- China’s central bank stepped in on three fronts in May – raising the cost of borrowing, increasing reserve requirements for banks and widening the daily trading band for the yuan. Despite these actions, monetary conditions in China are hardly restrictive.
- In the U.S., lacklustre economic growth is beginning to affect employment growth, a development likely to create headwinds for consumers at a time of surging gasoline prices and a continuing housing bust. The woes of the housing market have braked core CPI inflation.
- In Canada, job creation paused in April after one of the best quarters on record. Employment growth is likely to resume in the coming months, but at slower pace – a stronger currency means a greater need to raise productivity. We expect the current economic backdrop to keep Canada growing faster than the U.S. over the next two years on the strength of a large gap in domestic demand growth (3.2% vs. 1.8%). This is a recipe for a buoyant Canadian dollar.
World: China has yet to slow
China’s growth prospects remain impressive. Domestic expansion is strong and the trade surplus continues to swell. Despite Beijing’s recent interventions to slow the economy, monetary conditions remain far from restrictive.
The Chinese leading economic indicator for March, as reported by the OECD, shows the largest six-month rise since China joined the World Trade Organization in late 2001. As our top chart shows, its momentum is confirmed by metals prices and commodity-freight rates, both at new highs as these lines are written. The economy is so far refusing to follow the script of Beijing’s five-year plan, which called for 8% annual real growth. A recent tightening of lending conditions has yet to dent growth prospects.
In response, China’s central bank on May 18 raised its benchmark interest rate 18 basis points to 6.57%, the highest since November 1998. However, since inflation is now much higher than before, Chinese monetary policy is hardly restrictive. As our middle chart shows, the benchmark rate net of inflation is now 3.6%, compared to about 8% in 1998!
Neither is the exchange rate a significant restraint on the economy. Though the yuan broke 7.70 to the U.S. dollar in May – its strongest since the 1994 revaluation – it is up only 7% against the greenback since July 2005. And although the yuan has been appreciating against the USD, its real trade-weighted exchange value has barely budged since the beginning of the year, because it has been losing ground against the euro and other currencies. So overall Chinese monetary conditions have hardly tightened. As the bottom chart shows, our monetary conditions index for China – a weighted sum of changes in the real shortterm interest rate and the real effective exchange rate – has eased somewhat since the start of the year. In our view, further action will be required in the coming months to slow China’s growth.
In the meantime, China’s momentum has led us to upgrade our 2007 growth forecast for that country to 11% from 9%, and to raise our world growth forecast in consequence to 4.9% from 4.3%. We have also revised up our world forecast for 2008, to 4.3% from 3.9%, but continue to see global momentum fading in response to tightening by OECD central banks and Beijing’s ongoing restriction of credit.
