Risks to East Asia from Overinvestment in China

National Institute Economic Review, October 2006 | Go to article overview

Risks to East Asia from Overinvestment in China


The major economies of East Asia continued to expand rapidly in the first half of 2006, with output in Japan up by 3 per cent relative to a year earlier, output in Korea up by 5.7 per cent, Taiwan GDP up by 4.7 per cent and an expansion of 6.6 per cent in Hong Kong. The economies all benefited from strong external demand from China, where GDP rose by 10.7 per cent in the first six months of 2006 relative to a year earlier, the fastest rate of growth in a decade. Asian exports have also been supported by global demand for electronics and IT-related goods and services. With a tighter monetary policy, domestic demand growth slowed in Taiwan in the first half of 2006, but rose broadly in line with GDP in the other major economies. However, we anticipate a moderation in domestic demand growth in Korea in the second half of the year, as authorities have introduced an aggressive anti-inflationary policy, which is expected to restrain residential investment and consumption growth.

While a tighter monetary stance in Korea and Taiwan will moderate domestic demand growth next year, we expect a strong positive contribution to growth from net trade, as import demand from China and Japan is forecast to remain resilient. We expect GDP growth in Korea to slow from 5 per cent in 2006 to 4 per cent next year, with growth of about 4 per cent per annum expected in Taiwan in both years and growth of 5 1/4 per cent per annum in Hong Kong. This compares to a projected rise of 10 1/4 per cent in China in 2006 and 9 1/4 per cent in 2007, as shown in figure 8.

[FIGURE 8 OMITTED]

While we anticipate a modest moderation in Chinese growth next year, with growth falling towards the average annual rate over the last decade, the Chinese economy is expected to remain strong over our forecast horizon. Investment growth in China has been exceptionally robust recently, with nominal fixed capital formation up by about 30 per cent in the first 8 months of 2006 relative to a year earlier. This suggests that 50 per cent of GDP is going into investment, compared to an average investment share of about 20-25 per cent in advanced economies. While it is difficult to convert the nominal rise in investment into real terms without a proper deflator, prices measured by the retail price index rose by only 0.9 per cent over the same period, although the retail price of construction materials, metals and electrical materials rose by 3.6 per cent. This suggests that the rise of investment in real terms has also been exceptional. The strong investment can be partially attributed to infrastructure and capacity expansion in anticipation of the Olympic Games in 2008, with a 43.9 per cent rise in investment related to culture, sports and recreation, but we have also seen exceptional rises in investment in real estate, mining and certain manufacturing sectors. While the authorities have tried to cool investment through a series of monetary restrictions and administrative measures--with a rise in interest rates, increase in commercial bank reserve requirements, and controls on power and land supply--reinvested profits have financed a large share of investment, so the impact of the policy measures will be limited. However, the imbalances in the Chinese economy point to risks of a significant investment driven slowdown, especially if there are fears of a trade war with the US or of a significant, albeit temporary, loss of competitiveness because of a revaluation. We investigate the impact that this is likely to have on our projections for China and the rest of the world in the box above.

Box C. The impacts of a collapse in Chinese investment

In order to evaluate the impacts of a Chinese investment collapse using
NiGEM, we reduce investment by 20 per cent endogenously in the first
quarter of 2007. After the initial shock, investment grows in line with
our model equation, which is driven by internal and external demand,
terms of trade shifts and the accumulation of net foreign assets. … 

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