Bright spot of mainland economy balances gloom over US

Here we go again. Another set of headlines about the financial sector, this time the collapse of Carlyle Capital, has sent global stock markets reeling.

Meanwhile, downbeat employment and retail sales data out of the United States offers fresh evidence that the country is sinking into recession, potentially dragging down the world economy. All this has reinforced expectations of further US Federal Reserve rate cuts, pushed the US dollar to a 12-year low against the yen and record lows versus the euro, and sent gold soaring past US$1,000 per ounce.

The most notable bright spot on the global scene remains the momentum on mainland China as a key engine of world growth, helping to balance weakness in the US. China's gross domestic product growth is expected to remain strong at about 10 per cent this year, though down from the 11.4 per cent growth last year, the strongest in 13 years. This outlook for ongoing broad-based expansion was reiterated at this month's annual meeting of the National People's Congress. In his keynote speech, Premier Wen Jiabao named inflation and overheating as the key threats to the economy.

It was also reinforced by last week's monthly package of mainland data. January-February industrial production narrowed to 15.4 per cent year on year, down from the 17.4 per cent posted in December and the 18.5 per cent annual growth for all of 2007. But this was at least partly attributable to disruptions from severe snowstorms at the beginning of this year. Production remains solidly expansionary, sustained by strong domestic and export demand.

Retail sales during January and February continued at the robust 20.2 per cent December pace, the highest rate in data available back to 1999. And January-February urban fixed investment was up by 24.3 per cent, after annual growth of 25.8 per cent last year. The latest report showed February exports narrowing to 6.5 per cent growth year on year, from 26.7 per cent in January. But this was largely a base effect in comparison with an uptick a year earlier, and January-February combined were still a solid 17.4 per cent.

The biggest concern remains inflation, with the consumer price index jumping to 8.7 per cent in February compared with a year earlier - up from 7.1 per cent in January - the highest in nearly 12 years. It was exaggerated by blizzard-related disruptions, reflected in a spike in food prices - up 23.3 per cent year on year. Prices excluding food edged up 1.6 per cent, from January's 1.5 per cent increase. Acceleration in the headline CPI from 3 per cent last April has been concentrated in food and energy prices.

Headline CPI should begin to slow by mid-year, as meat prices start to come down. The government's projection for annual CPI this year - little different from the 4.8 per cent in 2007 - still appears within reach.

But CPI inflation is well above the central bank's annual target of less than 3 per cent, and the People's Bank of China has tightened monetary policy in an effort to contain it. It raised interest rates six times last year by a total of 135 basis points, most recently in December, raising its lending rate to 7.47 per cent, a nine-year high. It raised bank reserve requirements 10 times last year, and again in January to 15 per cent.

Continuing inflationary pressures mean further interest rate rises are likely. The quarterly monetary policy report of the People's Bank last month said it 'needs to carefully use interest rate tools to control the expansion of demand and stabilise inflation expectations'.

Equally noteworthy, the report said it would 'boost the exchange rate's role in adjusting the balance of payments and in curbing inflation'. It said it would make the exchange rate more flexible, heightening market expectations that it would tolerate faster appreciation of the yuan.

Highlighting the apparent policy shift, the yuan last week strengthened past 7.10 versus the US dollar for the first time since it was unpegged in July 2005. This brought cumulative yuan appreciation against the greenback to 14.5 per cent. It suggests a doubling from the fairly steady 5.5 per cent annual pace of appreciation during 13 months through October last year.

Note, however, that this comes in the face of the broad US dollar weakness, including the yen hitting a 12-year high versus the dollar and the euro at a new record. Against a basket of currencies, the yuan last week actually eased towards the low end of its range since the start of this year, and is barely 1 per cent higher than 12 months ago. This bolsters expectations for continued yuan appreciation versus the dollar.

A recession in the US would represent a potential shock to the global economy, and despite talk of 'decoupling', the mainland would not be immune.

This, together with government restraint measures to avoid potential overheating, might drag growth below 10 per cent.

Nevertheless, strong mainland growth continues as a key engine of world growth in the face of US weakness. Its expanding presence on world markets makes it an increasingly important driver of demand for commodities and manufactured products, to say nothing of Hong Kong retail sales.

David Cohen is founder of Action Economics