Global Insight Perspective
Significance	GDP in real terms expanded by 11.5% year-on-year (y/y) in the third quarter of the year, slowing just marginally from the 12-year-high rate of 11.9% recorded in the previous quarter.
Implications	Growth continues to be fuelled by external demand and bounding investment growth as private consumption continues to lag. The impact of monetary tightening and administrative adjustments has been minimal.
Outlook	Global Insight forecasts full-year growth at 11.5%—its highest level since 1993. However, the structure of growth is fuelling risks to economic sustainability over the medium term.
Risk Ratings	Global Insight has downgraded China's economic risk rating from 2.50 to 2.75 to reflect the growing weight of structural imbalances in the economy's outlook and the lack of a clear and aggressive policy blueprint to resolve them to date.

Economy Records Still Blistering Growth

Chinese growth maintained blistering momentum in the third quarter, despite slowing marginally from the 12-year-high rate recorded in the previous quarter. According to data released by the National Bureau of Statistics (NBS), GDP in real terms expanded by 11.5% in the three months through September, compared with the 11.9% annual gain recorded in the June quarter. Aggregate annual growth for the first three quarters of the year now stands at 11.5%. The economy is on course this year to record its fastest rate of growth since 1993, while China could supplant the United States as the largest contributor to global growth for the first time ever, according to the International Monetary Fund (IMF). Global Insight forecasts 2007 growth at 11.5%.

Investment and Exports Still Main Drivers

Inexorable growth in exports and investment continue to drive the economy. The cumulative US$185.7-billion trade surplus for the period January-September exceeded the US$177.5-billion total level recorded for the whole of 2006. Despite gathering headwinds over the global economy, exports have maintained traction, rising by 22.8% in September alone in y/y terms to US$112.5 billion, as imports grew at a more moderate rate of 16.1%. Foreign-exchange earnings have been further boosted by the continued influx of foreign direct investment (FDI), which rose by 10.9% on the year in the first nine months to US$47.22 billion.

Huge external surpluses continue to fuel robust liquidity growth. Money supply is being inflated by interventions by the People's Bank of China (PBoC) to stem upward pressure on the yuan exchange rate, generated by surging foreign capital inflows. Foreign-exchange gains account for 45% of money supply gains in the nine months through September. High liquidity continues to support robust expansion of credit. During the first three quarters of the year, urban fixed-asset investment (FAI) rose by 25.7%, slowing by just 0.2 percentage point from the 25.9% annual growth rate recorded in the first half, despite monetary tightening and the imposition of administrative controls. Concurrently, retail sales—a key gauge of private consumption—rose by 15.9% over the nine-month period. The rate was 0.3 percentage point lower than in the corresponding period of 2006. In inflation-adjusted terms, retail sales rose by 12.3%, indicating that household spending continues to lag significantly as a demand driver. The NBS reports that investment accounted for 42% of GDP growth in the first nine months of the year, against a 37% share for private consumption. This marks a reversal from dynamics at the beginning of the current growth cycle in 2002, when household consumption and fixed capital formation accounted for 44% and 36% of GDP, respectively. By comparison, the share of consumption to GDP in the United States stands at 70% and over 60% in India.

Implications and Outlook

A Growth Phenomenon But Risks Build

It is this changing structure of demand that is fuelling latent risks in China's economic outlook. As investment becomes the largest demand component in the economy, it is beginning to face diminishing rates of returns. Despite huge rates of investment, productivity growth has been relatively weak, highlighting inefficiencies in the economy generated by high and rising levels of excess capacity and the continued heavy presence of the state sector in the current business cycle. Downward pressure has been exerted on prices, undermining the already low margins of domestic firms. Much attention has been garnered by the high rate of inflation, which rose to five-year highs in August. However, pressure has been generated by supply-side constraints, fuelled by interruptions to the food supply. Non-food inflation continues to tread in the 0.0-1.0% range. If the economy should experience a downturn, the ability of firms to service debts could be compromised, creating the risk that a fresh generation of non-performing loans (NPLs) could be germinating in the banking system even as restructuring following a mass re-capitalisation of state banks proceeds. Providing an indicator, the estimates of new NPLs at the end of 2005 range between 1.3 trillion yuan (US$174 billion) and 1.8 trillion yuan, almost equalling the total re-capitalisation of banks in 1998-2005.

Asset Bubble Builds

Financial risks are also exacerbated by the current boom in financial markets. Excess liquidity is being ploughed into the stock market by retail investors, with speculation fuelled by so-called "hot money inflows", effectively round-tripping. The benchmark Shanghai A-share's profit/earnings ratio has soared from 16 at the end of 2005 to 73 in September 2007. In the year to date, the stock market has added US$2.5 trillion in value, broadly equivalent to overall GDP in 2006, while the benchmark index has soared by 161%. An asset bubble is clearly forming, compounded by the traditionally volatile nature of China's stock markets, and dominated by short-term trades. A major stock market correction would be unlikely to have a severe impact on the economy comparable to that experienced in Japan in the early 1990s. China's stock markets remain comparatively small in terms of capitalisation despite recent robust growth. The combined market capitalisation of the Shanghai and Shenzhen exchanges rose to 111% of GDP from 50% as of end-2006, but remains below Japan's 150% ratio in 1989. Moreover, only a quarter of shares in the Chinese market are liquid and available for trade. However, any collapse in the asset bubble would undermine attempts by authorities to deepen capital markets to diversify financial mediation from the banking system, providing a stronger infrastructure to support the emerging market economy.

Environmental and Socio-Economic Risks

The economy's extensive growth pattern has also caused additional imbalances. Investment-driven growth is more energy intensive than growth geared to consumption. China's severe environmental degradation is set to become an increasingly acute problem. In addition, investment concentrated in heavy industrial activities has resulted in lower employment generation than consumption-oriented industries. Lower rates of employment growth, compounded by layoffs from the state sector as restructuring proceeds, have served to depress household spending. The lack of adequate social security nets and the widening wealth gap reinforces the propensity to save.

Given building and conflicting pressures in the economy, the risk of a hard landing for the economy in the near term is accentuated. Further monetary tightening is required to curb the risks generated by as yet unbridled credit growth. However, if the pace of interest rate increases is intensified and combines with the probable bursting of the asset bubble, a major correction could occur in investment growth. Moreover, the ability of authorities to restrain the investment boom in the immediate term is debatable given the strength of stimulus from external surpluses. The current-account surplus is forecast to moderate just slightly to 8.8% of GDP in 2007, from 9.4% in 2006. At the beginning of the current cycle in 2002, the current-account-to-GDP ratio stood at 2.4%. Concurrently, external headwinds are gathering against global growth as the ramifications of the U.S. sub-prime loan crisis unfurl. A decline in export growth would simultaneously remove another demand prop from the economy. Any deceleration in growth would expose the economy's deeper structural problems of excess capacity, high unemployment, low corporate earnings, and the build-up of NPLs. The potential slowdown in external demand, coupled with the need to maintain growth at high rates to absorb shocks generated by state sector restructuring, will inhibit authorities from allowing more aggressive appreciation in the yuan exchange rate, which could ease upward pressure on the money supply. China's perceived policy self-interest could fuel the current wave of global trade protectionism, further exacerbating external risks.

Authorities recognise the need to re-orient growth from its current export-investment paradigm to greater emphasis on consumption. However, that reorientation will take time given the significant structural challenges it entails ranging from creating a more geographically balanced distribution of growth and a viable social security net to continued downsizing of the state sector to allow for more rapid growth in the more productive and efficient private sector. The recent realignment in the Politburo following the National People's Congress (NPC) has also failed to deliver a clear blueprint for the future direction of economic policy. Given the multifarious pressures building in the economy over the medium-term, Global Insight is downgrading its economic rating from 2.50 from 2.75. The China phenomenon has largely been grounded in the principle of growth at all costs, but some of those costs may now be coming to bear.