Investments in China rose 26.7 percent in 2003, the largest single increase in a decade. The surge prompted Premier Wen and the Central Bank to raise their concerns about China's economy overheating. Fixed asset investments in the Mainland grew by 43 percent in the first quarter of 2003, while the growth in M2 monetary supply remained high at around 20 percent. The CPI, which has risen for six consecutive months, increased by 2.8 percent during the same period, indicating China is in a period of inflation.

Overheating

China's economy is like a train hurtling down the tracks at full steam. With every unexpected turn, or pitfall to a market economy, this locomotive risks derailing. The Central Government warned of possible overheating in the economy last year and pushed the alarm bell to try and slow things down, with little effect. This has raised worries that China might again slam on the "brakes" to slow the economy. The last time it did this, 1994-1996, investments screeched to a halt and interest rates hovered in the double-digits. The con-sequences of this can still be seen today as half-finished buildings stand in cities around the country like tombstones of the companies that fell in the crash. It also serves to remind the authorities how difficult it is to exercise macro economic adjustments.

The 9.9 percent growth in China's GDP for the first quarter last year signalled the economy was overheating, even though it slowed slightly during the outbreak of SARS in the second quarter. At the end of 2003, the Central Government was acutely aware that some industries, especially iron and steel, electrolytic aluminium and cement, were being over-invested in. For the first quarter of 2004, the situation worsened with new investments in these three industries doubling those for the same period last year.

Two possible reasons for this over-investment are that the market has high hopes that prices will keep rising, and that most of these investments are by irrational investors, or local governments. As the market is self-regulatory, market expectation is unlikely to be the culprit. But if speculators and local governments are stoking this furnace, then the consequences could be disastrous. According to surveys conducted by Mainland authorities, the lion's share of these investments are owned by the state, while those owned by private enterprises have been offered preferential land and taxation treatment by local governments. Such practices will result in investors defaulting on their loans in the not too distant future. This tells us that the government's tinkering with the economy has done more harm than good and illustrates just how far China has yet to go before it can step out of the shadow of a planned economy.

Macro control

In mid-2003, when China's economy was in deflation, the Central Bank noticed that the economy was prone to overheating as a result of the rapid growth of M2 supply. As such, it raised banks deposit reserve rate by one percentage point to adjust for this. Six months later, both the CPI and M2 supply showed no sign of slowing down. In March this year, the Central Bank further increased the deposit reserve rate of private commercial banks by 0.5 percent. In April, the four major state-owned commercial banks followed suit.

Since 1997, China has been implementing an active fiscal policy and the stimulus that this is having on the economy is obvious. Recently, it also tightened the issuance of treasury bonds to 110 billion yuan this year, down 30 billion yuan from the previous year.

With regards to China's monetary policy, the renminbi/US dollar peg has considerably undermined its initiative in using monetary measures as a means of macro economic control. Hong Kong claims not to have any monetary policy because of the linked exchange rate regime and the free flow of capital. Although China's capital account has yet to become fully convertible, its operating account is actually open. This means that China's capital, despite not being able to move as freely as that of Hong Kong's, enjoys high mobility. Given this scenario, it is risky for China to raise its interest rates, especially now that the interest rate for renminbi is higher than that for the US dollar. Conversely, it is easier for China to exercise macro economic control through raising banks deposit reserve rates. This would have minimal impact on investment sentiment as the interest rates for the yuan would remain unchanged.

Tightening investment approval procedures would also enhance macro economic control, but its success would depend on the cooperation of local governments. Yet, when local governments are investors of many key projects across the country, following such a policy would be against their own interests.

If economic indicators -- including investments, the CPI and M2 supply -- show no signs of improving in the months ahead, China may resort to raising interest rates. The Central Bank said it will consider increasing interest rates across the board when those for loans become negative numbers and inflation exceeds 5 percent. Room also exists for China to do so after the U.S. raises its interest rates.

All in all, no matter what macro control measures the Chinese government adopts, the ultimate goal is to ensure stable and continual growth of the Mainland economy.

Inflation on the Mainland has a limited impact on Hong Kong's economy, because Chinese imports account for a very small proportion of Hong Kong's CPI. However, whether China can maintain stable economic development, obviously, is a critical issue for Hong Kong.

Trade with China accounts for 20 percent of Hong Kong's GDP and our economy would be badly hit by any reduction in China's foreign trade. Since China opened up to investment over 20 years ago, the country has been quick to learn and has made incredible progress in such a short time. As the Central Bank started to take precautions to prevent the economy from overheating since mid-2003, this writer believes the Chinese Government will not allow the hard economic landing that we experienced in 1994-96 to repeat itself.