China: Realising an Imported Soft Landing

Commencing on an imported soft landing in 4Q07: The Chinese economy appears to have commenced on an imported soft landing in 4Q07, as slower export growth (+22.2%Y in 4Q versus +26.2% in 3Q) cooled overall real GDP growth to 11.2%Y, from 11.5% in 3Q. We estimate that the contribution to overall GDP growth from the expansion of the trade surplus scaled back to just 0.3 percentage points in 4Q, compared to an average of 2.6 ppts over the preceding six quarters. Needless to say, sustained vigor in domestic demand contributed an increasing share of overall growth, at 10.9 ppts in 4Q, by our estimates.

Real economic activity maintained robust growth, supported by domestic demand: Industrial output growth, though slowing from 18.1% in 3Q, sustained a robust pace of 17.5% in 4Q (+17.4% in December). Domestic consumer demand continued to demonstrate strength, surging 20.2%Y in December, accelerating from 18.8% in November despite the ease in retail inflation in the month (+5.6% in December versus +6% in November). Fixed asset investment, on the other hand, showed some gradual deceleration in line with slower loan growth. Overall fixed asset investment in the whole economy grew 24.8% in the full year (down from 25.7% in January-September) to Rmb13.7 trillion, faster than the 24% gain in 2006. Urban FAI concluded the year gaining 25.8% (Rmb11.7 trillion), also faster than that in 2006 (+24.5%), but dipping from 26.8% in the first 11 months.

Inflationary pressures persist, justifying tight policy stance in the short term... CPI inflation moderated to 6.5%Y in December, from 6.9% in November, mainly reflecting some softening in food price inflation to around 16% (estimated from full year figure of 12.3%), from 18.2% in November. Food inflation accounted for 4 ppts, or 83% of overall inflation in 2007, while non-food inflation averaged just 1.1%. The acceleration in upstream inflation in December (PPI +5.4% versus +4.6% in November, RMPPI +8.1% versus +6.3% in November) serves as a reminder that inflation pressures are still persistent, justifying the maintenance of a tight policy stance in the short term. In our view, cooling money supply will remain a key tool to rein in inflation as well as inflationary expectations. We believe that, looking ahead, inflation should respond to slower monetary growth and government price controls, though with a time lag. We forecast CPI inflation to come under control in the course of the year, averaging 4.5% in 2008.

... but external weakness to allow earlier policy easing: We believe that the latest data perfectly demonstrate the dichotomy we have been looking for – external weakness and domestic strength – which strengthens our call for an imported soft landing this year (see Journey Into Autumn: An Imported Soft Landing in 2008, December 4, 2007). In the face of slowing external demand amid an imminent recession in the US economy, we forecast export growth to slow to 16% in 2008, and that the net exports contribution to GDP growth will dip to only 0.5ppt, from over 2 ppts in the last three years. In other words, external weakness will help cool the Chinese economy without further aggressive tightening actions through blunt policy instruments by the government.

Reiterating our call for an imported soft landing: The aggressive 75bp inter-meeting rate cut by the US Fed served as a wake-up call for Chinese policymakers, in our view, ensuring that they fully appreciate the downside risks facing the US economy, and would appropriately consider easing the existing policy controls as a first line of defense. In particular, we have changed our original PBoC call from “two more rate hikes in 1H08” to “no rate hike” in 2008 in response to the latest Fed rate cut. We believe that the sharp rate cut by the Fed has limited the room for China to hike rates, mainly because of the rise in sterilization costs of the PBoC’s open market operations. We believe that the PBoC will have to rely more on other measures (e.g., RRR hikes and administrative credit controls, and possibly complemented by faster RMB appreciation) to control liquidity and ease inflationary pressures. This is lowering the probability of “over-tightening by policy mistake” that we had feared before (see Two Types of Over-tightening, January 4, 2008). We reiterate our call for an imported soft landing as the baseline scenario for 2008 and maintain our forecast of China’s GDP growth decelerating to 10%.

By Denise Yam, CFA Hong Kong
Morgan Stanley
January 24, 2008