China’s Macroeconomic Outlook: Monetary Tightening

1. See the Disclosure Appendix for the Analyst Certification and Other Disclosures China’s Macroeconomic Outlook: Monetary Tightening Don Hanna Asia Pacific Economic and Market Analysis Shanghai December 2004

2. Overheating or Overinvestment? Growth of consumption, fixed capital formation and GDP (%) Source: China National Statistics Bureau, CEIC and Citigroup estimates.

3. Selective Tightening Policies

4. Tightening Slows Growth of Monetary Variables Growth money supply M2 and bank loans (% yoy) Source: China National Statistics Bureau, CEIC and Citigroup estimates.

5. But Economic Activity Remains Robust Growth of monthly fixed asset investment in 2003 and 2004 (% YoY) Growth of monthly retail sales in 2003 and 2004 (% YoY) Source: China National Statistics Bureau, CEIC and Citigroup estimates.

6. Changing Pattern of Investment Growth Growth of fixed asset investment by industry (% YoY) Source: China National Statistics Bureau, CEIC and Citigroup estimates.

7. Core Inflation Is Set to Rise Quickly Headline inflation likely peaking • While headline and non-food inflation are still moderate, they climbed from deflation 2 years ago • The official rates may still underestimate inflation pressures because of price controls • High input prices is likely to push inflation higher. Earlier analyses suggest that (1) 1% increase in raw material prices leads to 0.3% rise in CPI with time lags; (2) $10/barrel rise in oil prices pushes up CPI by 0.3-0.5% • Rapid growth of wages not only pushes up costs of production but also strengthens consumer demand in the markets Non-food CPI should grow further (%) Source: China National Statistics Bureau, CEIC and Citigroup estimates.

8. Power Shortage Became a Nation-wide Problem • 24 out of 31 provinces experience rationing of electricity consumption. Total shortage can be 3-6% of expected demand and net impact on GDP could be 0.3% • The government introduced new schemes to ease the shortages, including increasing investment, usage management and price liberalization • Stand-alone generators significantly reduce the impact of power shortages, but they at the same time raise cost of production and pollute the environment • Power shortages would not disappear until 2006E Source: National Statistics Bureau, and Chinese Academy of Social Sciences.

9. Shortage of Migrant Labor in Coastal China • Is labor supply unlimited? • Number of migrant laborers reached 98mn in November-2003 and has been growing by 5% yoy • Underdeveloped labor market – lack of information, low wages, poor social welfare benefits and skill mismatch • Some employers are already paying 20-30% more to attractive workers; and social welfare contributions could account for 40-50% of payrolls • Implications: hurting corporate profits, boosting consumption and adding inflationary pressure Rising urban unemployment rate (%) Source: National Statistics Bureau, and Chinese Academy of Social Sciences.

10. Beginning of Monetary Tightening • On 28 November 2004, PBOC announced changes to its interest rate policies • Ceiling for lending rates were removed for commercial banks (with the only exception of rural credit cooperatives) and deposit rates were allowed to float downward, but not upward • Base lending and deposit rates were raised, by 27bps for 1-year loans/deposits Changing lending rates, August 1996 – Oct 2004 (%) Source: People’s Bank of China and CEIC.

11. 90 90 1995 1955 1975 1995 70 70 1980 Exchange Rate relative to PPP (US=100) 50 50 1960 Korea 1960-1995 Taiwan 1955-1995 1950 30 30 China 1980-2002 Japan 1950-1975 2002 10 10 0 10 20 30 40 50 60 70 80 GDP per capita, percent of U.S. CNY May Appreciate At Least 25% in the Next 10 Years GDP per capita and exchange rates relative to purchasing power parity at five-year intervals: Japan; Taiwan; Korea; and China Source: Alan Heston, Robert Summers and Bettina Aten, Penn World Table Version 6.1, Center for International Comparisons at the University of Pennsylvania (CICUP), October 2002.; and IMF, April 2003 WEO Database .

12. Asia Pacific Asia’s Growth Is Linked to One Another More Than the US Business Cycle Concordance Based on GDP Growth Cycles Last 10 Years (1Q93-1Q03) Note: * Significant at the 10% level; ** Significant at the 5% level; *** Significant at the 1% levelSource: Citigroup calculations based on John McDermott and Alasdair Scott, “Concordance in Business Cycles” IMF Working Paper No. 00/37 (Washington DC: International Monetary Fund) 2000

13. Strong intra-regional trade linkages China and Intra-regional share in Asia Total Trade Source: CEIC, Citigroup estimates.

14. Asia Pacific Long-term Asia FX forecasts show appreciation Nominal Exchange Rate and Implied Real Exchange Rate Appreciation Source: Citigroup estimates

15. Asia Pacific Asian Macro Forecast: Hurt by Oil Source: Consensus Economics, Citigroup estimates

16. Tightening Did Not Solve the Fundamental Problem GDP growth and total factor productivity growth as a share of GDP growth (% YoY, %) Source: National Statistics Bureau, CEIC and Citigroup estimates.

17. Capital Is Too Cheap! Costs of capital and potential returns to capital in China (%) Note: Borrowing costs for private companies are from survey by PBOC officials Xie Ping and Lu Lei and average return to capital of listed companies is from Citigroup. Source: Citigroup estimates.

18. Rebound of Nonperforming Loans The government is accelerating its banking reforms. But are these sufficient? Source: China Banking Regulatory Commission and Citigroup estimates.

19. Asian Trade Reorienting Through China Share in Total US Imports Source: CEIC, Citigroup

20. Asia Pacific Pattern of Tech Dependence Shifting Sources: Citigroup calculations based on data provided by CEIC

21. China’s Regional Structure Likely to Remain Diversified • Domestic economic structure/costs will be diversified • Cost advantages over some Asian economies are already quite limited GDP per Capita (US$) Source: Citigroup, China Statistical Yearbook and CEIC.

22. Education Still an Opportunity Educational Attainment of Population 25+, 2000 Source: Barro & Lee

23. Governance May Be a Key to Growth Governance Indicator (Aggregate) Note: Governance indicators are oriented so that higher values correspond to better outcomes, on an aggregate scale from –15 to 15. Aggregate include voice and accountability, political stability, government effectiveness, rule of law, regulatory quality and control of corruption indicators. Source: D. Kaufmann A. Kraay, and M. Mastruzzi (2003) • World Bank Policy Research Working Paper 3106

24. China – Macroeconomic Forecasts Source: China National Statistics Bureau, CEIC and Citigroup estimates.

25. Disclosure Appendix ANALYST CERTIFICATION I, Yiping Huang, hereby certify that all of the views expressed in this research report accurately reflect my personal views about any and all of the subject issuer(s) or securities. I also certify that no part of my compensation was, is, or will be directly or indirectly related to the specific recommendation(s) or view(s) in this report.