With Olympic-driven development about to end and inflation rising, is growth going to slow?

John Ward of the Centre for Economics and Business Research analyses the macroeconomic picture, and overleaf EC Harris looks at the recent past and likely future of construction in the People’s Republic

01 / China and the UK construction industry

The rapid expansion of the Chinese economy in recent years has been a boon to the world economy. It has also created some problems, however, with the country’s seemingly insatiable appetite for raw materials driving global prices ever higher.

Sooner or later – probably sooner – the Chinese authorities are going to be forced to put the brakes on growth in order to bring down domestic inflation. This is doubly good news for UK building firms: construction costs will fall and a slowdown in raw materials price rises will give the Bank of England more flexibility to reduce interest rates.

02 / Chinese growth and raw materials prices

Church roofs, bus shelters and the propellers of the Royal Yacht Britannia might appear to have little in common, yet all have been plundered by thieves cashing in on the meteoric growth in raw materials prices.

According to the International Monetary Fund, between 1995 and 2008 the price of zinc increased 130%, copper 253%, lead 256% and iron ore a staggering 368%.

This across-the-board hike in world commodity prices has one principal driver – China’s economic growth. In less than 10 years, the size of the Chinese economy has doubled. Its contribution to world GDP is now second only to that of the US, if comparison is made on a purchasing power parity basis (an adjustment that accounts for the relative purchasing power of different currencies).

China’s economy has rested on a massive programme of industrialisation and infrastructure development: two power stations open every week. This programme has placed a massive demand on the global supply of raw materials and commodities, resulting in rapidly increasing prices.

The graph below illustrates this clearly. The dark green line shows the size of the Chinese economy each year (plotted against the left-hand axis) and the light blue and purple lines show indices of raw materials and metals prices (plotted against the right-hand axis).

03 / The prospects for inflation

China’s economic growth is not expected to change significantly as the build-up to the Olympics and recovery from the recent earthquake drive further construction. However, it will change after the Olympics.

Chinese inflation reached a 12-year high in February, at 8.7%. It has dropped somewhat since, and the latest figures this week show that prices rose 7.7% in the month to May. However, this is considerably higher than the inflation target of 4.8% set by the government for 2008.

The authorities recognise the need to bring down inflation and have focused on increasing the required reserve ratio – the proportion of banking deposits that banks must keep in their reserves. The higher the ratio, the less money there is sloshing about in the economy and so, in theory, the lower the rate of inflation. The reserve ratio has been raised 14 times in the past year, and the latest hike brought it up to 17.5% by the end of June. A year ago it was 11.5%.

On the other hand, real interest rates (taking into account the impact of inflation) remain negative. From this perspective, Chinese monetary policy looks lax. It is likely that the anti-inflation campaign will step up a gear after the Olympics.

The case against raising interest rates is that it may spark considerable inflows of “hot money”, especially from the US. Hot money is capital that can be moved at short notice between countries to exploit differences in available returns; in effect, the interest rates in each country adjusted for changes in exchange rates between when the capital is invested and when capital gain is realised. An influx of hot money would increase demand for the Chinese currency and make Chinese exports less competitive.

However, the decreasing likelihood that the US Federal Reserve will make further interest rate cuts makes it more attractive for hot money to stay in the US. So it would not be surprising to see a sustained period of interest rate hikes by the Chinese authorities – at least 1% higher by the end of the year.

Moreover, this monetary tightening is likely to come at the same time as the Olympics overhang hits. In recent years, Chinese economic output (GDP) has been biased towards investment. As a share of total economic output, investment has consistently accounted for about 40% since 2000. The equivalent UK figure is about 18%, and even India, the other fast-growing Asian superpower, has been closer to 33%. With so much investment in recent years – at least £20bn for the Games themselves – further expansion in productive capacity is unlikely to be necessary. This will further weaken the economic outlook.

Consequently, the Chinese economy is forecast to slow in the second half of 2008, and real GDP growth of 7% can be expected in 2009, compared with the 8-11% figures seen since 2002.

Of course, this is a relative slowdown: many countries can only dream of economic growth of 7%, let alone 7% growth during a downturn. Nonetheless, in the context of recent Chinese history, this is significantly slower.

04 / What does this mean for the UK construction industry?

If the Chinese economy does slow, this will provide two boosts to the UK construction sector. First, the prices of construction materials bought on internationally traded markets, such as steel, copper and aluminium, are likely to come down from their recent peaks. For instance, aluminium can be expected to fall by about 10% from its average 2007 price over the next two years, copper by about 15% over the same period and steel by as much as 20%.

But this is not all. Rapid Chinese economic growth has not only been behind the rise in the price of some construction materials, it has also been a significant driver of recent increases in general economy-wide inflation in the UK, particularly through its impact on the oil price. A slowing Chinese economy would reduce some of these inflationary pressures, and it is not inconceivable that the price of oil could come down to about $80 a barrel by the end of next year. Such an outcome would provide the Bank of England with the opportunity to reduce interest rates, bringing a sigh of relief across the construction sector.