Recent positive economic data is perfectly timed, but the challenges remain

October was an important month to get it right, and China nailed it. The debate over whether the economy is facing a hard or soft landing has raged for months, and seemingly in the course of a few days, fears of a hard landing were mollified and the road to recovery made clear as a raft of positive data came out. The data could not have come at a better time either, with the 18th National Congress of the Communist Party of China just weeks away.

The congress, a once-in-a-decade transition in leadership, is a big deal. Current leaders want to leave office on a high note, able to highlight their accomplishments, while the incoming government wants to inherit a stable and generally well-off economy.

To stabilize the economy, policymakers have introduced a series of stimulus measures over the past six months. In contrast with the program of 2008, when China introduced its 4-trillion-yuan of stimulus measures focusing on 10 industrial sectors, this year's is much smaller and targeted, focusing on tax cuts, consumer subsidies and increased fiscal spending on infrastructure. In a departure from last time, sectors such as steel, non-ferrous metals, shipbuilding, textiles, equipment manufacturing and others are not specifically encouraged.

Taken as a whole, the measures seem to be working. While GDP growth fell from 7.6 percent year-on-year in the second quarter to 7.4 percent in the third quarter, it rose a faster-than-expected 2.2 percent quarter-on-quarter, up from revised growth of 2 percent quarter-on-quarter in the second quarter, indicating an acceleration in growth. The better growth was also confirmed by improvements in monthly data for September, including trade (exports and imports), retail sales, industrial production, urban fixed-asset investment and money supply.

This was firstly led by a big increase in the money supply, with broad money, M2, growing 14.8 percent year-on-year against expectations of 13.7 percent and previously 13.5 percent. In line with this, renminbi bank loans rose 32.8 percent year-on-year, and total social financing, which includes a variety of other sources of funding, more than doubled.

Although it may be too early to call a full recovery after just one month's data, positive signs have been emerging for months. In particular, there have been more signs of an improving property market, which has always been a key driver of the economy as a whole.

The property market was hard hit for many months because of strict government curbs on purchases. Keeping property prices stable or growing slower than incomes, thereby making property more affordable, has been a key policy goal of the government.

While curbs are still in place, funding for the sector is returning, with developers finding it easier to obtain loans and the cost of mortgages falling, boosting borrowing. Lending to developers has risen about 30 percent year-on-year over the past two months, and mortgage lending has risen about 50 percent year-on-year for the period. The greater funding has led developers to increase land purchases, with the next step likely to be a rebound in new construction, which will provide a boost for downstream sectors such as steel, aluminum, cement and more.

The timing for this return to growth could not be better, as external factors are making it more difficult for China to ease monetary policy. The reserve requirement ratio was last cut in May, and the most recent interest rate cut was in July. While the central bank has been using other methods to supply funds to the market, mainly open-market operations, even this may need to become more prudent because of the changing market.

In particular, the newest round of quantitative easing in the US is driving an increase in foreign currency inflows and may drive up commodity prices at a time when China's consumer price index looks set to rebound because of rising food and housing prices. The money printed to buy foreign currency flowing into the banking system rose 130.7 billion yuan last month, almost equivalent to the last four months combined and the highest level since January.

Meanwhile, political considerations are also likely to limit further easing. Around the upcoming Party Congress, leaders want to see a stable economy and stable domestic situation. As a result, officials are counting on existing measures to sufficiently boost growth to ensure stability.

Lodged somewhere between the threat of returning inflation and the political desire to maintain stability is the fact that China may now have limited room to take additional steps to support the economy, over and above those already taken. While the seeds of recovery have been planted and government officials, from Premier Wen Jiabao on down, are confident that China will reach its 7.5 percent annual growth target, one must still wonder how things will play out in coming quarters.

Looking forward, China plans major adjustments to the structure of its growth over the next three years (the final three years of the 12th Five-Year Plan that runs from 2011 to 2015), boosting domestic consumption while reducing reliance on investment. It is widely believed that the current economic growth model is unsustainable, with change to the structure being of paramount importance. The increase in consumption will be achieved through a number of measures, wage and income increases being coupled with more government spending on social security, pensions and medical insurance, reducing the need for precautionary savings.

However, at odds with this adjustment is the fact that the growth that China is now generating is driven by investment in infrastructure and property-related sectors. As stimulus measures have been implemented, the contribution of final consumption spending, including government spending, to GDP growth fell from 6.4 percent in the first quarter to 4.7 percent in the first six months and 4.2 percent for the first nine months of the year. The 4.2 percent contribution is the lowest since the third quarter of 2009. So although the return to growth is positive in the short term, it is making it harder for China to achieve its longer-term objectives.

Further supporting this view is the limited expansion of the service sector. As part of the plan to boost consumption, China wants to increase the number of people living in cities while at the same time boosting the service sector's share of GDP by 4 percentage points to 47 percent by 2015 (close to current levels in the US). But according to Sheng Laiyun, spokesman for the National Bureau of Statistics, the service sector accounted for just 43.8 percent of GDP in the first nine months of the year. This means that in over one-third of the period, China has completed just one-fifth of the target, indicating that progress is slower than expected.

If the transition was easy to make, it would already be done. But as the current economic situation shows, fundamental change is easier said than done. Growth is returning and there are plenty of opportunities ahead for China, but the new leaders will have to make tough choices quickly if they are to alter the direction of the country for the better.

The author is head of the Beijing division of NSBO China, a UK-based Chinese government policy investment research firm. The views do not necessarily reflect those of China Daily. Contact the writer at obarron@nsbo.com

(China Daily 10/26/2012 page8)