FROM THE ECONOMIST INTELLIGENCE UNIT

Data released in May point to the possibility of a hard landing in China, or at least a choice between a significant weakening of the economy or further ill-conceived stimulus measures that could create problems for the future. China's unbalanced economic model, which gives too much prominence to investment spending, could yet give way to years of under-par growth. In the short term, GDP growth rates are likely to remain above 7%, but even this would amount to a significant slowdown in the world's second-largest economy.

As recently as 2007, Chinese real GDP grew by 14.2% a year. It is a definitional question as to what would amount to a "soft landing" or "hard landing" for the economy, but GDP growth was down to 9.2% in 2011 and came in at a surprisingly weak 8.1% year on year in the first quarter of 2012. By Chinese standards, the current pace of growth is approaching levels at which the government needs to take action to prevent a hard landing.

Part of the reason for the slowdown is faltering external demand for China's exports. The external balance once provided a support of 2-3 percentage points to GDP growth in China, but the National Bureau of Statistics (NBS) indicated that net exports deducted 0.8 percentage points from first-quarter GDP growth on a year-on-year basis.

However, an even more significant factor affecting growth in the short term is the declining contribution from investment spending. At the height of the recent boom, massive investment spending fed into rapid increases in exports, financed by a state-owned banking system that used "financial repression" mechanisms—chiefly low deposit interest rates—to force households to fund investment. The response to the economic crisis of 2008-09 was to launch massive stimulus investment projects, backed by credit ordered to be supplied by the state-owned banking system. Arguably, such large-scale investment spending eventually needs to be backed by final consumption demand to avoid the creation of overcapacity. The interplay of private consumption spending and investment patterns will be key to the sustainability of China's economic growth rate in the years ahead.

The NBS has claimed that investment spending supported GDP growth by only 2.7 percentage points in the first quarter, with "consumption" adding 6.2 percentage points. At first glance, this appears to show that China has achieved a sudden but welcome rebalancing of the economy towards private consumption spending and away from credit-fuelled investment. However, Chinese data are among the least reliable of those published by the major economies of the world, and thus a great deal of caution is advisable. "Consumption" spending includes both private consumption expenditure and government expenditure.

In addition, government figures claiming a rebalancing towards consumption conflict with data showing rapidly slowing retail sales (which include some government purchases in China). Retail sales were up by 15.2% year on year in March (11.3% after inflation), falling to 14.1% in April, the slowest rate for three years. China's monthly fixed-asset investment (FAI) data also show a pronounced slowing, with FAI spending up by 20.2% year on year in April, bringing the January-April increase to 27.3%, well below investment growth rates of as much as 35% in mid-2009. The fall in investment spending growth is also likely to be behind the fall in import growth to just 0.3% year on year in April; in keeping with the Economist Intelligence Unit's forecast that growth will slow in the second quarter.

A small stimulus?

The government has indicated that, quarter on quarter, GDP grew by 1.8% in seasonally adjusted terms in the first quarter of 2012, a slower rate than any of the four quarters of 2011. The economy is not being helped by relatively subdued industrial production, which grew by 9.3% in April, down from 11.9% in March. The 0.7% year-on-year increase in power output in April has also raised eyebrows, because power data are highly correlated with GDP growth (and have often in the past been used by economic commentators to challenge the NBS's published GDP growth rates). Officials at China's National Development and Reform Commission have indicated that the second quarter is expected to be even weaker, with year-on-year GDP growth likely to fall below 8%.

The government has responded to recent data by cutting banks' reserve requirements to a still-high 20%, although the 33% month-on-month fall in new bank lending in April calls into question how effective this will be. Consequently, the slowdown in the pace of economic growth in the first quarter, apparently extended in the April data, is expected to be addressed by yet another stimulus package of some kind, to keep annual GDP growth over the previously announced target of 7.5%. Massive investment spending over the past few years makes a repeat of the 2009 Rmb4trn (around US$630bn) stimulus package inadvisable. The government has indicated that any stimulus package is unlikely to be equivalent to that in size, with infrastructure and consumer spending set to once again be encouraged.

China continues to struggle

In theory, the Chinese economy continues to grow at an impressive rate. However, beneath the headline rates of growth little progress has been made in shifting the economy towards more sustainable sources of demand. With private consumption spending around one-third of GDP, only increases in private consumption spending at well above the rate of GDP growth for many years in succession could shift the economy away from its reliance on investment. For this reason, government claims that "consumption" has become the key support of GDP growth need to be treated with scepticism.

China is likely to be able to keep GDP growth above 7.5% by means of government control of the banking sector, but the wider question is how and when the global economy can work through its current crisis, with all major players moving into sustainable growth. In April China's 4.9% increase in exports was coupled with a negligible rise in imports, producing a larger than expected trade surplus of US$18.2bn. This is bad news for China's trade partners: faltering investment spending in China, which in turn weakens China's imports, will have negative repercussions for the global economy.

Finally, the spectre of bad debts, particularly in the form of local government loans, continues to hang over the banking sector. Even if the government can use a bit of pump-priming now to maintained economic expansion at a rate regarded as the minimum acceptable, China, in common with many other economies, still appears to be kicking the can down the road, waiting for the wider global recovery. Next year will be an interesting one, with a new political leadership in place in China (and potentially the US), and possibly with greater clarity over what is likely to happen in the euro zone economies. Still, the day when China will have to say "no" to further stimulus packages, and move away from state-directed investment growth, is coming closer.