Does China need a second stimulus?

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Yes, it sounds like a ridiculous question. Especially since we found out on Thursday that GDP grew 10.3% in the second quarter of 2010 from a year earlier. That’s a significant deceleration from 11.9% in the first quarter, but hardly worthy of concern. The government, in fact, has been trying to slow the economy down, mainly by curtailing bank lending, after raging growth last year sparked fears the economy could overheat.

But believe it or not, there’s a bunch of talk among economists that China might well try to stimulate the economy again. That’s because the concern about China’s economy has suddenly shifted. Now the worry is a hard landing.

How’d that happen? There is some feeling in financial markets that China might be slowing down too quickly. In June, retail sales, fixed asset investment and especially industrial production all surprised on the downside. Forecasters are predicting China’s growth in the second half of 2010 will be slower than in the first.

So some economists are expecting China to reverse its tightening stance, perhaps later in 2010, to add further lubrication to growth. There is speculation that China will allow the financial sector to exceed the $1.1 trillion target for new loans set earlier this year (yes, this is still a country that sets loan limits). That larger-than-expected expansion of credit could accelerate growth. Most analysts have also pushed off their expectation of when the central bank might raise interest rates until 2011. On top of that, the government recently announced major new infrastructure investments in the far west. And despite un-pegging the yuan from the U.S. dollar in June, Chinese officials have been making it very clear not to expect significant appreciation of its currency, which means Chinese exports will stay as competitive as ever.

But does China really need more stimulus? No one seems to expect China to slow down all that much in the second half – to 8% at the very worst. And there is a general agreement among economists that the “hard landing” fears are overblown. Qu Hongbin, an economist at HSBC, commented that China is experiencing “just a slowdown towards more sustainable growth; not a meltdown.” Thus there is no agreement among economists right now that China will loosen policy, let alone that it needs to loosen it.

So why would China throw more fuel on the economic fire? On some level we could just ask: Why not? With inflationary pressures abating and property prices inching downward for the first time in 16 months in June, Beijing’s policymakers have less reason to restrict growth. If you can get away with 10% growth without major consequences, there’s no reason not to go for it, right?

But on the other side, China’s possible need to stimulate growth again shows how little progress the country has made on reforming its economic structure over the past two years. China’s own leadership has stressed the need to “rebalance,” away from an invest-and-export growth model to one based more on domestic consumer spending. That would produce healthier, long-term sustainable growth.

However, the possibility that China may ramp up banking lending again – which goes into investment, not consumption – and maybe use other stimulus tools shows that Beijing feels it can’t count on naturally created domestic demand to keep growth rates up where it wants them. Thus we’re far from the rebalancing China needs. A renewed boost of stimulus would also lend more weight to those economists who are arguing that China’s growth has become overly dependent on debt accumulation. Here’s Mark Williams, senior China economist at research firm Capital Economics:

Our longstanding view has been that GDP growth will slow to around 8% y/y at the end of the year. It may be on course for worse. However, the government has ample room to ease policy. A relapse into policy stimulus should allow the government to avoid a hard landing. But it will also underline that China’s challenge of generating strong and sustainable domestic demand growth remains unresolved.

In other words, China’s economy is growing, but it may not be reforming.