China: The Probability of an Imported Soft Landing in 2008 Is Rising

Feels like winter: The recent sell-off in the Chinese stock market has reflected investors’ concerns about the risk of policy over-tightening in China as well as weaker-than-expected external demand as a result of a US recession, in my view. The market appears to have priced in the ‘winter scenario’: aggressive policy tightening chokes off domestic demand, exacerbating the impact of a global synchronized downturn and resulting in an outright hard landing of the economy. For instance, the property and financials sectors – which are domestic demand-oriented and heavily influenced by domestic tightening – are being hammered as much as the export-oriented sectors that are most vulnerable to a sharp slowdown in external demand. As discussed in our earlier note, we fear that the winter scenario will be “disastrous” for the stock market (see China Economics: Journey Into Autumn: An Imported Soft Landing in 2008, December 4, 2007).

A wake-up call from the US Fed: Last night, the FOMC announced a 75bp cut in the fed funds target. This is the first inter-meeting move since the days immediately following 9/11. Our US economist, David Greenlaw, now expects another 25bp cut at next week’s FOMC meeting. In my opinion, this decisive move will make Chinese policy-makers fully appreciate the large downside risk facing the US economy and seriously consider easing the existing policy controls as a first line of defense. I therefore believe that the risk of the ‘winter scenario’, or ‘over-tightening by policy mistake’, is now substantially lower than before (see China Economics: Two Types of Over-tightening, January 4, 2008).

Changing our interest rate call: In light of these latest developments, we now change our original PBOC call from ‘two more rate hikes in 1H08’ to ‘no rate hike’ in 2008. While the authorities will unlikely make any formal announcement to suspend the current round of macro tightening, we expect the officials’ policy tone to become less hawkish in the next couple of months and the stance to eventually (and quietly) ease by mid-year.

Reaffirming our ‘imported soft landing’ call: We now attach a higher probability to ‘an imported soft landing’ as the baseline scenario for 2008 and maintain our forecast of China’s GDP growth decelerating from about 11.5% in 2007 to 10% in 2008. The global downturn should help the Chinese economy to cool off without the government taking aggressive tightening actions by resorting to blunt policy instruments, which may bring about a hard landing.

Reiterating our early assessment of market implications: Under our baseline scenario of an imported soft landing, the Chinese economy – in adapting to a weak external environment – will likely be able to realize a welcome rebalancing (away from external to domestic demand) that would otherwise be unachievable, thus boding well for a sustained and robust expansion over the medium term. While this growth rebalancing should be positive to the equity market over the medium term (i.e., 1-3 years), the stock market performance would likely be moderately negative in the near term (i.e., 6-12 months). Specifically, low-valued and low-margin export-oriented sectors (e.g., textiles) may be hard-hit, as firms in those sectors may attempt to hold onto their market share by squeezing their profit margins in order to remain competitive. At the same time, domestic market-oriented sectors – especially those exposed to capex spending supported by the government – should do relatively well, as the government increases its spending to shore up domestic demand, offsetting external demand.

By Qing Wang Hong Kong
Morgan Stanley
January 23, 2008