Index signals China’s economy still steady

Sturdy domestic demand will see it through global downturn

MOST economic indicators are backward-looking or at best coincident in nature.

Why? Some are due to their inherent characteristics. For example, employment numbers are backward-looking because employees normally lose their jobs only after economic activity has slowed down for some time.

Conversely, employers normally do not start hiring until they are sure that recovery has come and there will be a sustained increase in demand for their products or services.

Most economic indicators are not forward-looking because of the time lag needed to collect and compile the data.

Therefore, they can only measure past economic performance and cannot tell much of what lies ahead. For example, industrial production data for January would only be released in mid-February at the latest.

Fortunately, there are indicators that are forward-looking and are vital in gauging economic activity in the months ahead.

These indicators become particularly important at a time when the economy is making a turning point.

The purchasing manager index (PMI) is one such indicator. PMI is an extremely useful indicator in gauging economic health because its results are based on surveys that cover every aspects of economic activity.

In addition, PMI is usually released within the first few days of the month, hence it provides the badly-needed, timely information.

China started constructing its own PMI for the manufacturing sector only in 2005. The PMI for the non-manufacturing sector came three years later.

The manufacturing PMI is certainly the more famous of the two PMIs and receives significantly wider coverage.

However, this week, i Capital will focus on the less-noticed non-manufacturing PMI.

Although manufacturing is still the largest sector in China’s economy, it is heavily exposed to conditions outside of China. This explains why China’s industrial production has been plunging along with the plunge in exports.

Now, China is counting on domestic demand to carry it through the greatest global economic crisis in many decades.

Since the services sector and China’s in particular, predominantly serves the domestic economy, it is a good indicator in assessing domestic economic conditions.

The non-manufacturing PMI is a leading indicator on China’s services sector, and hence the country’s domestic economic conditions.

China’s non-manufacturing PMI is modelled primarily after the non-manufacturing PMI of the United States, with some modifications to suit China’s economic conditions.

The index is made up of 10 components: business activity, new orders, new export orders, backlog of orders, inventories, prices paid for intermediate inputs, prices charged, employment, supplier deliveries, and expectation of business activity.

Unlike the US, China’s non-manufacturing index does not have an import component because most of China’s service enterprises do not have any import activity.

However, China’s non-manufacturing PMI has two components that are not found in its US counterpart, i.e. expectation of business activity and prices charged.

China’s non-manufacturing PMI is derived from questionnaires sent to a sample size of 1,191 enterprises. Respondents are asked if they are experiencing higher, lower, or no change in activity in each of the 10 components listed above.

Once the results are tallied, a diffusion index is employed to quantify each of the 10 categories listed.

There is no overall composite index; instead, it uses the business activity index as a measure of the rate and direction of change in the services sector. An index value over 50% indicates growth, while below 50% indicates contraction.

The chart shows China’s non-manufacturing PMI in the past five months. As in the manufacturing PMI, China’s non-manufacturing PMI also fell off the cliff in November 2008.

However, it has risen above the 50% threshold in January 2009, indicating an expanding service sector. More importantly, it signifies that China’s domestic demand is expanding.

The fact that the expansion occurs in the month of the Lunar New Year carries even greater significance because in the short history of China’s non-manufacturing PMI, it has always fallen below 50% in the month of the Lunar New Year.

i Capital believes that this encouraging performance provides further assurance that sturdy domestic demand will see China through the current global economic turmoil.