Barely a year ago, we were talking of China decoupling from the global economy. How do you see China performing in 2009?
We never subscribed to the theory of decoupling. If anything, ChinaÆs economy has become more dependent on global demand for growth. Developing the export sector has worked extremely well for China, as demonstrated by its strong economic performance over the past decade. However, in the midst of a global recession, it also makes for a challenging 12 months ahead.
Specifically, exports contributed 37% of ChinaÆs gross domestic product (GDP) growth in 2008, versus 18% in 1998, by our estimates. Given our expectation for a severe slowdown in the G7 economies û where we forecast a 2% contraction in 2009 û we believe China will experience -5% export growth this year. We subsequently forecast China to achieve GDP growth of 7% in 2009.
The single most important driver for the decline in GDP growth this year, in our view, is a fall in fixed asset investment (FAI). FAI is driven largely by Chinese companies, with the property, manufacturing and mining sectors accounting for around 60% of the total and government-sponsored investments accounting for around 15%.
Given the difficult outlook ChinaÆs companies face in light of the global drop in export demand and a weaker property sector, we see FAI growth falling from 26% in 2008 to 10% in 2009 and 8% in 2010. The property sector is also important to consider, given it has become a much larger contributor to GDP growth since 1998. That year, 7% of ChinaÆs GDP growth came from this sector. In 2008, this figure jumped to 13%. We expect property to weaken in 2009 as valuations decline and supply outweighs demand. Specifically, our China Property Developers survey shows the value of developersÆ investments falling by 25% this year.
Those are dire figures. How does the current economic crisis compare to the challenges of 1998?
In terms of the economic impact, 2009-10 is likely to be a more difficult period than 1998-99. This is primarily because we expect GDP growth in the G3 countries to contract by 2%-3% in 2009, compared to 3% growth a decade ago.
ChinaÆs export-to-GDP ratio has increased since 1998, making it more susceptible to the economic ebbs and flows of global demand. We estimate that for every percentage point deceleration in G3 GDP growth, ChinaÆs export growth slows by around seven percentage points, translating into a one percentage point decline in Chinese GDP growth.
With less money being generated by exports, companies will seek to cut costs and less will be invested in the domestic economy in the form of investments. However, net exports will likely remain in positive territory as imports fall, meaning ChinaÆs trade balance will stay positive this year. For example, while ChinaÆs exports have fallen about 17% since July 2008, the monthly trade balance has actually improved from $25 billion to $40 billion due to a large contraction in imports.
To what extent can China support economic growth through fiscal stimulus?
China retains the ability to significantly grow its fiscal deficit to stimulate domestic economic growth. This puts it in a unique position among its regional peers. However, we believe a choice must be made between accepting lower levels of economic growth than the current GDP growth target of 8% and an excessively large fiscal deficit of above 3% of GDP. We believe China will accept lower growth and leave room for further stimulus through a further increase in the fiscal deficit, if needed, in 2010.
The widely noted Rmb4 trillion ($587 billion) fiscal stimulus package announced in November 2008, will help stimulate investment growth. However it should be pointed out that the majority of the components in the package were already announced. The most accurate measure of fiscal stimulus is to look at the size of the fiscal deficit. We forecast the official central government budget will turn from a small surplus to a deficit of Rmb600 billion, or 2% of GDP, in 2009. Combined with the likely on-lending to local governments of Rmb200 billion, proceeds from new issuance of state construction bonds, and assuming a fiscal multiplier of one, the aggregate fiscal stimulus may boost GDP growth by 2.6% in 2009.
Is the credit crunch being felt in China?
From the perspective of consumer demand in Europe and the US being eroded, the credit crisis is having an impact. However, it is important to note that ChinaÆs banking system is awash with liquidity and retains ample capacity to lend.
Our fixed income research team estimates the banking system has surplus liquidity of around $1.3 trillion. We also think the reserve requirement could be reduced by another 200bp-300bp over the next 12 months to give the banking system even more capacity.
While corporate lending is expected to decrease, the announced government stimulus package provides a large number of attractive infrastructure projects for banks to lend to. Indeed, this could see infrastructure lending grow by 30% this year and will partially offset declines in loans to the corporate, property and consumer sectors.
What are the implications for monetary policy?
We see the PBOC reducing rates by another 108bp over three to four cuts in 2009. Along with a fall in reserve requirements, we expect the central bank to further relax monetary policy by reducing issuance of central bank bills, which will give banks even more lending capacity. Given these measures and the economic outlook, we expect overall loan growth to remain around 15% in 2009.
Deflation emerges as a material risk this year and we think the PBOCÆs rate cuts are likely to continue being front-loaded (ie: more aggressive cuts in the first half of this year compared with the second half). We see Chinese CPI inflation at zero and PPI inflation falling to -5% for the year.
So when do you expect economic growth to recover?
We expect a double-dip scenario for quarterly GDP growth over the next year and a half. We think the first trough will come in the fourth quarter of 2008 (official numbers are due for release January 20-23), when growth will have hit 6% due to a sharp decline in power production growth, continued capacity reduction in the steel and coal industries, and weak shipping rates. Growth should pick up again sometime in 2009 as the effects of the governmentÆs stimulus package and bank lending to a number of infrastructure projects is filtered through to the construction sector.
However, the decline in investment across the real estate, manufacturing, mining and export sectors, along with the subsequent spill-over effect on consumers, will likely result in another decline in GDP growth into the first half of 2010. This is when we expect the second trough of GDP growth û at around 6% - and following which, the final recovery should begin.
Investment growth would have decelerated for nearly two years by this time and capacity should have slowed enough for a shortage to emerge. This will in turn push up profit margins and induce stronger investment activities, driving fixed asset investment growth upwards and taking GDP growth with it by the second half of 2010.
How are you advising clients to position themselves given your expectations for economic growth?
In equity markets, we expect several themes to dominate this year. Counter-cyclical services such as healthcare and education could demonstrate resilience to the economic slowdown, while government-sponsored investments could boost demand for cement and railway construction.
Ongoing industrial consolidation could see certain steel, non-ferrous, and property companies become long-term beneficiaries, while electronics producers may significantly benefit from the governmentÆs subsidy programme for the sale of electronic goods to rural households.
In credit markets, our fixed income strategists see potential value in the US dollar bonds of certain Chinese companies. This is of course partly due to the widespread sell-off in cash bonds we have seen in credit globally û the widening basis between bond and CDS prices being an example of this. However, Asian credit spreads have traded wider than the global median. In the case of China, this discount ignores the fact that Chinese banks are largely unaffected by the subprime crisis and remain able and willing to lend. Many companies in China also have the implicit backing of state enterprises.
While the economic outlook has worsened, we believe there are names that have been oversold and which offer potential value as growth expectations are eventually upgraded.
Given the rise in prosperity over the past decade, is there a chance for social unrest in the months ahead?
We believe concerns of social unrest are overdone. While it is true that falling growth and rising unemployment will create certain pressures, this is unlikely to lead to widespread social unrest. Indeed, the 7% GDP growth we expect in 2009 is significantly above the 4% low seen in 1989 and is in the same range as that experienced in 1998-99.
Statistics show that social unrest events and criminal cases in China are not correlated with GDP growth. Instead, most events over the past few years are linked to land and environmental issues. ItÆs also important to note the progress of ChinaÆs social insurance system over the past decade. 80% of the urban labour force is now covered by unemployment insurance, as opposed to close to none in 1998, so unemployment is unlikely to be a cause of social unrest as it may have previously been.
Could China devalue the renminbi to support the export sector?
We do not think this will happen. While there will be some volatility against the US dollar in the short term, we expect the renminbi to be broadly stable in 2009 with a slight depreciation of around 2% to Rmb7.0 against the dollar.
Significant depreciation of the renminbi would not actually be positive for China. First, it could cause investors to sell renminbi-denominated assets, particularly in equities and the property market, and result in capital outflows. It could also spark competitive devaluation from other Asian exporters, which in the long term could hurt Chinese exports.
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