Summary
China will suffer as the global downturn deepens and export growth
collapses, raising the risk of a hard landing and deflation.
Concerned, Beijing launched a RMB4trn stimulus package, with new
spending to reach 2-4% of GDP in 2009 and 2010. This is likely to
lift GDP growth to well over 8% in 2H09, though we think weaker
growth in 1H09 will drag down the whole year average to 7.8%, the
lowest in nine years. Government-supported investment will replace
exports as the key growth driver, raising questions about the
profitability of the growth. China’s pump-priming will create
USD586bn additional demand for capital spending through 2010,
helping commodity exporters rather than other Asian economies.

Strong headwinds
As the world’s factory, China’s economy is not immune to the global downturn. Since the Eurozone, US
and Japan account for over 56% of China’s total exports, the synchronised developed world recession is
cutting into export growth significantly. Chinese exports to other emerging markets still grew over 20%
y-o-y in the first 10 months of 2008, but signs have emerged that these economies are also beginning to
slow, reflecting the knock-on effects of the deepening recession in the developed world and falling
commodity prices. As a result, emerging market demand for Chinese products is also likely to weaken
soon. We expect growth in the dollar value of Chinese exports to drop sharply – to -3% in 2009 with a
cyclical low of -19% in 1Q09. Since growth in imports of intermediate goods used as inputs for export
processing, which account for over 50% of China’s total imports, will also slow, net exports will fall,
albeit at a moderate pace.
There are also signs of weakness on the domestic front. First, the transaction volume of property sales in
big cities has been falling by 20-40% y-o-y since the start of the year, implying the slowdown in property
investment by private developers is likely to accelerate into 2009. The announced RMB900bn new fiscal
spending on public housing for the next three years should provide a buffer, but is not enough to fully
offset the downturn in private property investment. Combined with a sharp slowdown in car sales, this is
forcing producers in metal and machinery sectors to adjust expectations and hence inventories. As a
result, growth in industrial production dropped sharply to 11.4% in September and further to a seven-year
low of 8.2% in October, from above 17% 10 months ago. We expect this unwinding of excessive stock
and even capacity to continue until there is meaningful improvement in demand. Without Beijing’s policy
response, the economy would have had a hard landing (GDP growth slowing to 6% or below) in 2009.

RMB4trn stimulus
Fearing nasty social and economic consequences of a hard landing, on 9 November Beijing policymakers
announced a RMB4trn stimulus package. Since then, provincial governments have been racing to produce
their own investment plans that together total over RMB10trn. Not all of the planned investment can be
new spending, yet our conservative estimates of 30-40% of the central government’s RMB4trn plan for
the new money imply an annual stimulus of 2-4% of GDP in 2009 and 2010, still substantial by any
measure. Funding the plan should not be a problem because there is still a savings glut in the private
sector and the government has some leeway to borrow. The bulk of the plan will be additional investment
in railways, roads, public housing and rural infrastructure, while the government has also promised to
increase subsidies for farmers and cut taxes. Government spending on public housing, schools, hospitals
and rural areas should also help to lower households’ precautionary savings, thereby “crowding in”
private consumption. In addition, Beijing’s tradition of making medium- to long-term plans for
infrastructure development gives it the ability to start the stimulus more quickly simply by bringing
forward construction work on planned projects. That said, winter is normally a slow season for
construction, and we expect a bulk of the new spending to filter through starting in 2Q09. Once it kicks
in, we think the stimulus package can lift GDP growth above 8% in 2H09, though we expect a weaker
growth rate in 1H09 to drag down the whole-year average for 2009 to 7.8%, the lowest in nine years.
Maximum easing
Fiscal policy will play a dominant role in countering recessionary forces in the coming years. But the
massive pump-priming still needs to be accompanied by much looser monetary conditions. Since the
major macro risk has already shifted from inflation to deflation, the People’s Bank of China (PBoC) has
some leeway to significantly ease credit. Despite four cuts in the last three months, the one-year
benchmark lending rate still stands at 5.58%, well above current 4% CPI inflation, which is likely to
continue to fall rapidly in 2009. We expect the PBoC to slash the rate by around 200bp by June 09.
Meanwhile, we think the central bank will reverse its six-year long quantitative tightening by abolishing
loan quotas and cutting the required reserve ratio (RRR) by 400bp. This is likely to put RMB1.6trn new
liquidity back into the banking system. With the loan-deposit ratio at only 67%, banks have some scope
for lending the additional liquidity to the real economy. There is no doubt the banks will remain cautious
on lending to exporters and SMEs in the current circumstances. But we believe the banks, especially big
state banks, are likely to lend to government-sponsored infrastructure projects given that these projects
are low risk and politically correct. With external demand contracting, currency depreciation will not
effectively lift exports, and hence won’t be a policy focus.
Investment-centric growth
Beijing’s massive pump-priming is likely to keep the growth rate at around 8% in 2009. This will still be
a respectable growth rate given the global economic environment. However, the main engine of growth
will shift from exports to infrastructure-led investment. In other words, government-sponsored investment
will be in the driving seat as globalised and market-driven manufacturers stand aside. This is likely to
undermine the quality of growth, as the massive public investment will inevitably include some low
return and wasteful projects. We expect growth in private consumption to remain steady in 2009, thanks
to a significant increase in government subsidies for farmers and tax cuts plus a secular trend of

expanding consumption. Yet it could be unrealistic to expect consumption to drive overall economic
growth in the years ahead given greater economic uncertainty as well as the country’s still fragile
healthcare and pension systems.
Spill-over effects
China’s massive stimulus package will likely boost domestic investment and narrow the savingsinvestment
gap, helping to adjust global imbalances. But to make this trend more sustainable, China must
find ways to make consumption a more important engine of growth. In terms of immediate impact on the
global economy, the stimulus will create at least USD586bn of additional demand for capital spending
through 2010. This should provide a buffer for the fall in commodity prices and help cushion the growth
downturn for commodity exporters. Countries that supply China with advanced machinery and capital
goods should also gain. On other hand, although trade flows between China and the rest of Asia have
surged, over 60% of China’s imports from other Asian countries is intermediate goods used as inputs for
export processing rather than consumed domestically. As a result, China’s economic stimulus will offer
little help to neighbouring economies.
Summary of China economic forecasts
% Year (annual average) 2004 2005 2006 2007 2008f 2009f 2010f
Nominal GDP (RMBbn) 15,988 18,322 21,192 24,953 28,914 31,127 34,175
Real GDP 10.1 10.2 11.6 11.9 9.2 7.8 8.9
Consumer spending 7.2 8.5 8.7 9.0 8.9 8.0 8.5
Government consumption 8.6 12.9 11.7 14.3 12.0 18.0 16.0
Nominal fixed-asset investment 27.6 27.2 24.5 25.8 24.0 17.5 19.0
Merchandise exports 35.4 28.4 27.2 25.7 14.4 -3.0 9.0
Merchandise imports 36.0 17.6 19.9 20.8 20.4 1.0 11.0
Industrial production (VAI) excl. small
enterprises
16.3 15.9 16.2 16.0 12.7 9.5 12.0
Nominal retail sales 13.3 12.9 13.7 16.8 18.3 15.0 16.0
Consumer prices, year avg. 3.9 1.8 1.5 4.8 6.1 -0.2 0.8
Current account (% GDP) 3.6 7.2 9.4 11.3 8.9 5.1 4.3
Budget balance (% GDP) -1.3 -1.2 -1.0 0.3 0.0 -2.7 -3.2
Foreign currency reserves (USDbn) 610 819 1066 1528 1900 2100 2250
RMB/USD, year end 8.28 8.07 7.81 7.30 6.80 6.80 6.80
3-month time deposit (%), year end 1.71 1.71 1.80 3.33 1.98 0.36 0.36
1-yr lending (%), year end 5.58 5.58 6.12 7.47 5.58 3.42 3.42
Source: HSBC estimates

4
Macro
China Economics
December 2008
abc
Exports collapse 5
Signs of domestic weakness 9
RMB4trn stimulus package 14
Maximum credit easing 23
Quality of growth to
deteriorate 28
Consumption to hold up 30
Save which world? 35
Economic indicators &
forecasts 39
China economic forecasts 41
Disclosure appendix 46
Disclaimer 47

Exports collapse
􀀗 Synchronised developed world recession, plus weakening demand
from emerging markets will cut external demand for exports…
􀀗 …leading to a collapse in export growth from 20% y-o-y in the first
10 months of 2008 to -3% in 2009, with a cyclical low of -19% in
1Q09
􀀗 Yet the drop in net exports will be more modest because slower
exports also reduce growth in imports of intermediate goods

Synchronised developed world
recession hits exports hard
China is not immune to a synchronised global
downturn, even though the credit crunch has not
set foot directly in China. Yes, the relatively
isolated domestic financial system remains largely
intact and Chinese banks still have strong balance
sheets with sufficient liquidity. Yes, Chinese
households still have high savings and low
leverage, low debt and fewer credit cards than
developed markets. However, the China
manufacturing sector is fully integrated into the
world economy. This means that the much weaker
external demand amid the global recession will
translate into a dramatic fall in export orders,
weighing on China’s economic growth.
Despite the increase in diversification, exports to
the developed markets - the US, EU and
Japan - still accounted for 46% of total exports in
the first 10 months of 2008 without taking into
consideration re-exports via Hong Kong.

After adjusting for re-exports through Hong
Kong, the share of exports to the US, EU and
Japan should rise to 56%.
The reason for the importance of developed
markets to Chinese exports is simple: China has
become the world’s factory for consumer goods,
ranging from T-shirts to i-pods, while the
developed markets still account for 70% of global
private consumption. If the developed markets
catch a cold, Chinese manufacturers sneeze.

How well will demand from
EM countries hold up?
Demand from emerging markets is still strong and
has contributed the majority of export growth in
recent months. Chinese exports to markets besides
the US, EU and Japan rose 26% y-o-y in the first
10 months of 2008, significantly higher than the
22% overall export growth. Therefore, those
markets contributed 61% of incremental exports
in the first 10 months of 2008, dwarfing the 39%
from developed markets.
But how long will the strength in demand from
emerging markets last? The answer is, not too
long, and it won’t be strong enough to offset the
losses from developed markets. There are signs of
weakening demand from EM countries. For
instance, HSBC’s Russia economist now expects
zero growth in the Russian economy in 2009.
Taiwan entered a recession in 4Q 2008, following
its neighbours, Japan, Singapore and Hong Kong.
The most recent economic data releases paint a
gloomy picture ahead.
Therefore, we expect weakening emerging
markets demand to cut into Chinese exports in the
coming quarters for two major reasons. First, the
wealth of many emerging markets stems from
exporting commodities and natural resources.
Indeed, they benefited greatly from the upswing
in the commodity price cycle. As commodity

prices fell sharply in 2H 2008 (in particular, the
oil price plunged from a peak of around
USD150/bbl to less than USD50/bbl currently),
the wealth of commodity-exporting EM countries
is affected and their demand for Chinese products
is likely to weaken. Second, as the developed
world enters recession, the concomitant drop in
import demand directly affects the exports of EM
countries, especially those Asian countries with a
large share of exports to developed markets.
Supply-side policies won’t work
To help exporters cope, the Chinese government
has intensified its support via three increases in
export tax rebates since the second half of 2008.
The latest (effective 1 Dec-08) applied to 28% of
export products ranging from textiles to high
value-added machinery. So far, rebates on textile
exports have been adjusted to the ceiling rate of
17%. Export tariffs for a number of products have
been lowered or cancelled and the authorities have
almost halted the appreciation of the renminbi to
minimize exporters’ exchange rate losses. Finally,
more credit is due to be extended to SMEs,
including those in export sectors.

However, these supply-side policy measures can
only provide partial relief and are unlikely to have
a meaningful impact on export growth when
external demand is sinking. Despite the low
elasticity of demand for Chinese consumer goods

exports, US consumers’ prolonged de-leveraging
process should reduce consumption, including
Chinese imports, as indicated by the significant
fall in China’s exports to the US.
In fact, our quantitative model suggests that
external demand (world GDP growth) is the most
important factor driving China’s export growth
cycle. Exchange rates also matter, but much less
so, with a co-efficient of only 20% of that for
world GDP growth. That explains why the supply
side policies don’t work. Based on our model, we
expect China’s export growth to contract in 1H09,
with a cyclical low of -19% in 1Q09.

In sum, we expect a sharp slowdown in China’s
export growth from 20% in the first 10 months of
2008 to -3% on average in 2009, as a
synchronised developed world recession, plus
weakening demand from EM markets is set to cut
sharply into export growth in the coming months.
A leading indicator of Chinese exports, Taiwan’s
October export orders fell for the first time this
year, portending an ugly downturn in Chinese
export growth in a few months.

Still competitive
Although we expect export growth to plunge in
2009, it is mainly due to worsened external
demand. The competitiveness of Chinese products
remains unchanged and China’s role as the
world’s production factory should remain intact.
Despite rising input costs and RMB appreciation,
Chinese exports are still very competitive; we
expect export growth for the whole year 2008 of
around 14.4%, significantly higher than the 4.5%
world trade growth predicted by WTO.
Meanwhile, the latest Chinese export growth
figure for October is higher than single digit or
even negative export growth rates in other Asian
countries, such as Singapore, Korea and Taiwan.
This implies that Chinese exports will increase
their share of world trade and that their
competitiveness is not impaired by the demand
shock.
The fundamental factors sharpening the
competitiveness of Chinese exports remain solid.
First, China has abundant cheap and adequately
literate labour. Despite fast rising wages in recent
years, unit labour cost has not increased. In fact,
even faster productivity improvement and
technology advancements have made productivity
growth fast enough to offset wage growth.

Second, after 30 years of export-oriented
development, infrastructure has improved
dramatically and regional supply chains are well
established. For instance, Dongguan, an industrial
centre in Guangdong province, specialises in
high-tech and light manufacturing. Despite rising
labour costs, many foreign investors will not
move from such industry clusters to places with
cheaper labour and land (such as Vietnam or
inland provinces) because of the unique overall
environment, including the convenient
infrastructure, downstream supplier networks and
close ties with regional trade centre Hong Kong.
Third, the Chinese policy of embracing
globalisation remains intact. The authorities still
actively support export growth and local
governments are keen to attract foreign direct
investment (FDI). Integration of the China
economy into the global economy not only creates
millions of jobs, but also necessitates new
technologies for industrial upgrades. The policy
stance on exports hasn’t changed but it has been
strengthened by the increase in rebates for export
sectors and financial support to SMEs.
In a nutshell, China’s comparative advantage will
not be easily taken away and economies of scale
are supported by the growing proportion of
working age population in the next decade.
Benefiting from a baby boom in the 1960s and
early 1970s, China’s working age population will
grow an average 1.5% pa over the next decade,
tripling the rate of overall population growth. As a
result, an additional 65 million working age
people will join the workforce in the next decade,
boosting the country’s total working age
population to nearly 1 billion by 2015, a
staggering 20% more than the total of all
developed countries combined.
Combined with rapid urbanisation, this 65
million-strong increase in the labour force of the
world’s largest labour-intensive production centre

is likely to further deflate wages in the globally
tradable sector, especially wages for less skilled
workers in other emerging markets. Meanwhile,
an increase in the proportion of Chinese labour
engaged in the tradable goods sector should also
increase the labour-capital ratio and improve the
rate of return on capital.

Conclusion
As the factory of the world, China’s real economy
is not immune to the global downturn. We expect
the synchronised developed world recession plus
weakening demand from emerging markets to cut
sharply into export growth, reducing it from 20%
in Jan-Oct 08 to -3% on average in 2009, even
though the fundamentals supporting the
competitiveness of Chinese products remain
unchanged.
The government’s supply-side measures are not
enough to reverse the dramatic downturn in export
growth in the coming months. Yet, net exports
will fall only at a moderate pace since we expect
growth in imports of intermediate goods used as
inputs for export processing, which account for
over 50% of China’s total imports, to also drop
off.