Global Markets – 1st quarter 2007 : China powers ahead – but at what cost?

In 2006 the Chinese economy grew by 10.7%, which is the highest growth rate recorded since 1995, when growth of 10.9% was recorded. The main drivers of growth last year were investments and exports. After four consecutive years of growth above 10%, the government has been concerned about these consistently high growth levels. As a result, they introduced a range of measures in order to slow economic growth down. According to the Chinese National Bureau of Statistics commissioner, "these policies and measures proved to be effective and helped economic development avoid moving from speedy growth to overheating."

In 2006 the trade surplus in China reached a new record high of $177.47bn, which is up 74% on the figure recorded in 2005. In January, exports increased by 33% compared to the same month a year earlier, while imports increased by 27.5% - both numbers were ahead of expectations. These figures are likely to put more pressure on China to allow their currency to float more freely. "At present China only allows the Yuan to trade in a very narrow field against the dollar, but it has long pledged to allow the Yuan to trade more freely as and when this is possible."

However, not everyone is celebrating China's success. One view is that "...China's success is thanks to low wages, good infrastructure and enormous amounts of pollution. Factories can pollute at will, and the economic cost to the environment and to the health of the Chinese people has not been properly recorded. China's growth figures themselves come with a health warning." An article by Ma Jun, who recently wrote a report on a major study conducted on China's water resources, states that "among China's 600 cities, 400 of them have water shortages." He goes on to say, "there is a growing consensus that water shortages could be the bottleneck to China's economic and social development." Global warming, too, is not good news for China. Last summer, "the Yangtze River at Chongqing fell to its lowest level in a century." Another concern voiced recently was by Haruhiko Kuroda, president of the Asian Development Bank, when he "warned of increasing inequality across Asia." He commented that "rapidly growing economies like China and India have shown that although absolute poverty has been reduced substantially, the income gap between the poor and the rich has widened."

China will need to pay much closer attention to environmental issues as well as to the imbalances that exist if they wish to continue to grow their economy at a sustainable level.

REGIONAL COMMENTARY UNITED STATES OF AMERICA

The Federal Reserve kept interest rates on hold at 5.25% for the fifth consecutive meeting. It is interesting to note that this last "no change" vote was the first unanimous "no change" vote since August last year, when rates were placed on hold after being raised 17 times in 17 consecutive meetings from June 2004 to June 2006. Commenting after the announcement, the Federal Reserve stated that "recent indicators have suggested somewhat firmer economic growth, and some tentative signs of stabilization have appeared in the housing market." In addition, "readings on core inflation have improved modestly in recent months" and "inflation pressures seem likely to moderate over time." These comments served to fuel the growing view that rates are expected to remain on hold over the coming months, with the hope that they may even remain steady throughout 2007.

Although the new job number of 110 000 for January was disappointing, analysts believe that these figures still reflect "steady growth in the market." Unemployment in the US is currently at 4.6%. Another report confirmed that consumer sentiment reached a two-year high in January. Commenting on this data, a senior economist at TD Bank Financial Group stated that "this is one of the best outcomes that the Fed could have expected. There's not any threat of wage-push inflation but still a significant number of people employed."

EUROPE

The European Central Bank (ECB) raised interest rates by 0.25% in December to 3.5%. This brings to six the number of interest rate increases since December 2005. While rates remained on hold at the January and February meetings of the ECB, it is expected that they could be raised again (to 3.75%) as early as March. This view follows a number of hints from ECB President, Jean-Claude Trichet, about inflation where he has stated that "there is no room for complacency" and that "strong vigilance" was required in order to deflect "risks to price stability." Good growth figures for 2006 – of 2.7% compared to 1.4% in 2005 – are also fuelling the view that rates are likely to rise again soon. The European Commission recently raised the growth forecast for 2007 to 2.4%, from 2.1%.

Commenting after the news conference following the latest meeting of the ECB, Sandra Petcov of Lehman Brothers, stated that "judging by the prepared statement, the ECB seems to have strengthened its hawkish language, warning more explicitly than it had done in the past about upside risks from wages and stating explicitly that they will watch the current wage negotiations carefully." Other factors that point to an interest rate hike soon, are the fact that "unemployment has fallen in France and Germany, with consumer confidence remaining strong, despite Germany's decision to increase value added tax (VAT) from 16% to 19%." Lena Komileva of Tullet Prebon also believes that "growth looks likely to remain above trend in the first half of the year."

UNITED KINGDOM

Following a surprise 25 basis point increase in interest rates in January, the Bank of England (BoE) left interest rates unchanged at 5.25% at their meeting in February. The primary reason for the increase in January was to curb inflation, which reached an 11 year high of 3% in December 2006. Commenting after the BoE meeting on the 8th February, EEF chief economist Steve Radley stated "the Bank is right to hold its fire until the smoke clears and the impact of the recent rises becomes clearer. Another rise so soon after the last risks spreading unnecessary alarm amongst business and the consumer."

A report released by the BoE on the 13th February indicated that inflation was likely to remain above the target level of 2% if interest rates remained at their current level of 5.25%. Commenting on this report, Standard Chartered's Gavin Redknap said "the overall tone of today's report leaves us confident in our prediction that the next, and final hike in the Bank rate will come in May." The BoE stated in their report that "there is much uncertainty about the path for inflation, in both the near and medium term." They indicated that the better than expected inflation figure for January (2.7%) "does not mean that we can ignore concerns about inflation ahead."

It is reported that GDP growth for 2006 came in at 2.7%, which is slightly below Chancellor Gordon Brown's forecast of 2.75%. The service sector was the largest contributor to growth at the end of last year, with this sector expanding by 1% in the last quarter. "Within the services industry, distribution, hotels, catering and retailers expanded by 1.8%, marking the fastest rate of growth in almost five years." Growth in 2007 is expected to reach 3% by mid year and then decline to 2.8% for the remainder of the year, "because of lower spending by the government as well as consumers."

JAPAN

The Bank of Japan (BoJ) raised interest rates by 0.25%, resulting in rates doubling to 0.50% in February. This is the second interest rate increase in the region in six and a half years, with the first being in July last year. Official figures show that one of the key investment indicators – machinery orders – are increasing steadily. This supports the view that the economic recovery in Japan is corporate driven rather than consumer driven at present. The BoJ have made it clear that future increases in interest rates would by gradual. The current view is that changes are unlikely to be made to interest rates until at least the third quarter of this year.

In a recent development, it has been reported that Japan is "considering joining the US in filing a complaint with the World Trade Organization against China" over "claims that China, its largest trading partner, gives national firms preferential taxes, giving them an unfair advantage." Japan is currently investigating these claims. The matter was first raised by Susan Schwab – the US trade representative to China – she claims that China has used tax legislation to "encourage exports and discriminate against imports". This is clearly not good news for either Japan or the US.

SOUTH AFRICA

The Reserve Bank (SARB) increased domestic interest rates by 0.50% at their meeting in December, but left interest rates unchanged at their meeting in February. The Prime Lending Rate is currently 12.5%, while the Repo Rate is 9%. The reason given for the latest decision to leave interest rates on hold was that, on balance, the outlook for inflation has improved. Despite initial concerns that CPIX inflation would breach the upper level of the 3% to 6% target band in the first half of 2007, this figure has come in below forecasts and has remained at around the 5% level for the last three months. CPIX is now expected to peak at 5.6% in the second quarter of 2007. In addition, Producer Price Inflation (PPI) has declined from its peak of 10%. However, the Reserve Bank Governor cautioned that risks to the inflation outlook remained and that these would be closely monitored.

South African business has voiced concerns about the stability of the electricity supply, following a period of national electricity "load sharing" recently. In briefing parliament's public enterprises committee in mid February, Professor Anton Eberhard from the UCT Business School commented on the fact that South Africa currently has an electricity "reserve margin of just over half of what it should be." He said that "it's clear … that South Africa's security of supply is inadequate … the root cause was … policy uncertainty and the prohibition on Eskom building new capacity. A cabinet memo in 2001 prevented Eskom from building (new generating plants), and we had this critical period between 2001 and 2004 where there was this hiatus. The expectation was that private power would come in. In fact, nothing was done to facilitate that…it's not so much that the policy was basically wrong; the policy wasn't actually implemented." Thulani Gcabashe, chief executive of Eskom, said that the global benchmark for the reserve margin is 15% and that ours is currently "between 8% and 10%." This margin has been declining steadily since 2001, when it was at 25%. He said that the primary reason for the decline "included a growing Eskom customer base, which grew from 2 million in 2001 to 4 million this year; higher than expected GDP growth over the last three years; and a late start (in 2004) to the construction of new plants." SAPA reported after the briefing that "he said that it could take up to 5 years (2012) before Eskom's R97-billion investment in new generating capacity would raise the reserve margin to the benchmark 15%." Commenting on the power cut that took place on the 18th January, Professor Eberhard said, "the cost of this (power cut) was very significant. Eskom estimates the cost of unserved electricity to be about R75 000 a megaWatt-hour, and that was more or less a R3.75-billion hit to the economy." This is not good news for business, the domestic economy or international and local investor sentiment.

GENERAL – OIL AND GOLD
The oil price experienced volatility during the quarter under review, but ended the period almost in line with the previous quarter at R59.34 a barrel (compared to $62.86 per barrel at the end of November 2006). OPEC members reduced output in early 2007, with a view to stabilising prices. This was due to the price falling to below $50 a barrel recently after reaching highs of $78.40 in July 2006 (fuelled largely by geopolitical concerns). However, several factors have resulted in the recent upward movement in price – Occidental Petroleum, which produces 120 000 barrels a day in Elk Hills, California recently had to shut down 95% of its production due to a fire; renewed violence in Nigeria fuelled supply concerns from the region; increased demand for heating oil due to a cold "snap" in the US and comments that the US "plans to keep more oil for emergencies".

Gold continued its upward trend, ending the quarter under review at $671.95 an ounce, compared to $641.90 at the end of November. Commenting on the rising gold price recently, an investment house stated that "while the precious metals have always been notoriously difficult to predict, we would not be surprised if prices remain elevated for the foreseeable future."

THE 2007 / 2008 BUDGET
Trevor Manuel delivered his 11th budget speech on the 21st February. Moderate tax relief was announced, with the majority of benefits being focused on the lower to middle income groups. Some of the pertinent highlights, effective from 1 March 2007 (2008 tax year), are listed below: