China Outlook Update: What, Me Worry?By Adam Wolfe
Jun 20, 201111:15:00 AM | Last Updated

• Chinese growth is in a soft patch, but the government’s housing policy will spark a rebound in H2.
• The People’s Bank of China (PBoC) is likely to put the monetary tightening cycle on hold for most of H2 2011, but it will resume tightening in 2012 in response to persistent inflation.
• There are no signs of rebalancing away from investment-led growth in 2011-12, which will increase the risk of a hard landing after 2013.

Macroeconomic Dynamics: Just Build It
Despite the slowdown in economic activity in Q2, we stick with the growth forecast presented in our March 2011 Outlook Update. We had expected Q2 to be weak, and the current soft patch looks to be transitory. Energy supply disruptions are being resolved, and external demand is expected to pick up as Japan rebuilds and U.S. consumption gains steam; plus, Beijing has not wavered from its commitment to build 10 million low-income housing units. The pledge was a political one, while the current delay in construction stems from financing constraints. Since politics always trumps finance in China, it is safe to assume that credit constraints on urban development and investment companies will be loosened in the coming months to ensure that construction begins by November.
Investment will drive growth again in 2011 and in 2012 as China enters the height of its political cycle. We expect investment to contribute about 5 percentage points to growth in 2011, while consumption, including government outlays, will add 4 points. Retail sales have slowed in real terms as inflation eats into consumer sentiment and government subsidies expire. China’s exports are on track to gain about 20% in 2011 as imports jump 25%, shrinking the trade surplus to US$150 billion and the current account surplus to 4.2% of GDP. The effect on growth will be negligible, as the narrowing is mostly due to higher commodity prices.
Policy Implications: Strong Tiger, Weak Cage
Premier Wen Jiabao likes to refer to inflation as a caged tiger. To that end, the PBoC has hiked interest rates by 100 bps and required reserve ratios (RRRs) by 450 bps since October. Still, inflation looks set to peak at around 6% in June and stay above 4% in H2 to average about 5.2% for the year, slightly above the forecast of 5% we set only a few weeks ago. If RRRs go much higher, the banking sector’s solvency could be at risk. A couple more interest rate hikes are likely through August, but then we expect the PBoC to pause as higher interest rates encourage more capital inflows and increase sterilization costs. A stronger RMB would help, but politics trumps monetary policy, too, at least until a crisis emerges. With headline inflation trending down in H2, we do not foresee the RMB’s appreciation path moving above the current 6% annual rate against the USD.
Fiscal policy will loosen in H2 as monetary tightening takes a breather. The PBoC will have to resume tightening in H1 2012 to nudge deposit rates back into positive territory in real terms, while the leadership transition that begins in October 2012 will likely delay fiscal consolidation (at least at the local level). It will be difficult, if not impossible, for China to rebalance its growth toward private consumption during this phase, which will only exacerbate the problematic reliance on investment that the “Fifth Generation” of leaders will have to confront after 2013.
Upside Risks

• Global demand picks up, boosting Chinese exports.
• Commodity prices soften, reducing domestic inflation and boosting external demand.
• Private consumption accelerates as sentiment improves after inflation peaks in June.

Downside Risks

• Inflation expectations become unanchored, and the PBoC has to tighten more than expected.
• Delays in resolving the financing of the government’s housing plan prolong the growth soft patch.
• Japan’s reconstruction begins later than expected; U.S. private consumption remains weak.
• Real estate transactions decline sharply, increasing developers’ unsold inventories and straining their balance sheets, which sparks nonperforming loans and/or a collapse in housing and land valuations.
• A poor summer harvest requires a rundown of agriculture stockpiles and a jump in food imports.

Figure 1: Latest Data and RGE Forecasts

Source: Bloomberg, RGE
*Year-end policy rates
Note: q/q GDP forecasts are based on RGE’s in-house model, which may not match the new official series.
Figure 2: Chinese Commodity Demand Is Starting to Rebound (Jan 2007=100, 3mma)

Source: General Administration of Customs, RGE
Figure 3: IP Will Remain Soft for a Few More Months…

Source: Bloomberg, China Energy Council, RGE calculations
Figure 4: …But Real Estate Activity Remains Strong… (%, y/y, 3mma)

Source: NBS, RGE
Figure 5: …And Real Estate Investment Is Driving GDP (RMB, trillions)

Source: NBS, RGE
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