China: Macroeconomic Updates, Risks, and Emerging Trends

1. China: Macroeconomic Updates, Risks, and Emerging Trends Li-Gang Liu – Head of China Economic Research July 2010

2. China’s Macroeconomic Updates: Main Points China has returned to a more sustainable growth path • Q2 GDP growth moderated to 10.3% (y/y) from 11.9% in Q1 as the government has tightened credit conditions. • We expect net exports to contribute positively to growth in 2010, and trade protectionist sentiment is rising. Inflationary pressure unexpectedly eased in Jun • The Jun CPI inflation slowed to 2.9%(y/y), coming off a 3.1% gain in May. Meanwhile, the Jun PPI also slowed to 6.4% (y/y), from a 7.1% in May. • Inflation is expected to breach the 3% threshold again in the following months due to recent surges in rental prices and rising food prices caused by the floods in southern China. The RMB has resumed its appreciation path, ending a 23 month peg to the USD • The PBOC enhanced the flexibility of the RMB exchange rate on June 21, but the trading band still remains at +/- 0.5%. • We think policy actions are still warranted by further widening the RMB trading band in the foreseeable future to truly enhance the flexibility of the RMB exchange rate. We forecast growth to reach 10.1% in 2010 and 9.6% in 2011 • This forecast has priced in our expected monetary tightening moves. • Three risks facing China’s macroeconomic outlook: higher-than-expected inflation, property market slump, and rising trade tensions.

3. Macroeconomic Updates: GDP growth returned to a more sustainable level led mainly by strong domestic demand Growth moderated, but remained solid Monetary policy started to tighten The risk of overheating eased

4. Industrial Production: Stabilised at pre-crisis growth rates

5. Retail Sales: Moderated, partly due to base effects

6. Investment: Returned to a more sustainable pace

7. External Trade: Robust exports become a driver for growth

8. Inflation: Inflationary pressures eased slightly, but will increase again

9. Real Estate: Transaction volume declined; prices started to adjust

10. We don’t view China’s property market as a bubble because some favourable fundamental factors are still at play Source: PBoC Source: ANZ estimates for 2009

11. PBoC has only used quantitative measures to tighten monetary policy

12. China Signals Resumption to RMB Appreciation On 19 June, the PBoC announced to relinquish the RMB’s peg to the USD, while maintaining the existing allowed trading band at +/-0.5%, thus ending a 23-month peg to the US dollar. The RMB exchange rate has appreciated by almost one percent since the de-pegging. The PBoC has rule out large-scale appreciation, given the substantial weakening of the EUR. We think an up to 3% appreciation by the end of this year is still tolerable by the authorities. 12

13. External Pressures to Remain 13 • We think the return to the old regime will not be an optimal solution, as it will continue to allow one-way bet on RMB’s appreciation. As a result, China is expected to receive more “hot money” inflows, which compromise the PBoC’s policy objectives in maintaining price stability. • Going forward, we expect the trading band to be progressively widened further. • Given RMB’s long-run appreciation trend, the PBoC could allow the RMB to adopt a crawling band exchange rate system with the long-run trend determined by the market supply and demand conditions.

14. Nov 11 G20 Summit at Seoul, South Korea Aug Oct Jun Jul Sep Dec Nov Key events to watch for increased flexibility 21 Jun PBOC increased the exchange rate flexibility, allowing the RMB to appreciate 13-14 Nov Asia-Pacific Economic Cooperation (APEC) Summit at Yokohama, Japan 2 Nov U.S. Congress midterm elections 26-27 Jun G20 Summit in Toronto Jul 21 5th anniversary of the last RMB revaluation Jun 30 PBOC Q2 Monetary Policy Committee Meeting Jul 8 US Treasury’s Semi-Annual Report declined to name China as a currency manipulator TBD (Oct last year) Sino-US Joint Commission of Commerce and Trade End of Q3 PBOC Q3 Monetary Policy Committee Meeting TBD US Senator Charles Schumer vowed to push for a vote on anti-dumping and countervailing legislation

15. Three risks facing the Chinese economy Inflation remains a risk facing the economy • Though manageable, it requires further proactive moves to bring the accommodative monetary policy back to a more neutral level. Property prices could crash, leading to lowered private investment • The authorities have tightened bank lending and used aggressive administrative measures to tighten the property sector. This could send property prices to a sharp correction, leading to less private investment in this sector. • We believe the focus should be on increasing supply of economically affordable housing. Trade tensions with the ROW are a risk beyond China’s control • Over 35% of global anti-dumping cases in 2008 reported by the WTO are against China. The US and the EU led the developed world; Argentina and India led the developing world. • Trade tensions remain between China and the US, despite the recent RMB move, because of very high US unemployment rate and election year politics in the US. • Trade tensions can also disrupt financial flows, which may complicate the outlook for the global currencies, commodities, and global recovery.

16. China’s medium term outlook: Three emerging trends 1. China’s economic rebalancing has started with boosting consumption as a high priority. • Fiscal stimulus package already has components oriented to boost consumption (medical insurance package, income transfer programs to the rural sector, and wage increases for teachers and retirees). With political will, the chance for success is high. • China’s structural imbalance is not unique in its development experience, and external shocks often help effect changes in Asia’s growth pattern. 2. Urbanization will be a major driver for future growth • China’s urbanisation is to accelerate and infrastructure build is to continue. • China will in time become a large agricultural importer because of serious water shortage problems and the emergence of a sizable group of affluent urban consumers. 3. China is to become a large foreign direct investor; the RMB convertibility is also set to accelerate. • QDIIs will become large and more active in both emerging and developed markets. • Chinese outward FDI will surge because of its needs for resources, technology, and tariff jumping. • Financial liberalisation and capital account liberalisation are to accelerate and RMB internationalisation will speed up.

17. Trend 1: China’s economic rebalancing has started Income transfer and policy reform measures to stimulate consumption

18. China is not unique in its development pattern Japan’s Economic Structural Change, 1955-2007 Source: Economic Planning Agency, Ministry of Finance, and Roach (2009)

19. External shocks can effect changes in growth pattern Contribution to GDP by expenditure before and post the 1997 Asian Financial Crisis Sources: CEIC Data and author’s estimates.

20. Resources are available if there is political will to change • With limited national debt and massive FX reserves, China is in a very favourable financial condition to rebuild social safety net. • Policy makers already recognize the unsustainable nature of China growth pattern: Wen Jiabao states China’s economy is “instable, imbalanced, and unsustainable”. • Domestic needs, together with external shocks, should help rebalance the economy in the medium term.

21. Trend 2: China’s urbanization will be an engine for growth • China’s urbanisation process is expected to accelerate in the next 10 to 15 years, boosting the infrastructure investment and acting as a driver for sustained economic growth. • China’s urbanisation process requires continuing and large infrastructure investment, suggesting China’s demand for hard commodities will be long term. Meanwhile, its needs for clean energy resources and agricultural products will become bigger. Service sector, especially financial services, will also be benefited from the rapid urbanisation process. • China’s urbanisation process will depend on whether the country can successfully return to a path where domestic demand as the main driver to growth. Given the resources at disposal and political will, we think China’s rebalance act has a high probability to succeed.

22. Urbanisation is to be a major driver for growth in the medium to long run China’s urbanisation also requires huge infrastructural investment • 350 million people will be added to China’s urban population. That’s three times the amount of rural Chinese (103 million) that have migrated to the cities since 1990 • 1 million kilometres of new road and 28,000 kilometres of metro rail will be laid • 170 mass-transit systems will be built - twice the number that all of Europe has today • 40 billion square metres of floor space will be built to construct five million buildings - the equivalent of building two Chicago's every year • 97 new airports will be built and one in every ten planes assembled by Boeing and Airbus will be delivered to China • Energy demand will more than double from 60 quadrillion British thermal units (QBTUs) to between 123 QBTUs and 142 QBTUs – equivalent to 25% of the world’s total energy demand today

23. China still is a modest consumer of commodities per person on a global scale China consumption of key commodities Source: WBMS, ANZ

24. The biggest consumption still to come will be in oil and gas, while iron ore looks to be peaking China consumption of key commodities Source: BP, WBMS, ANZ

25. Planned infrastructure for China’s LNG industry Source: Gas Matters

26. Wind power will become China’s next source of green energy • China mainly uses coal to generate electricity, followed by hydro power. Wind and nuclear power generating capacities, despite their rapid growth, remain quite small. • Given China’s stage of industrialisation and its concerns over environmental pollution, clear energy such as nuclear, wind, and solar power will be bound to become more significant in the future.

27. China’s nuclear ambitions are high Current China Nuclear Project Locations Source: World Nuclear Association

28. China will in time become a large importer of agricultural commodities • The Japanese experience suggests that as investment share to GDP declines, demand for hard commodity will also decline. But as per capita income rises, imports for agricultural commodity will rise. • China is likely to follow the same pattern for the following reasons: • Our estimates show that the size of the population with an income level of USD7000 and above is around 130 million, already a sizable number. • Emerging middle and upper income class will naturally demand high quality agricultural products, which will take time for Chinese farmers to supply.

29. China not only has limited endowment on arable land, the country also has very limited water resources. Freshwater per capita in China is only 1/3 of the global average. Meanwhile, fresh water endowment is distributed very unevenly, with the Southern provinces relatively well endowed, but the Northern plains very poorly endowed. Northern China accounted for only 19.6% of naturally available water resources, 46.5% of the population, 64.8% of the arable land. As income increases, residential usage of water will also tend to increase. Around 400 of 660 Chinese cities are reportedly short of water. 108 cities, most of them in Northern China including mega cities like Beijing and Tianjin, are facing serious water shortage problem. More importantly, water shortage suggests that China can no longer maintain the same scale of agricultural production.

30. Service industry will also benefit from China’s urbanisation process • Cross-country comparison suggests that as the urbanisation process picks up, the service sector also grows. • The service industry only accounts for 40% of China’s economy, which is quite low compared with the developed economies. The weight of financial sector also remains low, at around 5-6% of the total GDP, compared to a 15-20% weight in OECD economies. It still has a lot room to catch up.

31. Trend 3: China is to become a large foreign direct investor • With its FX reserve at USD2.4tn, China is destined to become a large foreign direct investor. • Outward Chinese non-financial FDI reached around USD43 bn in 2009, increasing 15 fold from the early 2000s. • Financial QDII quota suggest that close to USD70 bn are designated; this is in addition to China’s holdings of US treasuries of close to USD 800 bn. • Looking ahead, resources and technology companies are possible targets. Countries in ASEAN will also benefit from Chinese FDI because of the FTA, effective 1 Jan 2010.

32. Internationalisation of the RMB is to accelerate Source: Hong Kong Monetary Authority

33. RMB as a trade invoicing currency has started; more RMB bonds were issued in Hong Kong Since the launch of the RMB trade settlement scheme in July 2009, total transaction using RMB as a trade invoicing currency in Hong Kong has reached RMB 23.6 billion. In June 2010, total RMB settlement amount in Hong Kong was RMB 7.5 billion.

34. China and Japan average 2.1% of total reserves in gold Central Bank Gold Reserves 1.9% 2.3% Source: WGC

35. How much FX reserves should PBoC hold? • We estimate that the People’s Bank of China only needs to hold $1.1tn FX reserves, which is only 40% of the current reserves. • Actually, China has already started to diversify its FX reserve positions. Aside the set up of the sovereign wealth fund (CIC), China also shows high interest in gold. • The central bank of China is currently holding 1054 tons of gold. If China continues to purchase the gold until reaching Fed’s current holding (4000 tons), its share to FX reserve will only be around 7.0%.

36. Appendix: Statistics and forecasts Note: Forecasts are presented in italics.

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