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China has gradually become a manufacturing hub of the world by letting in capital and technologies and bringing its low cost advantages into full play. However, the growth of the manufacturing sector in China has slowed down in the past seven months with a rise in inflation. Any such development in the Chinese economy sends ripples across the globe. This slow down in manufacturing has raised a few questions: Where is the Chinese economy heading? What are the likely implications of this slow down?

Manufacturing forms the backbone of the Chinese economy, and its six predominant industries, comprising petrochemical, metallurgy, forestry, medicine, food and machinery, have contributed separately to the overall growth of manufacturing in China. The manufacturing sector recorded its slowest expansion in 28 months in June 2011, with the Purchasing Managers Index (PMI) falling from 52 per to 50.9 per cent at a rate of 1.1 per cent per month, according to the China Federation of Logistics and Purchasing (CFLP). The PMI index gives an image of overall activity in manufacturing, including output, order flows and pricing, with a figure above 50 indicating growth in activity and a figure below that level indicating a contraction.

Inflation in China has become a major problem today. The Consumer Price Index (CPI), a main measure of inflation, jumped to its highest in three years surging to 6.4 per cent in June 2011. Inflation soared in China because of the rise in global commodities’ prices, pressure for higher wages and also because of a severe drought this year. To control inflation, the government has implemented a set of measures.
The People’s Bank of China has lifted the reserve ratio of commercial banks to absorb excess liquidity in the system and curb inflation. In order to control the inflation rate, the banks have increased the reserve rate by 0.5 per cent since March for the fifth time. It is now 19.5 per cent for small banks and 21.5 per cent for big banks, which is the highest in China’s history. However, the Chinese government has assured that it will try to maintain the inflation rate at around 4 per cent for the next five years.

In addition to internal problems, external factors are also playing a key role in curbing the growth of the manufacturing sector. The country’s imports are mostly half-processed goods and raw materials. The rising international prices of oil, coal, iron ore and agricultural products have forced Chinese factories to pay more for importing these raw materials before processing them into finished products. Chinese exporters are finding it difficult to pass on rising costs to US buyers because as exporters of labour-intensive products, China is weak in bargaining for better prices.
Export demands for Chinese goods have also gone down in major Chinese export destinations; partly because of the impact of the tsunami on Japan, high unemployment in the US and excessive debt in European nations. These nations are attempting massive cutbacks in expenditure, thus decelerating the demand for Chinese goods.

It is worth highlighting that with so many global multinational companies looking to their China operations to drive growth, a material slow down in China would have a negative impact on earnings and cash flows generated by these multinational companies from their operations.

Moreover, the slow down has been quite comprehensive, as apart from manufacturing even the automobile and housing sector have witnessed weaknesses in recent months. The value of land sales in Beijing this year has dropped 75 per cent as has the value of car sales owing to the withdrawal of incentives by the government. Retail sales have tapered off somewhat since the pre-holiday peak. This is an important indicator because domestic private consumption has become an increasingly important part of the Chinese economy.

Contrary to the above developments, China is entering a decade of double-digit wage growth, which is a good thing for economic rebalancing. But its inflationary impact should not be discounted. If not handled well, it could lead to instability. In 1988, Zhao Ziyang was criticized by conservatives for managing price reforms (although the idea of price reform originally came from Deng Xiaoping). Hence, China's growth is likely to go down from the current 10 per cent to 5 per cent by 2020.

Thus this slow down in the manufacturing sector can be attributed partly to external factors and partly to state-engineering, as demonstrated by the Communist Party’s ruling Politburo’s indication that economic growth remains the top priority of the authorities. China is engaged in a tug of war, trying to encourage sustainable growth while struggling to control inflation.