A close up on China’s economy seems appropriate given the current focus on the Beijing Olympic games. After hosting the games, many countries sink into recession as consumption and investment in the run up to the games drops and the post game miasma sets in. But this time, it might be more than a post game lack of spending. As the developed world sinks into recession, demand for China’s exports could also contract. Investors — which at one time not too long ago were focusing on the soaring Chinese economy and at the same time, prospects that the government would be able to slow growth to a sustainable level — are now looking to see what actions will be taken to keep the economy on an even keel. Below is a brief survey of key economic indicators.

Basic facts

Population — 1.321 billion

Major language — Mandarin Chinese

Monetary unit — 1 renminbi (yuan) (¥) = 10 jiao = 100 fen

Main exports — manufactured goods, including textiles, garments, electronics, arms

GDP growth — 10.1 percent on the year in second quarter

Central bank — People’s Bank of China

People’s Bank of China governor — Zhou Xiaochuan

Head of state — President Hu Jintao

Prime minister — Wen Jiabao

Source — The Economist, Chinaview

Growth

The economy continues to grow at a slower — albeit still rapid pace — of 10.1 percent, down from the second quarter of 2007’s torrid pace of 11.9 percent (on the year). China's economy is the world's fourth largest and even though GDP growth is at its the slowest pace since 2005, it is still the fastest among the world's 20 biggest economies. The data, in part, reflect the government’s concerted effort to slow growth to a sustainable level. Industrial production also has slowed. Growth here eased to a second quarter increase of 15.9 percent on the year from 18.4 percent just a year ago. Domestic demand is expected to strengthen thanks to strong wage growth which is expected to offset at least in part, a decline in net exports to GDP. Gross fixed investment is expected to ease thanks to higher interest rates.

With world growth shrinking around them, China’s authorities may have to adjust  tight policies to cater to individual regions and sectors that have found it difficult to survive with these policies. Already, monetary authorities have allowed the yuan exchange rate to decline; but while this could support growth especially for exporters, it also risks accelerating inflationary pressures.

Inflation

Consumer price data continue to offer good news — inflation has cooled somewhat and is expected to ease going forward. One of the reasons why consumer inflation is down since peaking in February is that food prices are easing. This can be attributed to the lack of flooding, a regular feature of the rainy season. Agricultural data show that prices rose only slightly while meat prices — a source of earlier price increases — actually dropped in July. But China raised the prices of oil products and electricity in late June and this will add to nonfood inflation going forward. While analysts expect nonfood inflation to continue to rise, the general downward trend in overall CPI inflation is expected to hold. Importantly, with inflation showing a soft-landing trend, inflationary expectations should start easing, lowering the risk of  more broad-based inflation and an inflationary spiral. This should provide some comfort to policy makers and allow overall macro policy to be more flexible, with the focus shifting toward preventing an excessive slowdown of the economy in response to external shocks.

Unlike consumer price pressures, those on the producer level continue to soar. The producer price index, which was up 10 percent on the year in July, could be a concern as costs filter through to consumer prices. As elsewhere, the main culprit in driving the PPI upward is increased domestic oil products and energy prices along with other price increases for commodities such as coal. But as global commodity prices respond to weakening demand and decline, these pressures are bound to ease, but with a lag.

Merchandise trade

July’s rebound in China’s merchandise trade surplus may have policy makers rethinking their concerns about economic growth. July’s trade surplus was $25.28 billion, up from June's $21.35 billion. July’s statements from both the Politburo and the People’s Bank of China dropped references to maintaining a “tight” monetary policy, although no monetary policy change was announced. This led to the perception that leaders are concerned about the export sector and are willing to ease monetary policy and slow the pace of yuan appreciation in order to lessen the burden on exporters. But should exports demonstrate continued resilience and inflation remain elevated, the recent policy stance may rapidly be reconsidered. China’s trade surplus with the U.S. for the first seven months of 2008 totaled $91.67 billion while the surplus with the European Union totaled $86.94 billion. The increases were 3.7 percent and 27.2 percent on the year.

Monetary policy

The People’s Bank of China, the country’s central bank, manages monetary policy primarily through interest rate and reserve requirement changes. Of late, both interest rates and reserve requirements have been lifted to stem inflation. The Bank also manages China’s currency — the renminbi or yuan — against a basket of currencies by setting a daily reference rate versus the dollar. China adopted its tight monetary policy late last year to prevent the economy from overheating. It was also guarding against a shift from structural price increases to evident inflation.

The PBoC last increased its policy interest rate in December 2007 to the current rate of 7.47 percent. Since then, the Bank has shifted its focus to reserve requirements to shore up monetary policy. It increased reserve requirements for the fifth time this year in June, this time to a record high of 17.5 percent. The increase is aimed at strengthening liquidity management in the banking system. The PBoC also said that corporate financial institutions in the worst earthquake-hit areas would postpone carrying out the regulation. The move was aimed at helping the country reduce inflationary pressures and to control excessive investment. Risks facing policy makers are many and include the global credit crunch and the ensuing decline in world growth, the widening gap between rich and poor in  China and worsening environmental conditions.

Yuan or renminbi

The currency continues to be held in a closely managed exchange rate system. However policy shifted just before the Olympics on July 25 from allowing the yuan to appreciate gradually against the dollar to one of allowing the currency to decline. The yuan touched a seven-week low after release of July's consumer price data on speculation that easing inflation will prompt policy makers to aid exporters by limiting currency gains. The currency began its recent decline after China's Politburo said that maintaining economic growth is as important as controlling inflation. As inflationary pressures ease, policy makers are more concerned about the effect of yuan appreciation on exports. When the yuan declines the amount of local currency exporters receive for their overseas sales increases and makes Chinese products more competitive in the global market.

China let the yuan strengthen after mounting criticism from the U.S. and Europe that the nation enjoys an unfair trade advantage. But some say that the recent fall of the Chinese yuan against the U.S. dollar underpins the government's commitment to allowing  two-way movement in the exchange rate while giving exporters breathing space in the face of rising operational pressures. However, there is a sizable group of analysts who would prefer to see the yuan strengthen further. It would keep China from importing inflation and it would increase the international purchasing power of the nation's people.

The PBoC manages the yuan against a basket of currencies by setting a daily reference rate versus the dollar, around which the local currency is permitted to trade by up to 0.5 percent on either side. The rate, set at 6.8659 per dollar on August 12, has been reduced on each of the past 10 days, the longest stretch of declines since the dollar peg ended in 2005.

Stock market

One would be remiss in a survey of this type without covering the stock index that went from the hottest to the coldest in terms of performance. China's stocks, the world's worst performers this year, continue to plummet as investors retreat on concern that slowing growth will hurt profits. The gauge, which surged sevenfold in the two years through 2007, became the worst performer among the world's 88 major benchmark indexes this year on concern rising fuel prices and central bank measures to curb inflation will hurt earnings. Airlines and especially local carriers have tumbled on concern that the government will allow the yuan's 26-month run of gains against the dollar to end. Unlike exporters, the local carriers are hurt by any weakening of the local currency because it inflates the value of their dollar-denominated debt when converted into yuan. So far in 2008, the Shanghai Composite has tumbled about 53.3 percent.

Bottom Line

China has been more willing to tolerate a stronger yuan than many investors expected. The Chinese currency is the best performer among the 10 most-active Asian currencies, excluding the yen, over the past year. However, China’s balancing act is daunting. On the one hand, the country must remain vigilant about inflation while at the same time maintaining economic growth. A stronger currency would help the People’s Bank of China control inflation while a lower yuan would make exporters more competitive and support growth. China appears to be siding with the U.S. Federal Reserve whose policies are putting recession risks ahead of the inflation threat.