bmi china business forecast report q1 2014

8/9/2019 BMI China Business Forecast Report Q1 2014

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Published byBUSINESS MONITOR INTERNATIONAL LTD

BUSINESS FORECAST REPORT

Q1 2014www.businessmonitor.com

CHINAINCLUDES 10-YEAR FORECAST TO 2022

Recovery Faces Renewed Risks

ISSN 1744-8778

Published by Business Monitor International Ltd.

Copy Deadline: 10 October 2013


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Executive Summary ................................................................................................................................. 5

Core Views ......................................................................................................................................................................................5

Major Forecast Changes ................................................................................................................................................................5

Key Risks To Outlook ....................................................................................................................................................................5

Chapter 1: Political Outlook .................................................................................................................... 7

SWOT Analysis .......................................................................................................................................................... 7

BMI Political Risk Ratings ........................................................................................................................................ 7

Domestic Politics ...................................................................................................................................................... 8

Third Plenary Session To Focus On Moderate Economic Reforms ..........................................................................................8

The upcoming Third Plenary Session of the 18th CPC Central Committee is likely to represent a step towards broader economicliberalisation. That said, we believe that the party leadership will opt for relatively modest rather than revolutionary economic reforms,potentially including the gradual reduction of capital controls along with the liberalisation of the Chinese yuan. While Xi Jinping's much-touted anti-corruption drive may also be prominently featured, we believe that the emphasis on broader political reforms will be relativelyminimal.

TABLE: POLITICAL OVERVIEW .............................................................................................................................................................................8

Long-Term Political Outlook .................................................................................................................................... 9

Major Challenges Over The Coming Decades .............................................................................................................................9

China faces myriad economic, social and environmental challenges over the coming decades that could seriously test the CommunistParty of China's ability to govern. The best-case scenario for any eventual political transition would entail an elite-led liberalisation of theauthoritarian system, while the worst-case scenario would involve a violent change of regime.

Chapter 2: Economic Outlook ............................................................................................................... 13

SWOT Analysis ........................................................................................................................................................ 13

BMI Economic Risk Ratings ................................................................................................................................... 13

Economic Activity ................................................................................................................................................... 14

Out With The Old, In With The New ............................................................................................................................................14

While the outlook for China's traditional economic growth drivers such as heavy industry and real estate construction remains cloudy,the more consumer-focused industries are expected to perform relatively strong over the medium term. That said, as the traditionalsectors remain the dominant drivers of the economy, we remain below consensus in our real GDP growth outlook and caution that theinevitable bursting of the ongoing credit bubble could also serve to undermine the protability of the consumer-focused industries. Weare revising up our real GDP growth forecast for 2013 to 7.6%, from 7.5% previously, and maintain our downbeat 6.7% forecast for2014.

TABLE: ECONOMIC ACTIVITY ............................................................................................................................................................................. 14

Fiscal Policy ............................................................................................................................................................ 16

Our Take On The Latest Stimulus ...............................................................................................................................................16The prevailing negativity surrounding China's near-term macro prospects has been softened somewhat by news of yet another 'mini-stimulus' unveiled by Beijing. As has been the case in the past, our view is that further scal and monetary pump priming will failto arrest the structural deceleration in the Chinese economy and will, at best, merely serve to cushion the slowdown. That said, anunwinding of downbeat sentiment bodes well for a continuation of relief rallies in Chinese equities and risk assets at large. We remaintactically bullish towards the Shanghai composite and Chile's benchmark IPSA indices.

TABLE: FISCAL POLICY .......................................................................................................................................................................................16

Monetary Policy ....................................................................................................................................................... 18

Interest Rate Reforms Leave A Lot To Be Desired....................................................................................................................18

The decision taken by the People's Bank of China on July 19 to allow further interest rate liberalisation was the latest in a growing seriesof piecemeal reform measures aimed at improving productivity in the Chinese economy. However, the move is unlikely to have anypractical signicance, as the lending oor did not act as a binding constraint to the banking system. Deposit rate liberalisation remainsthe key to reforming the banking system, and we are less condent that this will be forthcoming any time soon.

TABLE: MONETARY POLICY ...............................................................................................................................................................................18Exchange Rate Forecast ........................................................................................................................................ 19

PBoC To Keep Newly Implemented Peg In Place ......................................................................................................................19

TABLE: BMI CURRENCY FORECASTS .............................................................................................................................................................. 19

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Contents


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Chapter 3: 10-Year Forecast .................................................................................................................. 21

The Chinese Economy To 2022.............................................................................................................................. 21

6.0% Is The New 10.0% ................................................................................................................................................................21

China's economic growth in the coming decade will be much slower than in the previous one as the savings rate declines, the economicliberalisation process slows and population growth falls. These dynamics will result in real GDP growth averaging 6.2% over the nextdecade, in contrast with the 10.7% average of the past 10 years. Private consumption will be a major outperformer, averaging growth of8.2% and rising in importance as a share of GDP.

TABLE: LONG-TERM MACROECONOMIC FORECASTS ...................................................................................................................................21

Chapter 4: Business Environment ........................................................................................................ 23

SWOT Analysis ........................................................................................................................................................ 23

BMI Business Environment Risk Ratings ............................................................................................................. 23

Business Environment Outlook ............................................................................................................................. 24

Institutions ............................................................................................................................................................... 24

TABLE: BMI BUSINESS & OPERATION RISK RATINGS....................................................................................................................................24

TABLE: BMI LEGAL FRAMEWORK RATING.......................................................................................................................................................25

Infrastructure ......................................................................................................................................................... 26

TABLE: LABOUR FORCE QUALITY .....................................................................................................................................................................26

TABLE: ASIA ANNUAL FDI INFLOWS ..............................................................................................................................................................27TABLE: TRADE & INVESTMENT RATINGS .........................................................................................................................................................28

Market Orientation ................................................................................................................................................... 29

TABLE: TOP EXPORT DESTINATIONS (US$MN) ...............................................................................................................................................30

Operational Risk ..................................................................................................................................................... 31

Chapter 5: Key Sectors .......................................................................................................................... 33

Infrastructure ........................................................................................................................................................... 33TABLE: CONSTRUCTION & INFRASTRUCTURE INDUSTRY DATA, 2011-2016 ..............................................................................................34

TABLE: CONSTRUCTION & INFRASTRUCTURE INDUSTRY DATA, 2017-2022 ..............................................................................................35

Oil & Gas .................................................................................................................................................................. 36

TABLE: OIL PRODUCTION & NET EXPORTS, 2011-2016 ..................................................................................................................................38

TABLE: OIL PRODUCTION & NET EXPORTS, 2017-2022 ..................................................................................................................................38

TABLE: GAS PRODUCTION, CONSUMPTION & NET EXPORTS: HISTORICAL DATA & FORECASTS, 2011-2016 ....................................39

TABLE: GAS PRODUCTION, CONSUMPTION & NET EXPORTS: LONG-TERM FORECASTS, 2017-2022 ....................................................39

Other Key Sectors ................................................................................................................................................... 41

TABLE: PHARMA SECTOR KEY INDICATORS ...................................................................................................................................................41

TABLE: TELECOMS SECTOR KEY INDICATORS...............................................................................................................................................41

TABLE: DEFENCE & SECURITY SECTOR KEY INDICATORS...........................................................................................................................41

TABLE: AUTOS SECTOR KEY INDICATORS ......................................................................................................................................................42

TABLE: FOOD & DRINK SECTOR KEY INDICATORS ........................................................................................................................................42

TABLE: FREIGHT SECTOR KEY INDICATORS ...................................................................................................................................................42

Chapter 6: BMI Global Assumptions .................................................................................................... 43Growth Outlook ....................................................................................................................................................... 43Increasing Confdence In Growth...............................................................................................................................................43

TABLE: GLOBAL ASSUMPTIONS ........................................................................................................................................................................43

TABLE: DEVELOPED STATES, REAL GDP GROWTH, % ..................................................................................................................................44

TABLE: BMI VERSUS BLOOMBERG CONSENSUS REAL GDP GROWTH FORECASTS, % ..........................................................................44

TABLE: EMERGING MARKETS, REAL GDP GROWTH, % .................................................................................................................................45


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Core Views With Chinese economic activity stabilising, there is optimism that

growth could accelerate amid proposed free market reforms. While

we believe that resource price liberalisation, which would loosen the

power of state owned enterprise, and labour market reform could help

China to grow strongly over the coming years, these reforms are by

no means a given considering the opposition from vested interests.

Even if reforms are enacted, the dominant driver of the economy

in 2014 will be the unwinding of the country's credit bubble, whichis likely to undermine economic growth and create further stress in

the banking system.

Opposing inationary and deationary forces will complicate Chinese

monetary policy over the coming quarters. Excessive credit growth

and record property prices suggest the need for tightening, while

subdued headline consumer price ination, banking sector stress

and plunging equity prices suggest there is a case to be made for

easing policy. We believe that deation is more likely than a spike

in ination, and expect the central bank to act accordingly, easinginterest rates and providing support to the banking system as credit

growth slows, negatively impact the real economy.

China's upcoming Third Plenary Session of the 18th CPC Central

Committee, set to be held in November, will very likely provide further

insight into the scope of economic, nancial and social reforms that

the government is set to introduce. Hukoureform, the maturation

and opening up of the country's nancial markets and capital ac-

count, subsidy reform, and the wider transition from investment- to

consumption-led economic growth are likely to be on the table.

President Xi Jinping will likely use the session as a platform on which

he can further burnish his anti-corruption credentials, and the party

will, as always, look to present a completely unied front. That said,

a number of reports continue to reect a schism between reformist

and more reactionary factions within the government, and Xi will

likely choose to tread a middle ground between the two extremes.

Major Forecast Changes We have upgraded our 2013 real GDP growth forecast from 7.5% to

7.6% to reect the recent stabilisation in economic activity readings.

We have also revised up the outlook for the yuan, now expecting

stability rather than weakness. The central bank's determination to

resist depreciation over recent months in spite of regional weakness

is a positive sign that stability will be forthcoming.

Key Risks To Outlook The main downside risk to our economic outlook remains another

collapse in external demand, such as the one that occurred at the

height of the global nancial crisis. This would seriously undermine

growth in trade-dependent industries and hasten a fall in the property

market, potentially leading to an outright recession. There is also a

risk that continued scal and monetary stimulus by the government

and the People's Bank of China could usher in stagation.

The major political risk comes from a rise in social unrest and a surge

in public demonstrations against government corruption, inationand housing affordability, which could be triggered by overseas

events or an economic slump. While we do not see the rule of the

Communist Party of China as being at risk, such events would still

have a detrimental impact on the business environment and could

see the party strengthen its grip on the economy to the detriment

of growth.


Executive Summary


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Brief Methodology

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SWOT Analysis

Strengths The Communist Party of China, which has governed for more than

60 years, remains secure in its position as the sole political party in

China.

China's expanding economy is giving it greater clout in international

affairs, which will allow it to build politically important ties, especially

with the developing world.Weaknesses

As with any other one-party state, China's political system is inher-

ently unstable and unable to respond to the wider changes taking

place in society. Provincial governments often fail to enforce central

government directives.

Although bilateral ties have warmed in recent years, China's relation-

ship with Taiwan remains problematic, with Beijing refusing to rule

out the threat of force in the event of a declaration of independence

by Taiwan.

Opportunities China is actively expanding its political and economic ties with major

emerging markets in Latin America, Africa and the Middle East.

A new generation of leaders (the so-called 'fth generation') took

power in 2012. This is likely to ensure the continuation of reform

and modernisation.

Threats Growing corruption, widening inequalities, increasing rural poverty

and environmental degradation have led to an increase in social

unrest in recent years.

The Communist Party of China is facing increasing factional rifts

based on ideology and regionalism. While greater political debate

would be welcomed by many, internal regime schisms could prove

politically destabilising.

BMI Political Risk RatingsChina's Short-Term Political Risk Rating of 77.3 reects the high de-

gree of policy continuity and cohesion with regard to the policymaking

process associated with one-party rule. However, while this is a boon in

the near term as reected by the high score it acts as a drag on the

country's Long-Term Political Risk Rating of 62.9. Indeed, the absence

of a strong constitutional framework and the tight control over political

freedoms hurt China's long-term rating sharply, with the 'characteristics

of policy' subcomponent particularly low.

Chapter 1:

Political Outlook

S-T Political Rank TrendSingapore 94.8 1 =Brunei Darussalam 90.6 2 =Hong Kong 84.8 3 =Taiwan 83.3 4 =Laos 80.4 5 =Vietnam 79.0 6 =South Korea 77.7 7 =China 77.3 8 =Sri Lanka 77.1 9 =Malaysia 75.6 10 =Philippines 72.1 11 =North Korea 71.9 12 =Mongolia 70.4 13 =Indonesia 68.8 14 =

Bangladesh 68.3 15 =Thailand 65.0 16 =India 64.8 17 -Cambodia 64.0 18 -Bhutan 61.0 19 =Myanmar 56.9 20 =Pakistan 51.7 21 =Papua New Guinea 45.2 22 =Regional ave 73.0 / Global ave 65.2 / Emerging markets ave 62.7

L-T Political Rank TrendSouth Korea 84.2 1 =Singapore 80.6 2 =Taiwan 75.4 3 =Hong Kong 72.9 4 =Mongolia 67.7 5 =Malaysia 67.2 6 =India 65.7 7 =Brunei Darussalam 65.6 8 =

China 62.9 9 =Philippines 62.8 10 =Bangladesh 62.6 11 =Thailand 61.8 12 =Sri Lanka 60.2 13 =Indonesia 60.0 14 =Cambodia 59.3 15 +Vietnam 57.7 16 =North Korea 55.2 17 =Papua New Guinea 54.8 18 =Pakistan 53.7 19 =Bhutan 51.0 20 =Laos 46.9 21 =Myanmar 40.9 22 =

Regional ave 62.8 / Global ave 63.2 / Emerging markets ave 59.6


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Domestic Politics

Third Plenary Session To Focus OnModerate Economic Reforms

BMI VIEW

The upcoming Third Plenary Session of the 18th CPC Central Commit-

tee is likely to represent a step towards broader economic liberalisa-

tion. That said, we believe that the party leadership will opt for relatively

modest rather than revolutionary economic reforms, potentially includ-

ing the gradual reduction of capital controls along with the liberalisation

of the Chinese yuan. While Xi Jinping's much-touted anti-corruption

drive may also be prominently featured, we believe that the emphasis

on broader political reforms will be relatively minimal.

China's upcoming Third Plenary Session of the 18th Communist

Party of China (CPC) Central Committee, set to be held in No-

vember, will very likely provide further insight into the scope

of economic, nancial and social reforms that the government

is set to introduce over the next four (and to some extent nine)

years. Among China's annual plenary sessions, the third session

is perhaps the most important in terms of setting out the govern-

ment's reform agenda, as the rst two such meetings are typically

more focused on the consolidation of the incoming leadership.

Among the most likely issues that will come to the fore in the

session are hukoureform, the maturation and opening up of the

country's nancial markets and capital account, subsidy reform,

and the wider transition from investment- to consumption-led

economic growth.

Rumours of discord have been swirling around the Bo Xilai case

(the former Chongqing party secretary was recently sentenced

to life imprisonment for corruption and abuse of power), and

President Xi Jinping will likely use the session as a platform

on which he can further burnish his anti-corruption credentials.

The party will, as always, look to present a completely unied

front. That said, a number of reports continue to reect a schism

between reformist and more reactionary factions within the

government, and Xi will likely choose to tread a middle ground

between the two extremes.

Evolutionary, Not RevolutionaryEconomic Reforms ExpectedIn terms of the economy, perhaps the most fervent speculation is

regarding the liberalisation of the renminbi, and whether a more

objective timeline for the process will be laid out at the plenary

session. Indeed, the third plenum has historically been the forum

for the announcement of major economic reform initiatives dat-

ing back to 1978, when China's post-Mao leadership announced

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CHINA Q1 2014

TABLE: POLITICAL OVERVIEW

System of Government Single-party socialist republic

Head of State President Xi Jinping (serving rst of a maximum two ve-year terms)

Head of Government Prime Minister Li Keqiang (serving rst of a maximum two ve-year terms)

Last Election Presidential and parliamentary March 2013

Communist Party of China congress November 2012

Composition of Current Government Communist Party of China (CPC)

Key Figures The Politburo Standing Committee acts as the de facto highest decision-making body in Chinaand comprises the top leadership of the ruling party. Its members, in order of protocol, are: Xi Jin-ping (concurrently general secretary of the CPCy), Li Keqiang, Zhang Dejiang, Yu Zhengsheng,Liu Yunshan, Wang Qishan, Zhang Gaoli

Other Key Posts Finance Minister Lou Jiwei; Foreign Minister Wang Yi; Defence Minister Chang Wanquan;Minister of Public Security Guo Shengkun; Central Bank Governor Zhou Xiaochuan

Main Political Parties (number of seats in parliament) CPC: The founding and ruling political party of the People's Republic of China, whose paramountposition as the supreme political authority is guaranteed by China's constitution and realisedthrough control of all state apparatus. The CPC was founded in 1921 and came to rule all ofmainland China after defeating its rival, the Kuomintang, in the Chinese Civil War.

Next Election Presidential and parliamentary March 2018

CPC congress Autumn 2017

Ongoing Disputes Ongoing dispute over Taiwanese sovereignty and Tibetan autonomy; some minor territorydisputes with Asian neighbours, including with Japan over the Senkaku Islands in the East ChinaSea and with Taiwan, Malaysia, the Philippines and Vietnam over the Spratly Islands in the SouthChina Sea.

Key Relations/ Treaties Close Link With ASEAN, WTO member, permanent seat on the UN Security Council, foundingmember of the Shanghai Cooperation Organisation.

BMI Short-Term Political Risk Rating 77.3

BMI Structural Political Risk Rating 62.9

Source: BMI


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a new focus on modernizing the economy, effectively ending

the Cultural Revolution and paving the way for the Chinese

economy to embark upon its current growth trajectory. That

said, we expect economic reforms in this year's iteration of the

meeting to be decidedly more low-key, with a spate of smaller

and more gradual policy measures likely to be presented. Assuch, we envisage plans regarding the eventual liberalisation of

both China's capital account and the renminbito be measured in

nature, with bilateral currency swaps as well as limited offshore

trading hubs among the government's chosen expansion tools.

In general, the plenary session is likely to yield policies that

are more evolutionary than revolutionary in nature, with much

of the language ahead of the event focusing on the 'deepening'

of current reforms rather than the introduction of brand new

initiatives. While a good deal of attention will likely be paid tothe continued transformation of China's economic model from

one of investment-led growth to consumption-led growth, we

also note that the administration has yet to prove itself in this

capacity. Much has been made about the untenable credit excesses

within the economy, a large slice of which are attributable to

massive local government borrowing for infrastructure projects.

However, since Xi assumed power in March 2013, there has

not yet been a discernible slowdown in overall credit growth,

suggesting that the economy remains very much reliant on the

old growth model (see 'Another Credit Binge Will Not CureEconomy', September 12 2013), and that the government has

not yet chosen to clamp down on lending.

Major Political Reforms Unlikely,But Corruption To Be AddressedBeyond the economy, the plenary session is likely to be somewhat

light on the topic of political reform. As has been our outlook in

the past, we do not expect a concerted move towards political

liberalisation from the Xi government over the course of his

rst term, and therefore would not expect to see liberal politicalmeasures introduced in the upcoming plenary session. While

Xi himself may be slightly more liberal than his predecessor,

Hu Jintao, we believe that there are multiple constraints on

his ability to actually implement potentially painful economic

and political reforms (see 'New Leadership Facing Multiple

Constraints On Reforms', April 18 2013).

On the other hand, Xi's anti-corruption drive will likely receive

some attention at the plenum, as the party is keen to present a

united front against what it has deemed to be one of the greatestthreats to its legitimacy. The recent expulsion of former rising

star Bo Xilai from the Communist Party ahead of his sentencing

to life in prison, is largely signicant as an indication to the public

that no ofcial is too powerful to be prosecuted. Furthermore, Bo's

takedown could indicate that a wider purge may be taking place

within the Communist Party, as those who are targeted (particularly

higher level ofcials) are likely to have run afoul of the party's

top leadership. Notably, although such a purge would appear toindicate some level of tension between rival factions within the

party, it would not be without historical precedent and is unlikely

to signify any level of substantial political instability in China.

Long-Term Political Outlook

Major Challenges Over The Coming

Decades

BMI VIEW

China faces myriad economic, social and environmental challenges

over the coming decades that could seriously test the Communist Party

of China's ability to govern. The best-case scenario for any eventual

political transition would entail an elite-led liberalisation of the authori-

tarian system, while the worst-case scenario would involve a violent

change of regime.

Perhaps the biggest question concerning China's future is whetherthe country will eventually move towards a democratic system

of government. This question has received greater attention

following the political upheaval in the Middle East and North

Africa in 2011. China is increasingly an anomaly in that it is

the only major emerging economy that has not yet experienced

a transition to democracy. Other countries as diverse as Rus-

sia, Poland, Mexico, Brazil, South Africa, South Korea and

Indonesia all moved away from one-party rule to democracy

once they attained a certain level of economic development,

suggesting that China will, too. For now, the Communist Partyof China (CPC) derives its legitimacy from delivering rapid

rates of economic growth, which has lifted hundreds of millions

of people out of poverty over the past 30 years. Chinese state

planners widely regard an annual real GDP growth rate of 8.0%

to be the minimum necessary to create enough jobs to maintain

social stability. Thus, the weak global economy presents the

most immediate test of the CPC's governance. Even without

the anticipated slowdown, however, China will continue to

face many challenges.

Threats And Challenges To StabilityRising Inequality:As China's economy surged during the 2000s,


POLITICAL OUTLOOK


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inequality widened sharply. Although comparisons between

different organisations' calculated Gini coefcients are inexact

owing to differing methodologies, most observers agree that

inequality is rising. In December 2012, the Gini coefcient was

estimated at 0.61 based on a survey of 8,438 households by the

Survey and Research Center for China Household Finance, abody set up by the Finance Research Institute of the People's

Bank of China and Southwestern University of Finance and

Economics. This is an exceptionally high gure, far above a

government estimate of 0.41 in 2000, a World Bank estimate

of 0.42 in 2005, and a China Academy of Social Sciences gure

of 0.54 in 2008. Moreover, ongoing revelations that China's po-

litically connected elites have accumulated vast wealth through

corrupt practices are bound to raise public anger.

Regional Economic Imbalances: The eastern seaboard hasbeneted disproportionately from China's rapid expansion. In

particular, there is a relatively wealthy coastal belt consist-

ing of Tianjin, Shandong, Jiangsu, Shanghai, Zhejiang, Fujian

and Guangdong provinces where urban household per capita

GDP was higher than CNY21,000 (the average for urban China)

in 2010. Unsurprisingly, these provinces are also where most

of China's industry and foreign direct investment (FDI) are

concentrated. By comparison, rural household per capita GDP

was roughly CNY8,100. Much of the western and interior parts

of China remain poor and underdeveloped. Consequently, theeastern seaboard provinces are receiving migration inows from

other parts of China, although this was temporarily reversed

during the 2008-2009 slowdown. Although the government

has undertaken massive development plans to address these

imbalances, and new factories are gradually being built further

inland, this will be a long drawn-out process in a country of

China's size.

Employment And Working Conditions:The past decade or

so has seen an increase in labour unrest. Job losses from eco-nomic restructuring have generated some resentment towards

the CPC, which is ofcially a party of the workers. There is also

rising discontent over harsh working conditions, particularly

in China's coal mines, where deaths typically number in the

thousands every year.

Environmental Issues: China's rapid economic growth has

come at the cost of environmental degradation. In 2005, of-

cials acknowledged that more than 70% of rivers and lakes

were polluted. In July 2010, the Ministry of EnvironmentalProtection stated that 24% of China's surface water was unt

for any purpose, including industrial use. Furthermore, many

parts of China experience water shortages, and these are likely

to increase as urbanisation rates rise. China's cities are also

notoriously polluted as a result of coal power plants. In addi-

tion, villagers have taken to violent protests against pollution or

forced land clearing for new projects. The issue of land seizure

has led to major unrest in the countryside. Chinese leaders arewell aware of the risks to economic growth and social stability

posed by pollution. However, the implementation of tougher

environmental laws is being subverted by vested interest groups

and corruption.

Religions And Ethnicity:Chinese leaders are fearful of the

possibility of religious- or ethnic-based rebellions, which sig-

nicantly affected the country in the 19th and 20th centuries.

For example, the emergence of the Falun Gong sect in 1999

caught the Chinese leadership by surprise; the popularity ofthe group was seen as a threat to the CPC, prompting a harsh

(and ultimately successful) crackdown. Meanwhile, Christian-

ity is reportedly growing rapidly in China. The government

recognises an ofcial state-sanctioned church, but underground

churches and sects are on the rise. While neither Falun Gong

nor Christian groups pose a direct threat to the government,

any crackdown against them risks creating a broader backlash

against the authorities.

China has 18 nationalities with populations of more than 1.0mn,out of 56 recognised nationalities total. The most well-known

minorities are the Tibetans and the Muslim Uighurs of Xinjiang

province. The Tibetans staged a major uprising in 2008 and

may rebel again in the event of the Dalai Lama's death, as the

younger generation is considered more militant. The Uighurs

clashed with the Han Chinese in July 2009, leaving around

150 dead. Aside from these two groups, violence has erupted

between minorities and the majority Han population from time

to time. The government plays down the ethnicity issue, yet it

nonetheless has the ability to create instability.

Gender Imbalance:As a result of the one-child policy (adopted

in 1980) and a general bias in favour of sons, China has a pro-

nounced gender imbalance, particularly in the under-30 age

bracket. The Chinese Academy of Social Sciences stated in

2009 that more than 24mn Chinese men of marrying age could

nd themselves without spouses in 2020. A noteworthy book

('Bare Branches: The Security Implications of Asia's Surplus

Male Population') points out that such imbalances are potentially

destabilising for societies, since most crimes are committed bysingle males younger than 30.


CHINA Q1 2014


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Financial Stresses:Although the banking sector has avoided a

long-predicted crisis, there are concerns that it remains opaque

and that lending is still largely policy-driven. In addition, the

surge in bank lending since early 2009 could yet create more

non-performing loans for banks.

Internal Regime Fault Lines:Within the CPC, there are report-

edly factional schisms. These reect differences over ideology

(namely between those who favour more neoliberal reforms and

those who favour a more statist model), geographical regions

within China, the 'generations' within the party and the debate

over whether China should behave more assertively abroad.

All CPC factions favour a continuation of its rule, meaning that

they are unlikely to challenge the system outright. Nonetheless,

factional rivalry could complicate decision-making, thereby

leading to slower reforms.

Foreign Conict:Although Chinese ofcials have emphasised

the country's 'peaceful rise', the People's Liberation Army has

been sounding a more nationalistic tone. Beijing's increasing

assertiveness over its claims to the South China Sea and East

China Sea could lead to naval skirmishes or conict with Viet-

nam, the Philippines, Japan or even the US. In addition, China

continues to claim Taiwan as a province and has considerable

interests in neighbouring North Korea and Myanmar, which

may eventually necessitate intervention. Chinese military as-sertiveness could play well with nationalistic elements in society,

but could harm its international image and lead to intra-regime

tensions between 'hawks' and 'doves'.

BMI's Long-Term Political Risk Rating for China stands at

62.9. The weakest score, of 33/100, is in the 'characteristics of

polity' subcomponent, which carries a 30% weighting. This score

reects China's authoritarian one-party system of government,

which tolerates virtually no dissent. The 60/100 score in the

'characteristics of society' subcomponent (30% weighting) isconstrained by China's very high Gini (inequality) coefcient.

China scores a respective 85/100 and 90/100 in the 'scope of

state' and 'policy continuity' subcomponents (each with a 20%

weighting). Overall, the country's problems are by no means

unique to China. Rather, they are symptomatic of emerging

countries in general. However, they are on a scale never seen

before, which arguably gives them a qualitative dimension.

Furthermore, unlike citizens of other emerging nations, the

Chinese public do not have the opportunity to change their

government via the ballot box. This leaves open the possibilityof increased public unrest.

Scenarios For Political ChangeAlthough China's former paramount leader, Deng Xiaoping,

stated in 1987 that elections would be possible in 50 years,

Chinese leaders continue to reject moves to adopt Western-style

democracy, fearing that this would lead to chaos. Indeed, in

2005, the CPC released its rst white paper, 'The Building of

Political Democracy', which stated that 'democratic government

is the Chinese Communist Party governing on behalf of the

peoplewhile upholding and perfecting the people's dictator-

ship'. Rather than developing a Western-style liberal democracy,

the CPC believes that 'China's socialist political democracy has

vivid Chinese characteristics'. The Chinese leadership became

particularly worried about the possibility of revolution in China

following the upheaval that shook the Middle East in 2011, and

moved to suppress internet coverage of events there. China'simpressive economic achievements over the past 30 years have

given Chinese citizens less reason to resent their leadership

compared with Egyptians, Syrians, Yemenis etc. Nevertheless,

we would expect to see greater calls for democratisation over

the next 10-20 years.

Best-Case Scenario Elite-Led Transition: Against this

backdrop, the best-case scenario for political change in China

would be a stable, elite-led transition, under which a reformist-

minded CPC phases in free, multi-party elections at the city,provincial and national level over a period of several years.

Possible role models include South Korea and Taiwan, both of

which enacted democratic reforms in the late 1980s and early

1990s after decades of one-party rule. In both countries, the

governing party was able to hold on to the elective presidencies

for 10 and 12 years respectively and control the democratically

elected legislatures until the early 2000s. Should China follow

this pattern, the CPC could retain substantial political inuence

even after a putative transition to democracy. An alternative

to the multi-party model would be a system whereby the CPCremains the sole political party but allows multiple candidates

from its ranks to run for election to key administrative posts.

Under the best-case scenario, rapid economic growth would

remain on track and the liberalisation process should reassure

foreign investors that China is on the road to becoming a 'nor-

mal' country. However, South Korea (population 45mn) and

Taiwan (23mn) are far smaller and much more homogeneous

than China, and were considerably richer in the late 1980s than

China is today. As such, their experiences may not be easy toemulate at the present time.


POLITICAL OUTLOOK


13/47

Worst-Case Scenario Indonesia-Style Chaos:The worst-

case scenario for Chinese politics would be an extended period

during which the growing contradictions within the economy

foster more and more 'incidents of mass unrest' especially

organised unrest to the point that foreign investors withdraw

their capital and the government is forced to carry out a harsh

crackdown. The trigger for accelerated unrest could come from

a full-scale meltdown of the economy or a multi-year period of

growth substantially below what China has been accustomed

to (for example, 5% or less annually). We feel that both of

these developments are unlikely at this stage, but they cannot

be ruled out entirely.

Were the economy to experience such stresses, the CPC could

nd itself in a similar position to Indonesia's Suharto regime in

1997-1998, when civil unrest caused foreign investors to ee andthe government was ultimately toppled. Indonesia subsequently

democratised over a six-year period, but real GDP growth has yet

to return to pre-1997 levels, and the economy is still considered a

somewhat risky investment destination (although it has received

renewed interest in recent years). An 'Indonesia scenario' in

China would set the latter's growth story back years and could

entail regional separatism or even a military coup. China has

experienced several periods in its history during which central

government authority has been reduced to only nominal control

over the provinces and warlords have held sway.

Democracy No Quick FixThe above scenarios are not the only paths available to China,

and any transition could incorporate elements of both outcomes.

Overall, while a democratic government in China would very

likely be more responsive to popular demands and allow greater

political transparency, it would by no means provide a rapid

panacea for China's myriad problems. Beyond democratisation,

there would also be the issue of centre-periphery relations would

China remain a centralised state or would it adopt a federalmodel that would allow greater autonomy for its provinces?

Furthermore, the political and economic culture resulting from

decades of one-party rule will linger in China, and issues such

as corruption and close links between business and government

will not go away quickly. Finally, in a democratic China, popular

pressures could force the government to go slow on economic

liberalisation, as has happened in many emerging economies.


CHINA Q1 2014


14/47


SWOT Analysis

Strengths China has a massive trade surplus, and its huge foreign exchange

reserves serve as a major cushion against external shocks.

China's economic policymakers are committed to continuing their

gradual reform of the economy.

Weaknesses

China's economic growth boom has led to major imbalances andenvironmental degradation.

The country's dependency on investment to boost growth has made

it vulnerable to a slowdown in credit growth. Private consumption

remains weak at less than 40% of GDP.

The close relations between provincial leaders and local businesses

are fostering corruption, making it harder for the central government

to enforce its policies.

Opportunities China's economic growth is slowly becoming more broad-based, with

domestic consumption likely to rise in importance vis--vis exportsand investment.

As China moves up the value chain, it will develop its own global

brand-name companies, fostering innovation and growth.

Threats We believe that we have witnessed a permanent end to China's

double-digit annual growth rate.

The economy will face difculty in continuing to increase its share

of the global export market, and efforts to move up the value chain

will be fraught with problems.

BMI Economic Risk RatingsChina scores strongly across the board in our Short-Term Economic Risk

Ratings, securing an impressive overall score of 86.0. The country also

performs well in our Long-Term Economic Risk Ratings with a score of

76.4, buoyed by strong growth prospects, low and stable inationary

environment and a very secure external position. However, an over-

reliance on commodity imports and the manufacturing sector drag on

China's long-term rating, as does the paltry amount of government

spending on health and education.

Chapter 2:

Economic Outlook

S-T Economy Rank TrendSingapore 89.4 1 =China 86.0 2 =South Korea 85.0 3 =Taiwan 83.1 4 =Hong Kong 77.5 5 =Malaysia 75.0 6 =Philippines 74.6 7 -Thailand 72.1 8 =Vietnam 64.4 9 -Indonesia 64.0 10 +India 62.1 11 =Brunei Darussalam 56.9 12 +Bangladesh 56.2 13 =Sri Lanka 54.6 14 =

Myanmar 53.5 15 =Mongolia 48.3 16 =Pakistan 46.9 17 =Cambodia 46.5 18 =Papua New Guinea 45.0 19 =Bhutan 39.0 20 =Laos 36.2 21 =North Korea - -

Regional ave 62.6 / Global ave 53.8 / Emerging markets ave 52.0

L-T Economy Rank TrendSouth Korea 80.3 1 =Singapore 79.9 2 =Malaysia 77.5 3 =China 76.4 4 =Hong Kong 74.3 5 =Taiwan 74.1 6 =Thailand 71.5 7 -

Philippines 64.9 8 =Indonesia 64.3 9 -Vietnam 60.8 10 +Bangladesh 58.0 11 +Brunei Darussalam 57.2 12 =India 56.1 13 =Sri Lanka 52.4 14 =Myanmar 49.4 15 =Pakistan 48.8 16 +Mongolia 42.5 17 =Papua New Guinea 41.7 18 =Cambodia 41.2 19 =Laos 39.6 20 =Bhutan 37.2 21 =North Korea - - -Regional ave 59.4 / Global ave 53.4 / Emerging markets ave 51.0


15/47

Economic Activity

Out With The Old, In With The New

BMI VIEW

While the outlook for China's traditional economic growth drivers such

as heavy industry and real estate construction remains cloudy, the

more consumer-focused industries are expected to perform relative-

ly strong over the medium term. That said, as the traditional sectors

remain the dominant drivers of the economy, we remain below con-

sensus in our real GDP growth outlook and caution that the inevitable

bursting of the ongoing credit bubble could also serve to undermine the

protability of the consumer-focused industries. We are revising up our

real GDP growth forecast for 2013 to 7.6%, from 7.5% previously, and

maintain our downbeat 6.7% forecast for 2014.

The bullish and the bearish cases regarding China's economic

growth outlook both have merit. We have been in the bearish

camp over recent years, arguing that the excessive credit-fuellednature of China's economic expansion would result in a painful

hard landing. This remains our central outlook. Despite a recent

pickup, economic activity remains meagre at a time when credit

growth is still rising almost 20% annually from an already-high

base. It is difcult to dismiss the importance that the credit boom

will have on economic growth once it nally ends, as all credit

booms do. That said, in an emerging economy whose nominal

GDP stands in excess of US$8.0trn, there are clearly areas ofstrong growth and opportunity.

Old Versus New China

Commentators are increasingly talking of an 'old China' anda 'new China', with the old China referring to the low value-

added infrastructure investment that has characterised the

past few years of growth, and the new China referring to the

high value-added consumer and services driven growth that is

hoped will take over. The contrast is very neatly illustrated in

the charts on this and the following page. Above you have the

Shanghai Industrials Index, made up of the conglomerates that

have dominated China's resource allocation over recent years,

and which has been in a structural bear market. At right you

have the ChiNext, an index made up of high-growth tech-heavycompanies, which has been in a soaring bull market.


CHINA Q1 2014

TABLE: ECONOMIC ACTIVITY

2011 2012e 2013f 2014f 2015f 2016f 2017f

Nominal GDP, CNYbn [1] 46,547.1 51,469.3 56,922.3 62,504.5 68,088.5 73,995.3 80,431.5

Nominal GDP, US$bn [1] 7,200.4 8,159.2 9,151.5 10,146.8 10,937.9 11,839.3 12,869.0

Real GDP growth, % change y-o-y [1] 9.1 7.7 7.6 6.7 6.0 5.8 5.8

GDP per capita, US$ [1] 5,262 5,925 6,605 7,280 7,804 8,403 9,090

Population, mn [2] 1,368.4 1,377.1 1,385.6 1,393.8 1,401.6 1,408.9 1,415.8

Industrial production index, % y-o-y, ave [1] 10.8 7.8 8.2 8.5 8.0 8.0 8.0

Unemployment, % of labour force, eop [3] 4.1 4.9 5.0 5.0 5.0 5.0 5.0

Notes: e BMI estimates. f BMI forecasts. Sources: 1 National Bureau of Statistics, BMI; 2 World Bank/UN/BMI; 3 National Bureau of Statistics.

Bubble Still GrowingTotal Social Financing Stock, % chg y-o-y

Source: BMI, PBoC

In The DoldrumsShanghai Industrials Index

Source: BMI


16/47

'New China' Is BoomingWithin China's new economy there are a number of industry

sectors witnessing rapid growth. E-commerce is an area in

the headlines of late, with Alibaba Group's TMall,JD.com,

and Tencentleading a market that has risen exponentially in

recent years and generates more than CNY150bn (US$24.5bn),

according to some estimates. Our Pharmaceuticals team con-

tinues to project double-digit growth in both healthcare and

pharmaceutical spending over the coming years. China's IT and

semiconductor industries also continue to grow at a blistering

pace. These industries are likely to continue outperforming and

gaining in relative strength as China's economy transforms.

Shanghai Free Trade Zone A PositiveSignAs part of its push towards eventual liberalisation of the Chinese

yuan, Beijing has ofcially opened the country's rst free trade

zone in Shanghai. The Shanghai Free Trade Zone will help to

further propel the free-market-driven sectors of China's economyand is a sign of the potential that new China holds. Full details

have yet to be announced, but the free trade zone, spanning 29

square metres, will see the central government loosen regula-

tions across 19 industries, from banking to shipping and even

culture. It will also pilot reforms in several nancial products

and permit a freely convertible yuan.

Strong Yuan Supporting DomesticConsumption

The People's Bank of China's decision to appreciate the yuan isno doubt providing a boon to the domestic consumer market even

as it reduced external competitiveness. The yuan has appreciated

signicantly in real effective terms this year, lowering input

costs and increasing disposable incomes for Chinese consumers.

'Old China' Still The Dominant ForceRegarding the idea that the new China can take over, there are

two signicant obstacles. Firstly, the old China remains thedominant driver of the overall economy. Indeed, the recovery in

economic activity over recent months, as seen by the rise in the

purchasing managers' indices back above 50, has been largely

down to the boost in construction activity rather than the boom

in the service/consumer sectors. Indeed, following on from the

strong property sales gures seen in H113, construction activity

has begun to pick up, perhaps with the help of the renewed push

to roll out affordable housing. The real estate sector remains the

major driving force in the Chinese economy, and it is fuelled

by easy credit that, despite slowing, is growing far in excessof nominal GDP.

This brings us to the second obstacle. New China has certainly

beneted from the surge in credit growth and the appreciation

of property prices. During credit and asset bubbles, resources

are typically drawn towards high-order areas such as real estate

development, but as perceived wealth increases, so too does

consumer spending. While impossible to calculate, we believe

that the abundance of cheap credit and the appreciation of home

prices has played an important part in driving sectors of theeconomy that at rst do not appear to be credit sensitive. It is

only once we see credit growth begin to turn down, as it inevi-

tably will over the coming years, that the negative consequences

will emerge. Regarding our real GDP growth forecasts, we have

revised up our forecast for 2013 to 7.6%, from 7.5% previously,

while maintaining our downbeat forecast of 6.7% for 2014.


ECONOMIC OUTLOOK

Uncharted TerritoryChiNext Composite Index

Source: BMI


17/47

Fiscal Policy

Our Take On The Latest Stimulus

BMI VIEW

The prevailing negativity surrounding China's near-term macro pros-

pects has been softened somewhat by news of yet another 'mini-stim-

ulus' unveiled by Beijing. As has been the case in the past, our view

is that further scal and monetary pump priming will fail to arrest the

structural deceleration in the Chinese economy and will, at best, mere-

ly serve to cushion the slowdown. That said, an unwinding of downbeat

sentiment bodes well for a continuation of relief rallies in Chinese equi-

ties and risk assets at large. We remain tactically bullish towards the

Shanghai composite and Chile's benchmark IPSA indices.

In recent weeks, the prevailing negativity surrounding China's

near-term macro prospects has been softened somewhat by news

of yet another 'mini-stimulus' unveiled by Beijing. While facts

and gures are thin on the ground, the total slew of measures is

expected to total around CNY500bn (US$81.7bn) and will be

centred around a ramp-up in railway investment, temporary tax

cuts for small and medium sized enterprises, and an extensionof credit to local governments.

In this article, we look at the anticipated growth impacts of such

measures and, at the risk of repeating ourselves, argue whyyet another round of stimulus will fail to arrest the structural

deceleration in the Chinese economy.

Diminishing Returns Of Stimulus: We have written on sev-

eral occasions as to why further rounds of stimulus will deliver

diminishing marginal returns (see 'New Liquidity Surge Sup-

ports Core Views ', February 13 2013). In a nutshell, the base


CHINA Q1 2014

TABLE: FISCAL POLICY

2010 2011e 2012e 2013f 2014f 2015f 2016f 2017f

Fiscal revenue, CNYbn [1] 8,310.2 9,473.6 10,610.4 11,809.4 13,143.8 14,615.9 16,150.6 17,749.5

Revenue, % of GDP [1] 20.6 20.4 20.6 20.7 21.0 21.5 21.8 22.1

Fiscal expenditure, CNYbn [1] 8,987.4 10,326.5 11,462.5 12,539.9 13,706.1 14,967.1 16,314.2 17,766.1

Expenditure, % of GDP [1] 22.3 22.2 22.3 22.0 21.9 22.0 22.0 22.1

Current expenditure, CNYbn [1] 8,067.6 9,252.4 10,278.5 11,236.4 12,276.1 13,405.3 14,615.3 15,921.3

Current expenditure, % of total expenditure [1] 89.8 89.6 89.7 89.6 89.6 89.6 89.6 89.6

Current expenditure, % of GDP [1] 20.0 19.9 20.0 19.7 19.6 19.7 19.8 19.8

Capital expenditure, CNYbn [1] 919.8 1,074.1 1,184.0 1,303.5 1,430.1 1,561.8 1,698.9 1,844.8

Capital expenditure, % of total expenditure [1] 10.2 10.4 10.3 10.4 10.4 10.4 10.4 10.4

Capital expenditure, % of GDP [1] 2.3 2.3 2.3 2.3 2.3 2.3 2.3 2.3

Budget balance, CNYbn [1] -677.3 -853.0 -852.1 -730.6 -562.3 -351.2 -163.5 -16.6

Budget balance, % of GDP [1] -1.7 -1.8 -1.7 -1.3 -0.9 -0.5 -0.2 0.0

Notes: e BMI estimates. f BMI forecasts. Sources: 1 National Bureau of Statistics, BMI.

Less Bang For BuckManufacturing Purchasing Managers' Index

Note: Vertical dotted lines indicate announcements of major stimulus packages.Source: BMI, HSBC

Solvency RisksLocal Government Debt, % Of GDP

e = BMI estimate. Source: BMI, PBoC


18/47

effects of expenditure dictate that a new credit injection would

have to be larger than the previous one to generate an additional

unit of nominal GDP. In China, this is clearly not the case. The

impact of three of major stimulus packages on manufacturing

activity has diminished with each passing instalment, and so

too has the magnitude and duration of the rebound in activity.This time around, the CNY500bn that is being discussed would

represent a paltry 0.9% of GDP, a far cry from the 12.5% of

GDP package unleashed during 2008-2009. Simply put, this is

not a game-changer for the broader growth story.

Can't Cure Solvency With Liquidity: Despite the slowdown

in China's economy, credit aggregates until recently had been

expanding at a strong clip. Our estimates show that the stock

of total social nancing (the broadest measure of the country's

money supply) grew by a brisk 24.1% year-on-year (y-o-y) in the

rst seven months of the year. That the economy is still suffering

tells us that the growth malaise is more about the deep-rooted

balance sheet problems of Chinese corporates rather than a lackof available credit.

To be sure, we have seen a series of agship companies, such as

solar panel manufacturer Suntech Power Holdingsand ship-

builder Rongsheng Heavy Industries, run into severe nancial

distress in recent months due to massive overcapacity in China's

high order industries. Such structural solvency concerns will

not be cured with further stimulus. We note that much of the

funding has been earmarked for local governments, which have

seen their liabilities escalate in recent years. We believe thatthis additional nancing is unlikely to be channelled into new

capital spending but instead will be used to roll over existing

obligations, meaning that the net impact on economic activity

will be negligible.

Waning Appetite For Stimulus: From a political perspec-

tive, recent actions by China's edgling government point to

a waning appetite for constant pump-priming (see 'ReformMomentum Bittersweet For Growth Outlook', April 2 2013).

There appears to be a broad consensus in the upper echelons

of China's leadership that the huge stimulus packages of the

past, while positive for near-term growth, have exacerbated the

fundamental problems facing the economy. While some policy

loosening was to be expected given that the economy has lost

considerable momentum and credit concerns have come to the

fore, we believe Beijing will be unwilling to stomach a major

intensication of stimulus measures, not least because such a

scenario would further undermine longer-term efforts to rebal-ance the economy away from investment.

Financial Market ImplicationsDespite recent announcements, we remain comfortable with

our real GDP growth forecasts of 7.6% and 6.7% in 2013 and

2014 respectively. However, a further unwinding of downbeat

sentiment does bode well for a continuation of relief rallies in

Chinese equities and risk assets at large. Sentiment towards

Chinese stocks in particular remains extremely depressed, with

much of the bad news already priced into the market. Strikingly,

while few would contend that China's long-term growth outlook

is worse than that of Spain, the H-Shares Index is actually trading

at a discount to the Spanish IBEX on a trailing price-to-bookbasis for the rst time since mid-2008, from a premium in excess

of three times in 2007.


ECONOMIC OUTLOOK

PIIGS Or Dragon?H-Shares Index & Spanish IBEX, P/B Ratio

Source: BMI, Bloomberg

Relief Rallies In PlayChina's Shanghai Composite Index

Source: BMI, Bloomberg


19/47

We remain tactically bullish China's Shanghai Composite Index,

a view we have been playing against India's Sensex since July

2. This view is currently up 7.1%, and we see scope for further

gains in the near term.

We also see scope for a corrective bounce in a number of globalChina plays. The Australian dollar, for one, could looks well

placed for a technical bounce given that speculative positioning

on the currency is at all-time lows. Meanwhile, our Latin America

team has turned constructive towards Chile's benchmark IPSA

equity index. Not only is the bourse exhibiting bullish divergence

technically, but it is also likely to benet from a bounce in cop-

per as sentiment towards China's demand prospects perks up.

Monetary Policy

Interest Rate Reforms Leave A Lot ToBe Desired

BMI VIEW

The decision taken by the People's Bank of China on July 19 to al-

low further interest rate liberalisation was the latest in a growing series

of piecemeal reform measures aimed at improving productivity in the

Chinese economy. However, the move is unlikely to have any practi-

cal signicance, as the lending oor did not act as a binding constraint

to the banking system. Deposit rate liberalisation remains the key to

reforming the banking system, and we are less condent that this will

be forthcoming any time soon.

The principal measure undertaken by the People's Bank of China

(PBoC) on July 19 was the removal of the oor on lending rates

(except mortgage rates) offered by all nancial institutions.

While signicant from a symbolic perspective, in practice these

reform measures are unlikely to have any impact any time soon.

Given the funding pressure facing Chinese banks, we doubt that

there has been a great deal of lending occurring substantially

below the benchmark lending rate set by the PBoC (the oor

was previously set at 70% of the benchmark rate). So while in

theory the move gives scope for banks to provide cheaper credit,this is highly unlikely to happen in the current environment.

Lending Floor Not A Binding ConstraintThe lending oor is not a binding constraint on the rebalanc-


CHINA Q1 2014

TABLE: MONETARY POLICY

2011 2012 2013f 2014f 2015f 2016f 2017f

Consumer price index, % y-o-y, eop [3] 4.8 2.5 2.6 2.8 2.8 2.8 2.7

Consumer price index, % y-o-y, ave [3] 5.6 2.7 2.8 2.9 2.8 2.7 2.7

Producer prices, % y-o-y, eop [3] 3.2 2.9 2.6 2.6 2.6 2.6 2.6

Producer prices, % y-o-y, ave [3] 3.2 2.9 2.6 2.6 2.6 2.6 2.6

Wholesale price index, % y-o-y, ave [3] 3.8 3.6 3.0 3.1 2.9 2.7 2.7

Wholesale price index, % change y-o-y, eop [3] 3.8 3.6 3.0 3.1 2.7 2.7 2.7

M1, CNYbn [4] 28,985.0 31,883.5 35,071.9 38,579.0 42,436.9 46,680.6 50,881.9

M1, % change y-o-y [4] 8.7 10.0 10.0 10.0 10.0 10.0 9.0

M2, CNYbn [4] 85,159.0 96,229.7 105,852.6 116,437.9 128,081.7 140,889.9 153,569.9

M2, % change y-o-y [4] 17.3 13.0 10.0 10.0 10.0 10.0 9.0

Central Bank policy rate, % eop [1,5] 6.56 6.00 6.00 5.75 5.75 5.75 5.75

Lending rate, %, eop [4] 3.5 3.0 3.0 3.0 3.5 3.5 4.0

Lending rate, %, ave [4] 2.8 3.2 3.0 3.0 3.2 3.5 3.7

Real lending rate, %, eop [2,4] -1.3 0.5 0.3 0.1 0.6 0.7 1.3

Real lending rate, %, ave [2,4] -2.8 0.5 0.2 0.1 0.4 0.8 1.0

Notes: f BMI forecasts. 1 One-Year Lending Rate; 2 Real rate strips out the effects of ination. Sources: 3 National Bureau of Statistics, BMI; 4 IMF, BMI;

5 People's Bank of China, BMI; 6 BMI.


20/47

ing of the economy towards consumption. In fact, the best that

can be hoped for as a result of removing the lending oor is

cheaper loans to state-owned enterprises (SOEs). Indeed, given

that SOEs typically receive the cheapest loans in China, they,

if anyone, would be the ones who would benet. It is highly

unlikely, in our view, that Chinese banks have been looking toextend cheaper credit to the private sector but have been unable

to do so because of the lending oor.

A Precursor To Deposit Liberalisation?The hope is that these latest measures are a precursor to deposit

liberalisation, possibly the single most important step that the

government could take to help rebalance the economy. It is the

deposit ceiling, set at 110% of the PBoC's benchmark, that is

a constraint on the rebalancing of the economy more towards

private consumption. The removal of this would boost household

incomes and remove the free lunch offered to the banking system

by ensuring a large spread between lending and deposit rates.

Not So FastHowever, we have serious doubts as to whether deposit liber-

alisation will take place this year or next. As we saw with the

are-up of interbank rates in June, and the rising rates seen on

wealth management products, banks are now facing higher

borrowing costs through various channels. Raising deposit

rates would further squeeze banks' margins, potentially creating

further instability at a time when fears are already heightened.

Moreover, as we expect the economy to continue to surprise

to the downside over the coming months and quarters as the

hangover effects of the credit boom come to the fore (thereby

keeping nancial instability elevated over the medium term),we do not expect there to be an easy time for the PBoC to take

this difcult step any time soon.

Exchange Rate Forecast

PBoC To Keep Newly ImplementedPeg In Place

The People's Bank of China (PBoC) appear to have re-peggedthe yuan around the current level of CNY6.1200/US$, which is

where it is likely to stay for the foreseeable future. The fact that

the PBoC was happy to keep the yuan strong amid broad-based

foreign exchange (FX) weakness across the region is a sign that

it is committed to keeping the unit strong. Further gains are

unlikely, however, given the level of real effective appreciation

we have already seen so far this year.

Core View

The Chinese yuan has performed incredibly well over recentmonths, in spite of regional FX weakness. It is now the strong-

est it has been against the US dollar in two decades, and the

strongest it has been against its Asian peers since the height of

the global nancial crisis.

When it comes to estimating the yuan's fair value there are a

number of conicting forces. On the one hand ination has been

relatively high, exacerbating the trend in nominal appreciation.

On the other hand, vast increases in real GDP per capita over

recent years suggests a stronger currency is warranted by thefundamentals. As we have argued previously, we believe the

yuan is trading roughly at fair value versus the US dollar, and

is overvalued versus most other Asian FX.

Current account dynamics generally suggest that the yuan


ECONOMIC OUTLOOK

No More Floor1-Year Lending Rate & Lending Floor, %

Source: BMI, PBoC

TABLE: BMI CURRENCY FORECASTS

Spot 2013 2014

CNY/US$, ave 6.1212 6.2200 6.1600

CNY/EUR, ave 8.3400 7.823 7.6600

One-Year Lending Rate (%) 6.00 5.75 5.75

Spot price as of October 4 2013. Source: BMI


21/47

is roughly fairly valued. The current account surplus is on a

gradually declining trend from its 9.3% of GDP peak in 2007,

and we estimate it will come in at just 2.5% of GDP in 2013.

However, this masks some interesting trends within China's

trade account. China's surplus with its two main trading partners,

US and Europe, has been declining, while its decit with therest of the world has been narrowing sharply. Also, the bulk of

the fall in the surplus with the US and Europe has come about

from a pickup in imports rather than a fall in exports. Overall,

these trends suggest that the stronger yuan is not having a major

impact on the country's competitiveness. While it is too early

to tell for sure, and the impact of a stronger yuan could take

effect over an extended period, the country's external surplus

versus the US and Europe in particular appear to be narrowing

without causing too much pain to China's domestic demand,

which suggests that the PBoC will be happy to keep the yuanat the current rate over the medium term.

In the absence of reserve data, which was last released in June,

it is difcult to tell if there has been upside or downside fun-

damental pressure on the unit. Our view is that the forces are

roughly balanced. While there may have been outows in the

June-August period in line with what we have seen throughout

the region, with the current account still in surplus this would

likely have balanced out. With hot money owing back to the

region and appreciatory pressure likely to remain on regionalFX, downside pressure on the yuan is likely to be minimal over

the coming months, particularly with the domestic economy

stabilising. Furthermore, if the PBoC was happy to see the yuan

remain stable while its competitors' currencies were posting

double-digit losses, it is unlikely to steer the unit weaker as

regional FX appreciates. With this in mind we are revising up

our 2013 average forecast to CNY6.2200/US$ from CNY6.2000/

US$ previously. We are also revising up our 2014 forecast to

CNY6.1600/US$ from CNY6.2800/US$ previously.

Risk To OutlookRisks appear weighted to the downside. We remain bearish on

China's economic outlook and believe there is the potential for

a nancial crisis as a result of the credit boom that continues

unabated. Should this play out, the deationary threat could

pressure the PBoC to weaken its currency to provide a much-

needed boost to external competitiveness.


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The Chinese Economy To 2022

6.0% Is The New 10.0%

BMI VIEW

China's economic growth in the coming decade will be much slower

than in the previous one as the savings rate declines, the economic

liberalisation process slows and population growth falls. These dynam-

ics will result in real GDP growth averaging 6.2% over the next decade,in contrast with the 10.7% average of the past 10 years. Private con-

sumption will be a major outperformer, averaging growth of 8.2% and

rising in importance as a share of GDP.

The unprecedented growth boom in China over recent decades

has its foundations in the vast improvement made to productivity

through economic liberalisation. A major supportive tailwind

in the form of demographic trends provided additional support,

allowing savings to be accumulated at a rapid rate. Growth in

the coming decade will be much slower than during the last, asthe 'low-hanging fruit' of liberalisation has already been under-

taken and further reforms are likely to be slow and piecemeal,

as the Communist Party of China (CPC) would be reluctant to

give up too much economic power for fear of losing its politi-

cal dominance. A harshly deteriorating demographic situation

(slowing growth and an ageing population) will further weigh

on economic dynamism, resulting in real GDP growth of 6.2%

over the next decade, compared with the 10.7% average of the

past 10 years. Consumption will rise as a share of GDP and, as

a result, services' share of GDP will rise, presenting signicantopportunities in consumer-related elds.

Lower Investment Rate, Slower Growth: It is widely agreed

that to encourage sustainable high rates of growth in the com-

ing years, China must lower its investment rate and boost

consumption. Looking at historical precedents, it is clear that

an investment share of GDP at 48.6% is too high. However, it

is this high savings and investment rate that has allowed the

economy to grow so fast over the past decade. A lower rate of

savings and investment will mean slower growth.

Regarding the domestic imbalances that have built up as a result

of the high investment ratio, the problem is not high investment

itself but the lack of viability of such investment projects in

theory, there is nothing wrong with a high investment rate if

all the investments make a prot. Excessive state involvement

has resulted in excessive unproductive investment in an all-out

attempt to boost headline growth. This has come at the expense

of private consumption, with the consequences likely to be a

sharp slowdown in growth over the coming years.

Policy Reaction To Coming Slowdown Will Be Crucial:

Policies to 'boost' consumption using subsidies, wage hikes

and consumer loans, or persuading consumers to reduce their

savings rate by providing a more comprehensive social security

net, target the symptoms rather than the causes. Broad-based

structural reforms will be needed to rebalance the economy

and avoid a hard landing, and, so far, these reforms have been

lacking. We believe the government missed a key chance to

accelerate economic reforms during the global nancial crisis,

with the stimulus policy of forcing banks to extend recordloans to state-owned enterprises (SOEs) and local government

investment vehicles representing a step backwards in terms of


Chapter 3:

10-Year Forecast

TABLE: LONG-TERM MACROECONOMIC FORECASTS

2015f 2016f 2017f 2018f 2019f 2020f 2021f 2022f

Nominal GDP, US$bn [1] 10,937.9 11,839.3 12,869.0 13,986.6 15,199.5 16,511.3 17,939.6 19,496.7

Real GDP growth, % change y-o-y [1] 6.0 5.8 5.8 5.8 5.8 5.8 5.8 5.8

Population, mn [2] 1,401.6 1,408.9 1,415.8 1,422.1 1,427.8 1,432.9 1,437.3 1,441.1

GDP per capita, US$ [1] 7,804 8,403 9,090 9,835 10,645 11,523 12,482 13,529

Consumer price index, % y-o-y, ave [1] 2.8 2.7 2.7 2.7 2.7 2.7 2.7 2.7

Current account balance, % of GDP [1] 0.9 0.5 0.1 -0.4 -0.9 -1.4 -2.0 -2.6

Exchange rate CNY/US$, ave [3] 6.2 6.3 6.3 6.3 6.3 6.3 6.3 6.3

Notes: f BMI forecasts. Sources: 1 National Bureau of Statistics, BMI; 2 World Bank/UN/BMI; 3 BMI.


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its long-term liberalisation drive. In doing so, these policies

have ignited a property and investment bubble that is likely to

burst, ushering in a sharp slowdown and undermining growth

potential in the early part of this decade. It is how Beijing deals

with the impending economic slowdown that will determine

whether China can continue sustaining 8%-plus growth, andour baseline case argues that positive economic reforms will

be hard to come by.

Efciency Gains Unlikely:Agricultural land reform and the

deregulation of the hukouhousehold registration system provide

potential for gains in productivity by allowing more labour

market exibility and further freeing up labour for urban migra-

tion. There has been progress on this front, with the Chongqing

government initiating a pilot scheme giving migrant workers

who have been working in the city the right to non-agriculturalstatus, with the aim to turn 10mn farmers into urbanites by 2020.

While progress has been slow since then, we expect this policy

to continue to spread over the long term, supporting further

urbanisation and growth.

The idea of urbanisation as a driver of growth, however, is valid

only insofar as entrepreneurs in cities can generate prots suf-

cient to warrant expanding their labour force. Over the long

term, this will depend on the government's willingness to allow

further economic freedom. In this regard, we believe that pro-gress over the next decade will be much slower than in the past.

Financial Liberalisation Unlikely:Perhaps the most important

reform the CPC could make to boost productivity would be to

liberalise the banking system, allowing interest rates to reect

market forces and removing the political nature of lending, which

results in excessive capital going to inefcient state-owned

enterprises. The response to the 2008 crisis has made it clear

that this will not be forthcoming any time soon. From a political

viewpoint, the CPC would not want to give up its major lever ofeconomic power and therefore risk losing its political strength.

Closely related is the outlook for general capital market reform

opening up the capital account and allowing a exible exchange

rate. We have seen some progress here, with greater currency

exibility allowed over the past year and gradual liberalisation of

foreign nancial investment (one of the many goals of the 12th

Five-Year Plan is to make it easier for local private investors to

buy into overseas markets, and in January the city of Wenzhou

publicised a trial policy that would allow individual investorsto make direct overseas speculation). We expect further gains

to be made, improving capital allocation. This is by no means

guaranteed, however, as the impending growth slowdown could

raise the potential for a political backlash against this kind of

reform among the party's elite.

SOE Liberalisation Has Run Its Course: As well as allowing

price liberalisation and greater external trade, opening up SOEsto private competition was a major factor in boosting produc-

tivity. However, these particular reforms may have hit a brick

wall. Although the CPC relinquished a great deal of power in

removing itself from a large number of industries, it remains the

monopoly force in several key industries. As with the banking

sector, it will be difcult for the CPC to allow further private-

sector involvement into these sectors given the risk this would

pose to its grip on economic power.

Minimum Wage Hikes And Social Security Will HurtGrowth Outlook: In the name of boosting consumption (as

well as placating the working classes), the CPC seems intent

on hiking minimum wages and increasing the size of the social

welfare system (for example, boosting healthcare and pension

spending, and ramping up social housing construction). While

this may be desirable from a social perspective, we do not be-

lieve these types of measures hold the key to raising consump-

tion spending; rather, these policies are likely to reduce labour

market exibility and increase the already heavy tax burden,

reducing the ability of businesses to generate prots. In termsof the composition of demand in the economy, these policies

will help to lower the savings ratio and, by extension, increase

the share of consumption in GDP although they will do so at

the cost of reduced growth potential.

Demographic Dividend Reversing: Over the past decade, the

working population has risen at an average rate of 1.26% per

year, providing a supportive tailwind for growth. Over the next

decade, we expect this gure to fall to just 0.71% per year, acting

as a direct drag compared with the previous decade, particularlytowards the end of our forecast period when we see the working

age population actually shrinking slightly.


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SWOT Analysis

Strengths China is continuing to open up various sectors of its economy to

foreign investment.

With its vast supply of cheap labour, the country remains the top

destination for foreign direct investment in the developing world.

Weaknesses

Foreign companies continue to complain about the poo

bmi china business forecast report q1 2014

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