining company, rose 12 percent in the third quarter to a record 47.5 million tons on demand from steelmakers in China, the company said in an Oct. 14 statement.

China Mobile Ltd., the world’s biggest phone company by market value, reported that subscriber numbers rose to 508.4 million at the end of September, more than the populations of the U.S. and Japan combined.

World Bank’s Remedies

The effect of stimulus spending will taper off starting in mid-2010; the overall impact will be less than half what it was this year, said Wang Tao, a UBS AG economist in Beijing.

On the World Bank’s list for measures to reduce dependence on investment-led growth are: boosting spending on health, education and social welfare to aid low-income earners and reduce their reluctance to consume; providing greater funding for small- and medium-size enterprises; and allowing more flexibility for the yuan to appreciate, making imports cheaper.

“Keeping the Chinese economy growing is very important for employment generation and to avoid social instability,” said Yolanda Fernandez Lommen, chief China economist at the ADB in Beijing. “The easy part has been done. The real challenge is ahead.”

By developing service industries and ensuring easier access to consumer products and credit, China can boost domestic consumption by $2.2 trillion, or more than France’s annual output, by 2025, the McKinsey Global Institute said in an Aug. 21 report.

Driving Investment

Some areas of the economy may emerge as new drivers of growth even as stimulus and new lending slow. Net exports may contribute 0.5 percentage point to next year’s expansion after slashing more than 3 percentage points from this year’s GDP rise, said UBS’s Wang.

A rebound in property construction, which contributes about a quarter of urban fixed-asset investment, will also pick up some of the slack in 2010, said Wang. Property sales jumped 73.4 percent in the first nine months of 2009 from a year earlier to 2.75 trillion yuan.

China may still have to get used to a lower average annual growth rate as reduced demand from Western nations slows exports. The World Bank estimates 2 percentage points may be shaved off the average 10 percent yearly growth recorded over the past decade, the ADB envisions a trajectory of 8 percent to 9 percent and Pettis says the economy may have to adjust to a trend growth rate of 5 percent to 7 percent.

“The government has been postponing the difficult and painful reforms,” said Fernandez Lommen. “It’s a huge task ahead.”

–Kevin Hamlin, with assistance from Andreas Cremer in Berlin. Editors: Anne Swardson, Chris Anstey.

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