Credit tap kept open as economic risks persist

China's economy is rebounding even as decelerating forces remain. The cooling housing market is China's biggest downside risk, but its effects have been ameliorated so far by government actions and a bounce in net exports. The government continues to fine-tune the economy, which increasingly means shifting toward monetary easing, and this should be sufficient to keep growth close to the 7.5 percent target this year.

Risks remain weighted to the downside. The current boost from net exports is temporary, and a rebound in imports is expected to subtract from growth in coming months. Although there are some signs pointing to a cyclical rebound in housing, any recovery is likely to be modest, and it will continue to weigh on the economy through the rest of 2014.

Demand for housing is constrained by a variety of government restrictions and expectations among potential buyers that excess inventories will push developers to cut prices. Sales volumes across the country have fallen close to 10 percent from a year ago, and new housing starts are 20 percent lower. Prices of new apartments fell in 55 of 70 major cities across China in June. Prices nationwide are still 4.2 percent above a year ago, but the trend is down.

The 2013 housing boom was seen primarily in large cities ranked in the top tier by Moody's Analytics — Beijing, Guangzhou, Shanghai and Shenzhen. They have been the target of the most restrictive cooling measures, with the highest mortgage down payments, outright bans on third home mortgages and a 20 percent capital gains tax in Shanghai and Beijing, among other measures.

Although they avoided the worst of the government's restrictions, lower tier cities are performing worse than their counterparts. New apartment prices in cities in tiers two through four are rising below the national average. House prices in tier one cities have been more resilient because of high latent demand. Reversing the restrictions could cause a rebound, which is the key reason why the government is wary of enacting stronger stimulus measures, such as a broad reserve ratio cut.

In the meantime, the central government has endorsed a variegated approach to housing. A handful of smaller cities have begun unwinding housing restrictions. The coastal city of Wenzhou just announced the full removal of restrictions on first and second homes. If the 2011-12 cycle is any guide, a gradual removal of housing restrictions across the country, coupled with price cuts as developers shift inventories and boost cash flow to pay down debt, will cause the market to turn and enter a cyclical rebound.

　　Second-quarter rebound

Economic activity picked up slightly in the second quarter, thanks to net exports and government stimulus measures. Industrial production and fixed-asset investment both accelerated in June on increased activity related to utility and infrastructure investment.

Local governments have been at the forefront here. Cuts to banks' reserve ratios for agricultural and small-business lending, increased rail and utility investment, and value-added tax rate cuts also have helped.

China's merchandise trade surplus rose to US$86 billion in the second quarter, from US$17 billion in the first and from US$66 billion in the second quarter of 2013. This contributed 0.9 percentage point to nominal GDP growth, compared with a 1.2 percentage point decline in the first quarter. Exports to major destinations, outside of Japan, are increasing at a solid clip.

Some of this reflects the steady global recovery, but some also reflects the slightly weaker yuan, a range of stimulus measures such as an expansion of an export loan insurance program, and overcapacity in some industrial sectors causing producers to export surplus inventory. For this reason, exports of price-sensitive goods, such as clothing, toys and steel, are outperforming electronics and other higher value-added manufactured goods.

Electronic and other technology exports could rebound if a recent increase in technology component imports is any guide. That might be just as well since factors such as the yuan's recent appreciation and dropping steel inventories suggest the current export bounce will not last. Production levels are growing much closer to demand.

Another reason for the trade gains is sluggishness in China's imports. This is mostly an issue of raw materials and hard commodities, and an upturn in China's investment cycle will cause a recovery in import volumes and prices, pushing up the import bill.

The government's fine-tuning and the bounce in net exports caused a slight uptick in second-quarter GDP growth to 7.5 percent. The economy grew 2 percent, quarter-on-quarter, and 8.2 percent on an annualized rate. That is within China's potential growth range.

The statement accompanying the second quarter GDP data struck a relatively confident tone, highlighting that the economy showed ''good momentum of stable and moderate growth'' and that the task for the ''next stage'' was to ''deepen reform, promote innovation, adjust the economic structure and transform development patterns." This is an upgrade from the first quarter statement, which noted that the economy ''still faces downward pressure.''

Uneasy money

Premier Li Keqiang in June declared the economy is on track to make the 7.5 percent growth target. He stated that it had met 60 percent of the 10-million jobs target in the January-May period. But there seems to be widespread unease about the sustainability of the recovery. The China Beige Book shows that many firms were reluctant to apply for credit and invest in the second quarter, which corroborates a central bank survey of banker confidence showing weak loan demand among entrepreneurs. Purchasing managers are mildly optimistic on net, but mostly about the export situation.

Forward indicators of the economy, such as the National Bureau of Statistics leading indicator and the OECD composite leading indicator, point to a slide toward below-trend growth over the next few months. Housing and net exports will weigh on growth, meaning that growth will likely be driven by further investment in infrastructure.

A lack of enthusiasm about the recovery may be the result of the government's increasing reliance on more credit to drive growth. Aggregate financing — a sum of bank lending, foreign currency loans, trust loans, and other ''shadow'' forms of financing — was equivalent to 35 percent of nominal GDP in the second quarter.

The saying "as the state advances, the private sector retreats" gained currency in China after the 2008 global financial crisis. Free market reformers bemoaned the influence of those favoring a strong, activist government to drive the economy.

With the need to deflate a housing bubble, the underdeveloped consumer and financial sectors, and a still-lackluster global recovery, China will continue to channel credit to fund official infrastructure investment to drive growth.