China Economic Outlook

chapter 1 2

Political Outlook Economic Outlook

SWOT Analysis Strengths China is the fastest-growing major economy in the world, and this has lifted hundreds of millions of people out of poverty over the past generation. China has a massive trade surplus, and its US$1.9trn of forex reserves serve as a major cushion against external shocks. China’s economic policy-makers are committed to continuing their gradual reform of the economy.

Weaknesses China’s economy has been growing too fast for its own good. This has led to major imbalances, and environmental degradation. China’s dependency on exports to boost growth has made it vulnerable to the global recession. Private consumption remains weak, at less than 40% of GDP. The close relations between provincial leaders and local businesses are fostering corruption, and are making it harder for the central government to enforce its policies.

Opportunities China’s economic growth is slowly becoming more broad based, with domestic consumption likely to rise in importance vis-a-vis exports, thanks to a middle class of 200mn-300mn people. China’s ongoing urbanisation will be a major driver of growth, and new cities will emerge in the less-developed inland provinces. The UN forecasts China’s urban population rising from 40% in 2005 to 73% in 2050, a gain of 500mn people. As China moves up the value chain, it will develop its own global brand name companies, fostering innovation and growth.

Threats There are fears that the global recession of 2008-10 will mean an end to China’s double-digit growth rate. Despite a halt to the appreciation of the yuan currency, the recession is leading to job losses in China’s export sector, and thus increasing social instability. Relatively high food price inflation could become structural, as farmland is lost to industry or pollution, and farmers migrate to cities.

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CHINA Q2 2009

BMI Economic Risk Ratings The Chinese government has decided to train one million unemployed university graduates over the next three years in addition to providing loans to companies who hire them. According to Chinese news agency Xinhua, the government will provide loans of up to CNY2mn (US$292,400) to labour-intensive companies who recruit graduates, and will provide a grant of CNY50,000 (US$7310) to graduates who want to start their own companies. However, with an estimated 6.1mn college students expected to graduate in 2009, the government’s efforts are unlikely to be enough at a time when unemployment is continuing to rise.

14

China Hong Kong Taiwan Thailand Malaysia South Korea New Zealand Philippines Indonesia Japan Australia India Bangladesh Cambodia Vietnam Pakistan Sri Lanka Singapore Laos North Korea Myanmar Regional average 63.0

S-T Economy 93.5 82.9 81.3 74.8 73.8 71.9 70.6 68.1 64.4 63.8 63.1 62.5 54.2 54.0 48.3 43.8 37.3 Global average 62.4

Rank Trend 1 = 2 = 3 = 4 = 5 6 = 7 = 8 = 9 = 10 = 11 = 12 13 = 14 = 15 16 = 17 = 18 19 = 20 = 21 = Emerging Markets average 59.8

Taiwan Malaysia Hong Kong South Korea China Australia New Zealand Thailand Japan Indonesia India Vietnam Philippines Bangladesh Sri Lanka Cambodia Pakistan Singapore Laos North Korea Myanmar Regional average 63.0

L-T Economy 77.9 75.7 75.2 73.9 71.6 71.1 68.0 67.9 65.9 62.1 61.8 57.8 55.4 53.8 50.5 49.3 45.0 Global average 62.4

Rank Trend 1 = 2 = 3 = 4 + 5 = 6 = 7 = 8 = 9 = 10 = 11 12 + 13 = 14 = 15 = 16 = 17 18 19 = 20 = 21 = Emerging Markets average 59.8

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ECONOMIC outlook

Economic Activity Q408 GDP Data Confirm Our Fears As anticipated, Q408 GDP data confirmed that China is far from immune from the unfolding global recession, with real growth dropping to 6.8% y-o-y. This marked the weakest outturn in seven years and dragged full-year growth to 9.0%, a sharp decline from the 13.0% recorded in 2007 and the first time since 2002 that the world’s third largest economy had failed to register double-digit headline growth. With things expected to get worse before they get better, we are anticipating further grim news from China in H109, and reiterate our below-consensus 5.6% growth forecast for the year.

BMI View Economic growth dipped to a seven-year low of 6.8% in Q408, dragging full-year growth for 2008 to 9.0% – a sharp decline from the 13.0% recorded in 2007 and the first time since 2002 that the world’s third-largest economy had failed to register double-digit headline growth. However, the bad news does not stop there. Recent macroeconomic data has shown that

Indeed, trade data for December revealed that both imports and exports suffered a second consecutive month of contraction, with exports falling by 2.8% y-o-y, accelerating from the 2.2% decline recorded in November, while imports plummeted by 21.3% y-o-y having dropped by 17.9% in the previous month. Notably, Exports to the US (which purchased 17.7% of China’s total exports in 2008) fell by 4.1% y-o-y in December to compound November’s 6.1% decline, while shipments to the EU (which, with a 20.5% share, was

economic activity continues to cool, and we do

China’s single biggest export destination in 2008) fell 3.5% y-o-y in December after remaining flat in the previous month.

to slow to 5.6% in 2009.

not foresee any turnaround in fortunes for the Chinese economy until the second half of 2009 at the very least, highlighting that is more likely to be 2010 before a recovery gets under way. With this in mind, we expect real GDP growth

We have recently revised down our 2009 growth forecasts for both the US and the EU – from -2.0% and -1.6% to -2.3% and -2.5%, respectively – implying that export growth is likely to remain in negative territory (or at least remain very weak) over the near term. Meanwhile, imports are likely to follow suit as commodity prices continue to trend lower, demand for inputs for manufacturing exports decline and domestic demand remains sluggish.

Domestic Demand Unlikely To Come To The Rescue

Worst Outturn In Seven Years Real GDP (chg % y-o-y)

To be sure, although not as bleak as recent trade data, leading indicators of domestic demand are painting an increasingly bearish picture. Retail sales grew by 19.0% y-o-y in December, and although this is still a strong number, it nevertheless marked a third consecutive month of slower growth having reached 23.2% in September 2008. Meanwhile, urban fixed asset investment (FAI) growth slowed to 26.1% in 2008. Once again, while this is still an impressive outturn, December nonetheless represented a third straight month

11 10 9 8 7 6 5 4 3 2 1 0 Q101 Q201 Q301 Q401 Q102 Q202 Q302 Q402 Q103 Q203 Q303 Q403 Q104 Q204 Q304 Q404 Q105 Q205 Q305 Q405 Q106 Q206 Q306 Q406 Q107 Q207 Q307 Q407 Q108 Q208 Q308 Q408

of slower growth after peaking at 27.6% in the January-September period. Moreover, real estate investment continued its rapid slide in December, with growth decelerating for a sixth month in a row to 20.9% y-o-y, having hit a record high of 33.5% in June.

14 13 12

Souce: National Bureau of Statistics

Property price growth dipped into negative territory in December, and leading property market indicators suggest that the slowdown has further to run. The quantity of land purchased – an indicator for future property development – fell by 5.6% y-o-y in November, according to the most recent data available from the National Statistics Bureau, compounding the previous month’s 2.6% decline, while growth of floorspace of commercial buildings sold spent a ninth straight month in negative territory after it contracted by 16.5% y-o-y in November. Perhaps most worryingly though is the fact that despite growth of floorspace of commercial buildings under construction continues to slow (it registered growth of 18.7% y-o-y in November, down from a peak of 32.1% in February 2008), it is still expanding. Business Monitor International Ltd

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CHINA Q2 2009

Downturn Has Further To Run

Property Sector Leading Indicators (Top) and Prices (Bottom), % chg y-o-y 40

This means that the gap between supply and demand is rising at a rapid rate, implying that property prices will remain subject to strong downward pressure throughout H109. Given that real estate investment accounts for approximately 20% of all urban FAI, and that FAI in turn accounts for more than 40% of GDP, this bodes very ill for headline growth.

30 20 10 0 -10 -20 -30

Jul-08

Sep-08

Mar-08

May-08

Oct-07

Dec-07

Apr-07

Jun-07

Aug-07

Feb-07

Jul-06

Sep-06

Mar-06

May-06

Oct-05

Dec-05

Nov-06

Floorspace Of Commercial Buildings Under Construction Land Area Purchased Floorspace Of Commercial Buildings Sold

-40

14 All Property New Homes Existing Homes Non-Residential

12 10 8 6 4 2 0

Oct-08

Dec-08

Nov-08

Sep-08

Aug-08

Jul-08

Jun-08

Apr-08

Mar-08

May-08

Jan-08

Feb-08

Dec-07

Nov-07

Oct-07

Jul-07

Sep-07

Aug-07

-2

Source: National Bureau of Statistics, National Development and reform Commission

Consumer Price Growth To Follow Producer Prices Into Negative Territory Consumer & Producer Price Inflation (%)

12 Consumer Price Inflation Producer Price Inflation

6 4 2 0

Sep-08

Jan-08

May-08

Sep-07

May-07

Jan-07

Sep-06

May-06

Jan-06

Sep-05

Jan-05

May-05

Sep-04

-2 Jan-04

Can The Government Save The Day? In view of the increasingly dismal outlook for the Chinese economy, we are expecting further aggressive monetary easing and fiscal stimulus to be rolled out as Beijing tries to avoid a doomsday scenario. Indeed, given that producer price inflation dipped into negative territory on a y-o-y basis in December, contracting by 1.1%, and that consumer price inflation – which slowed to just 1.2% y-o-y in the same month – is likely to follow suit in Q109, the People’s Bank of China (PBoC) certainly has scope to slash interest rates.

10 8

May-04

Furthermore, with investment in manufacturing contributing an even bigger slice to urban FAI than real estate, there seems little reason to hold out hope that FAI growth in 2009 can maintain anywhere near the 20%+ levels witnessed during China’s recent boom period in 2009. Although industrial output growth rebounded slightly in December from the record low of 5.4% y-o-y registered in November, it still remained lacklustre at just 5.7%. To put this in context, full-year average industrial output growth in 2007 was 18.0%, and was 16.1% in H108, and official sources have been quoted as saying that factory output needs to grow at at least 12% if the government is to meet the 8% growth target which is widely seen as the minimum required to ensure sufficient job creation. Meanwhile, yearto-date growth in secondary industry slowed to 9.3% in Q408, according to the National Bureau of Statistics, marking a sixth straight quarter of decelerating growth after peaking at 13.7% in Q207.

Source: National Bureau of Statistics

However, given the lagged effects of any such moves, and the immediacy of China’s problems, we fear that they will not have the desired effect. Indeed, with approximately CNY3.1trn of China’s mammoth CNY4trn (US$585bn) fiscal stimulus package earmarked to be spent on infrastructure projects in their various guises, it seems difficult to see how Beijing will be able to successfully front-load its additional spending given the length of time required to put construction projects into action. Thus, although we’re not saying that government initiatives will have no effect, we maintain our 5.6% growth forecast for 2009.

table: ECONOMIC ACTIVITY 2005

2006

2007

2008e

2009f

2010f

2011f

2012f

2013f

Nominal GDP, CNYbn [1]

18869.2

22164.8

24973.5

26844.5

28634.6

30518.2

32859.8

35415.2

38063.8

Nominal GDP, US$bn [1]

2303.60

2780.90

3285.00

3864.90

4170.50

4522.30

5095.90

5712.90

6344.80

Real GDP growth, % change y-o-y [1]

10.4

11.9

13.0

9.0

5.6

6.8

7.9

7.6

7.6

GDP per capita, US$ [1]

1762

2116

2459

2870

3072

3305

3696

4111

4531

1307.60

1314.50

1336.10

1346.80

1357.50

1368.20

1378.90

1389.60

1400.30

Industrial production index, % y-o-y, ave [1]

16.3

16.4

18.0

12.9

6.9

9.0

11.1

10.6

10.1

Unemployment, % of labour force, eop [2]

4.2

4.1

4.0

4.2

4.8

4.4

4.4

4.3

4.2

Population, mn [1]

Notes: e BMI estimates. f BMI forecasts. Sources: 1  National Bureau of Statistics, BMI. 2  National Bureau of Statistics.

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ECONOMIC outlook

Beijing’s Nightmare Coming True

Grim Prospects For Employment

Purchasing Managers’ Index Employment Sub-Index 56 54 52 50 48 46 44

More worryingly, however, are previous comments made by Liu which suggested that growth below 7% could trigger social unrest. We are now already at this point, and with mounting anecdotal evidence and official data highlighting the rapidly weakening of the country’s job market, social unrest is worryingly close to becoming a reality. Indeed, an

Jul-08

40 Oct-08

Apr-08

Jul-07

Jan-08

Oct-07

Jan-07

Apr-07

Jul-06

Oct-06

Jan-06

Apr-06

Jul-05

Oct-05

Jan-05

42

Apr-05

Our concerns appear to be increasingly echoed by government officials, with Liu Mingkang, chairman of the China Banking Regulatory Commission, describing the task of meeting the official 8% growth target as ‘exceptionally arduous’, and central bank governor Zhou Xiaochuan also admitting that downside risks exist. Moreover, the State Information Centre (SIC), a government think tank, has said the FAI may decelerate in 2009 despite Beijing’s ambitious spending plans. According to the SIC, the government funded only 3.88% of FAI projects in 2008, with 77.43% financed by companies’ own funds and the rest by bank loans and foreign investors. Amid the current global economic climate, Chinese and foreign companies alike are very unlikely to be able to increase capital spending to the extent required. The SIC has said that while local governments were eager to start new projects, most planned investments would stay on the drawing board without corporate support.

Source: National Bureau of Statistics

estimated 10 million migrant workers have reportedly already lost their jobs, while the latest purchasing managers’ index revealed that employment prospects weakened further in December with the employment sub-index falling to 43.3 from 44.3 in November. While many other governments will be facing similar pressures, the lack of any outlet for citizen dissatisfaction in communist-ruled China makes the current situation a particularly volatile situation.

Fiscal Policy Fiscal Shortfall To Widen Sharply In 2009 Having recorded a surplus of CNY1.2trn in the first eleven months of 2008, China’s full-year budget balance plunged into the red in December as the combined spending of central and local governments climbed by 30.8% y-o-y to CNY1.66trn (US$243bn). With revenues lagging way behind at CNY325bn (a meagre 3.3% increase over the equivalent year-ago period), a CNY111bn full-year deficit was recorded, reversing the CNY154bn surplus registered in 2007.

BMI View China’s fiscal balance swung sharply into deficit in December 2008 as Beijing ramped up spending in the final weeks of the year in an attempt to counter the ongoing economic slowdown. With economic activity forecast to slow further in 2009, China’s fiscal shortfall is expected to widen from the 0.4% of GDP estimated for

While this was equivalent to a still very manageable 0.4% of GDP, it nonetheless represents a sharp reversal in fiscal policy direction. Since reaching a multi-year high of 2.6% of GDP in 2002, China’s fiscal deficit had narrowed in each of the following four years, and actually reverted into surplus for the first time in over 18 years in 2007. Thus, the 2008 budget figure signifies an end to fiscal consolidation and the dawning of a far more aggressive approach to fiscal policy. Indeed, December’s data underscores Beijing’s intent to throw all its available resources at propping up rapidly sagging growth, and with this in mind, we expect to witness a sharp widening of China’s budget deficit in 2009.

2008 to 2.6% in 2009, as the government tries to spend its way out of the current crisis. Meanwhile, with such a heavy focus on infrastructure spending, we continue to question the efficacy of the government’s CNY4trn (US$585bn) fiscal stimulus package.

China has already announced a CNY4trn fiscal stimulus package aimed at boosting economic activity over the next two years, and Prime Minister Wen Jiabao was quoted in Business Monitor International Ltd

17

CHINA Q2 2009

the Financial Times as recently as February 1 saying that Beijing ‘may take further new, timely and decisive measures’. Indeed, with real GDP growth slowing to a seven-year low of 6.8% y-o-y in Q408, and 20 million migrant workers having lost their jobs, according to Chen Xiwen, the director of the Office of the Central Rural Work Leading Group, it appears that further fiscal stimulus is very much on the cards. At the same time, the Chinese government must contend with slowing revenue collections. Among a number of moves to ease the tax burdens on its citizens, Beijing has cut income and stock-trading taxes, lowered taxes on property transactions, scrapped the withholding tax on interest income and raised rebates for exporters, while taxes gathered from corporates also continue to weaken as corporate profits deteriorate in line with softening economic activity. Against this backdrop, we are forecasting China’s fiscal deficit to widen sharply in 2009, to CNY740bn (or 2.6% of GDP), as revenue growth slows from 19.4% to 17.0% and expenditure growth moves in the opposite direction, accelerating from 25.3% to 26.8%. However, with risks to government spending weighted to the upside, and risks to revenues firmly skewed to the downside, we highlight that China could be facing a far larger shortfall.

Consolidation Efforts Taking A Backseat Budget Balance (% of GDP)

1 0.5 0 -0.5 -1 -1.5 -2

Nonetheless, we remain confident that China’s budget position will remain within manageable parameters. The central government has been running a fairly conservative fiscal policy in recent years, meaning that scope to expand expenditure exists, even at a time when revenues are forecast to suffer. Indeed, central government debt has been estimated at around 18% of GDP at the end of 2008, suggesting that additional borrowing would be a viable option to fund the anticipated rise in government spending. Moreover, Wen has said that a plan to use of some of China’s foreign currency reserves for domestic purposes is under discussion, and with more than US$1.9trn at its disposal, Beijing’s reserves should provide an ample source of extra funds.

2013f

2012f

2011f

2010f

-3

2009f

2007

2008e

2006

2005

2004

2003

-2.5

e/f = BMI estimate/forecast; Source: Ministry of Finance

Efficacy Of Stimulus Package In Question The recently published breakdown of China’s mammoth fiscal stimulus package has revealed that, in line with our expectations, the majority of the spending will be channeled into infrastructure projects, with 45.0% of the CNY4trn package to be spent on railways, highways, airports and power grids, 25.0% to be spent on post-disaster reconstruction and 9.3% on rural development and infrastructure. This equates to approximately CNY3.1trn being spent on infrastructure projects in their various guises. Although this will have significant positive effects on employment and the construction industry over the near term, it is, as we have previously suggested, likely to have a far more table: FISCAL POLICY  

2004

2005

2006

2007

2008e

2009f

2010f

2011f

2012f

2013f

Fiscal revenue, CNYbn [1]

2639.6

3164.9

3873.1

5132.2

6130.0

7172.1

8319.6

9318.0

10417.5

11594.7

Fiscal expenditure, CNYbn [1]

2848.7

3393.0

4021.3

4978.1

6240.0

7912.3

9075.4

9910.4

10871.7

11893.6

Budget balance, CNYbn [1]

-209.0

-228.1

-148.2

154.1

-110.0

-740.2

-755.8

-592.4

-454.2

-298.9

-1.3

-1.2

-0.7

0.6

-0.4

-2.6

-2.5

-1.8

-1.3

-0.8

Budget balance, % of GDP [1]

Notes: e BMI estimates. f BMI forecasts. Sources: 1  National Bureau of Statistics, BMI.

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ECONOMIC outlook

muted impact on growth – at least in the short term – than if the money were to be channeled into tax cuts or subsidies, which would have a far more direct impact on consumers. Moreover, with such a vast amount being thrown at boosting infrastructure, there is a not insignificant risk of building ‘bridges to nowhere’ (i.e. projects which serve little purpose upon completion, and whose only raison d’être is to boost short-term employment). While it is true that China may be able to make those ‘nowheres’ into ‘somewheres’, given the vast number of underdeveloped settlements outside of the eastern seaboard, the construction of ‘bridges to nowhere’ would nonetheless provide substantial reason for concern. Indeed, it could suggest that policymakers in Beijing appear to have learnt little from the ongoing global economic meltdown. China’s growth model of aggressively boosting fixed investment and exporting its excess capacity, which has yielded such phenomenally successful results over the past decade, is ultimately unsustainable – a fact underscored by developments witnessed over the past year. To be sure, if China is to achieve a more balanced growth path over the longer-term horizon, it must shift its focus away from its external sector and towards building a base for private consumption. However, on this front, precious little progress has been made in recent years.

Time Lag Will Be A Key Issue

Fiscal Stimulus Package Breakdown (%) Rural Development and Infrastructure Projects, 9.3

Ecology and Environment, 8.8

Independent Innovation, 4.0 Affordable Housing, 7.0

Post-Disaster Reconstructio n, 25.0

Health, Culture and Education, 1.0

Railw ays, Highw ays, Airports and Pow er Grids, 45.0

Source: National Development and Reform Commission

A better option for long-term economic development would be to spend more on building adequate health and social safety systems. One reason often cited for China’s high savings rate is that people need to squirrel away money for medical treatment or possible retrenchment, given that loss of work has often meant a loss of the social benefits that come with the job. Thus, in the long term, China could increase consumption by providing a safety net that would obviate the need for such high savings. However, with only 1.0% of the proposed fiscal package being spent on health, culture and education, such a policy route appears to be off the table for the time being. Moreover, this is merely one of our concerns. The actual size of the planned additional spending is still under debate, as is the source of financing for the additional spending, while inherent corruption also remains a key concern. Thus, we remain sceptical as to the ability of Beijing’s announced fiscal stimulus package to rescue the economy from its current doldrums.

Exchange Rate Policy Yuan To Fall By 1% In 2009 With the deluge of increasingly dismal data flooding out of China showing few signs of stopping any time soon, we are forecasting the yuan to end 2009 around 1% lower than its 2008 close, at CNY6.9000/US$. Looking ahead to 2010, however, we are anticipating the yuan to once again resume its appreciatory trend as economic growth momentum begins to pick up. Yet, we do not believe that the unit will be able to match the 6.9% gains witnessed in both 2007 and 2008, and are subsequently forecasting appreciation of approximately 4.5%. This will see the currency end 2010 at CNY6.6000/US$

BMI View In view of rapidly deteriorating growth prospects in China, we expect the yuan to remain within the CNY6.8000-6.9000/US$ range, as the People’s Bank of China (PBoC) ensures the unit remains range-bound in order to promote price stability and bolster the all-important export sector. However, we emphasise the fact that a definite weakening bias remains in place.

The once enormous upside pressure on the yuan, stemming from persistently colossal trade surpluses and massive capital inflows, has all but disappeared as economic boom turns to Business Monitor International Ltd

19

CHINA Q2 2009

bust in China. The years of persistent double-digit growth now look firmly behind us as the collapse of the Western consumer continues to weigh on demand for Chinese shipments, which in turn is seeing investment – which has been firmly focused on the export sector during China’s recent boom period – take a tumble. Despite Beijing’s considerable efforts – which have included the unveiling of a mammoth CNY4trn (US$585bn) fiscal stimulus package and 216bps worth of interest rate cuts since September 15 2008 – we remain sceptical of their efficacy, and as such we have once again revised down our 2009 growth forecast. Having previously been anticipating a below-consensus expansion of 6.8%, we have become even more bearish and are now expecting growth to dip to just 5.6%.

Rangebound For Now, But Risks Weighted To the Downside Exchange Rate, CNY/US$

8.4 8.2 8.0 7.8 7.6 7.4 7.2 7.0 6.8

Jan-09

Mar-09

Jul-08

Sep-08

Nov-08

Jan-08

Mar-08

May-08

Jul-07

Sep-07

Nov-07

Jan-07

Mar-07

May-07

Jul-06

Sep-06

Nov-06

Jan-06

Mar-06

Source: BMI

May-06

Jul-05

Sep-05

Nov-05

May-05

6.6

Indeed, recent data releases have underpinned our view. Exports fell 2.8% y-o-y in December to compound the previous month’s 2.2% decline, which marked the first since since February 2002 and the biggest drop since April 1999. Meanwhile, imports plunged by a mammoth 21.3% in December having dropped 17.9% in November, and while plummeting commodity prices will to an extent have been responsible, the dramatic fall nonetheless underscores not only weakening domestic demand but also a dearth of demand for inputs for manufacturing exports. In addition, industrial output growth slowed to 5.4% y-o-y in November, down from 8.2% in October, marking a fifth straight month of deceleration and representing the worst monthly reading – excluding the months of January and February when the Lunar New Year distorts industrial output data – since the monthly data series began in 1999. Furthermore, growth in urban fixed asset investment decelerated for a third consecutive month, slowing to 26.1% y-o-y in the January-December period, from 26.8% in the first 11 months of the year, having peaked at 27.6% in September. Finally, there is increasing anecdotal evidence that unemployment and factory closures are both rising at a rapid clip. Reportedly, more than 60,000 businesses closed down in 2008, while in the province of Shandong alone, nearly 700,000 people lost their jobs. With the liklihood that y-o-y inflation is poised to turn negative in Q109 also thrown into the mix, there appear few good reasons to expect anything other than a weaker yuan in 2009.

Risks To Outlook If anything, we suggest that risks to our CNY6.9000/US$ forecast are weighted to the downside. If growth really slows sharply, and in particular too far below the government’s 8% target, the People’s Bank of China (PBoC) could allow the unit to drop further in order to try to boost export competitiveness and counter the negative effects of deflation. Indeed, a one-off devaluation still cannot be completely discounted, although we stress that this remains a low-probability scenario. To be sure, a competitive devaluation of the yuan would be a very risky strategy that would not only risk drawing the ire of the rest of the world – and the US and its new president in particular – but also potentially provide the catalyst for a series of regional devaluations and an ensuing trade war. Thus, we continue to believe that the political implications of letting the currency fall too far will continue to prevent China from pursuing such a policy.

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ECONOMIC outlook

Balance Of Payments BoP Position To Remain Secure China’s all-important external sector ended 2008 on a distinctly sour note after trade data for December revealed that both imports and exports suffered a second consecutive month of contraction. Exports fell by 2.8% y-o-y, accelerating from the 2.2% decline recorded in November, while imports endured a similar fate, plummeting by 21.3% y-o-y having dropped by 17.9% in the previous month. These developments saw China post a trade surplus of US$39.0bn in December, just shy of November’s all-time high of US$40.1bn, and brought the full year surplus to a record US$295.5bn, 12.7% higher than the US$262.2bn recorded in 2007.

BMI View China’s current account will suffer at the hands of the global recession, with the country’s overall trade balance shrinking from an estimated 9.5% of GDP in 2008 to 8.3% in 2009. This will see China’s current account surplus fall from an estimated 11.8% of GDP to 10.9% over the same time horizon. Meanwhile, mounting concerns over capital flight also threaten the country’s financial account. Nonetheless, we

Exports to the US (which purchased 17.7% of China’s total exports in 2008) fell by 4.1% y-o-y in December to compound November’s 6.1% decline, dragging the full-year growth figure down to 8.4%. This marked a notable decline from the 14.4% expansion recorded in 2007 and a fourth consecutive year of decelerating export growth to the US, but, most significantly, it marked the first time since 2001 that growth had come in below double digits.

remain confident that despite the mounting downside risks, China’s overall balance of payments position will remain secure.

Meanwhile, exports to the EU (which, with a 20.5% share, was China’s single biggest export destination in 2008) fell 3.5% y-o-y in December after remaining flat in the previous month. However, most significantly on this front, the full-year growth figure plummeted to 19.5% from a whopping 49.1% in 2007. With the eurozone forecast to contract by 2.5% in 2009, this figure is likely to fall even further over the coming year. Finally, having already plunged by 20.1% y-o-y in November, exports to Hong Kong (China’s third largest export destination with a 13.4% share) tumbled 15.4% in December.

Trade Surplus Has Reached A Peak Trade Balance (% of GDP)

10 9 8 7 6 5 4 3 2

2013f

2012f

2011f

2010f

2009f

2007

2008e

2006

2005

0

2004

1

2003

This latest data merely underscores our bearish view on the world’s fourth largest economy, and adds weight to our sharply below-consensus 2009 growth forecast of 5.6%. Indeed, although plummeting commodity prices will to an extent have been responsible for the sharp drop in imports, the dramatic falls witnessed in both November and December also underscore not only weakening domestic demand but declining demand for inputs for manufacturing exports. Moreover, with demand for Chinese goods continuing to weaken across its key export markets, the current trends appear to have further to run.

e/f = estimate/forecast; Source: National Bureau of Statistics, BMI

Indeed, we are forecasting growth of total exports to slow from the 22.3% clip estimated in 2008 to just 12.0% in 2009, with services buoying the headline figure as growth in goods exports slows from 21.7% to 10.9% over the same time horizon. Meanwhile, although import growth is also forecast to slow in 2009, it will nonetheless outpace that of shipments. Imports of goods are forecast to rise by 16.8% in 2009, down from 21.9% in 2009, while imports of services are expected to increase by 19.3%, slowing from an estimated 30.7% rise recorded in 2008. These developments will see China’s balance of goods shrink from an estimated 9.9% of GDP in 2008 to 8.6% in 2009, while the overall trade balance will fall from an estimated 9.5% of GDP to an anticipated 8.3%. Although still-strong net transfers and income from abroad will continue to buoy the overall figure, the weaker performance of exports will drag China’s current account surplus lower Business Monitor International Ltd

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CHINA Q2 2009

from the 11.8% of GDP figure estimated for 2008 in 2009. However, China’s current account will nonetheless remain in healthy surplus at 10.9% of GDP.

Risk Of Capital Flight Replaces Concerns Over Hot Money

Export Weakness To Weigh On C/A Exports (% chg y-o-y)

60 50 40 30 20 10

Jul-08

Oct-08

Jan-08

Apr-08

Jul-07

Oct-07

Jan-07

Apr-07

Jul-06

Oct-06

Jan-06

Apr-06

Jul-05

Oct-05

Jan-05

Apr-05

0 -10

Source: National Bureau of Statistics

While China’s current account position will remain secure, the prospects for its financial account remain far less certain. In the first half of 2008, hot money inflows were perhaps the single biggest issue facing the Chinese authorities as they attempted to prevent an economy accelerating from already double-digit growth from overheating. With the yuan seemingly only heading in one direction, speculators were falling over themselves to buy the Chinese currency in the firm belief that they would be making a risk-free profit as the undervalued unit was allowed to appreciate in order to help curb mounting inflationary pressures and cool rampant economic expansion. Indeed, the yuan gained 6.4% against the dollar in the first six months of 2008, up from a 4.1% rise in the previous six months and a 2.6% increase in H107, while the spread of spot CNY over 12-month CNY non-deliverable forwards (NDFs) – a leading indicator of investor sentiment towards the Chinese yuan – spiked to a record high of 0.819 on March 13 2008. While it is nigh on impossible to get hold of accurate figures reflecting the actual amount of speculative capital entering China, Michael Pettis and Logan Wright, writing in the Financial Times in July 2008, suggested that the trade surplus, FDI and interest on China’s reserves accounted for as little as 39% of the country’s reserve accumulation in the January-May 2008 period. This implies that hot money inflows totalled almost US$165bn in the first five months of 2008. Now, however, as economic boom rapidly turns to bust, the Chinese authorities are in fact facing the opposite problem: potentially damaging capital flight.

C/A To Remain In Healthy Surplus Current Account (% of GDP)

14 12

Indeed, Hu Xiaolian, the head of the State Administration of Foreign Exchange (SAFE), has warned that China faces a threat of ‘abnormal’ cross-border capital flow because of global financial tumult, cautioning that more money flowing out of the country could increase the risk of liquidity strain in the economy. In addition, October 2008 saw China’s foreign exchange reserves fall for the first time since December 2003 when they dropped to US$1.880trn, having stood at US$1.906trn in September.

10 8 6 4

2013f

2012f

2011f

2010f

2009f

2008e

2007

2006

2005

2004

0

2003

2

e/f = estimate/forecast; Source: National Bureau of Statistics, BMI

In a sign of how concerned Beijing is becoming over this issue, the Ministry of Commerce has proposed in new draft rules that Chinese companies will have to seek ministry approval if they want to invest US$100mn or more overseas. Under the planned new rules, which would replace the existing ones promulgated in 2004, companies may also need the ministry’s approval if they want to invest in countries that have no diplomatic relations with China, foreign infrastructure projects or highly risky countries or regions. Existing rules require China’s central government-controlled companies to apply for the ministry’s approval if they want to invest overseas, while other firms need only ask for the permission of the ministry’s provincial bureaus. These rules do not restrict applications by any monetary threshold. In a statement made on its website, the Ministry of Commerce said that ‘the regulations are drawn up to promote and regulate the development of overseas investments’, after a few major Chinese companies reported big book losses on investments abroad. However, it seems that fears surrounding an outflow of capital at a time when economic growth is

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ECONOMIC outlook

slowing at an alarming pace is also likely to be a prime motive. Indeed, the draft rules also deleted an existing provision that said that ‘the state supports and encourage companies with various sorts of advantages and ownerships to go abroad to invest and establish new firms’, underscoring Beijing’s apparent policy shift. The ministry said the new rules would take effect after their formal publication, but it did not say when this would happen. However, Chinese authorities typically issue new rules within a month after seeking public feedback, which in this case ran until January 20. While the move will not necessarily stop money leaving China, it nonetheless underscores Beijing’s growing concerns, and highlights the possibility that a more draconian clampdown could be implemented going forward. Moreover, it suggests that China’s secure balance of payments position may be under threat. However, given that China has posted an average financial account surplus in excess of US$40bn since the end of the Asian financial crisis, and that its current account is forecast to stay in healthy surplus, we remain confident that the country’s overall balance of payments position will continue to be secure throughout the global recession.

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