Recovery on Track, but Not Overheating (3Q 09)

China October 23, 2009 By Denise Yam, Qing Wang & Katherine Tai Hong Kong & Steven Zhang Shanghai GDP Economic growth remains robust in 3Q09: The Chinese economy grew 8.9%Y in real terms in 3Q09, recovering further from 7.9% in 2Q. On a seasonally adjusted basis, sequential quarter-on-quarter growth slowed, as expected, to 2.3% (+9.6% annualized), from the very strong 4.5% in 2Q. On the other hand, nominal GDP growth (at 6.4%Y in 3Q, implying a 2.3%Y decline in the GDP deflator) remained undermined by deflation, offsetting the gains in the terms of trade. Though a tad below our forecast (+9.5%Y, +2.9%Q), the pace is undoubtedly robust, in our view, characterizing the economic recovery as on track, but not yet overheating, calming fears of an imminent shift in policy stance towards tightening. Should we mark-to-market our full-year growth forecast to reflect the latest result, it would imply a figure that is moderately below our current projection of 9%, and we will likely revisit this in the coming weeks. Industrial Production Pick-up attributable to export recovery... Industrial value-added grew 13.9%Y (+1.3%M SA) in September (+12.3% in 3Q versus +9.1% in 2Q, +8.7% YTD), ahead of our (+13.5%) and market (+13.2%) forecasts. We believe that this is attributable to the narrowing decline in exports (-15.2%Y in September versus -23.4% in August), as delivery for exports recorded a single-digit (-9.9%Y) decline for the first time this year. ...though domestic demand is still the key growth driver: Needless to say, the manufacturing sector remains dependent on domestic demand for growth as external demand still takes time to recuperate. This is evidenced in the continued outperformance of local enterprises (shareholding companies +16.6%Y in September, collectives +13.5%, SOEs +11.8%) over foreign-invested producers (+8.9%). Trade A pleasant surprise in September... After disappointing results for several months, sticking out like a sore thumb in China's sound recovery story, trade data finally provided an upside surprise in September, adding to the good news from Korea and Taiwan in the same month. Even though we had forecast a narrowing in the year-on-year declines in shipments compared to results reported for August, the improvements were much larger than expected. In September, the year-on-year drop in exports narrowed to 15.2% (-23.4% in August), while imports slipped only 3.5%Y (-17% in August). On a seasonally adjusted month-on-month basis, exports and imports grew 6.3% and 8.3%, respectively, the strongest pace since April, picking up from 3.4% and 1%, respectively, in August. ...with manufactured imports reclaiming positive growth ahead of expectation: The strong recovery in domestic demand lifted imports of manufactures by 1.8%Y, returning to positive growth for the first time in 11 months. Overall imports of primary products are still declining year on year (-14.7% in September versus -29.1% in August), primarily due to lower international prices, but copper (+49% in value in September) and aluminum (+51%) intakes have already returned to positive growth, while ferrous metals demand is also recovering steadily (iron ore -4%, steel products -10%). We remain convinced that the worst is over for the trade sector. As year-on-year declines in shipments are likely to narrow significantly in the coming months, we believe that we remain on track to reach our full-year forecasts for exports (-16%) and imports (-13%). Retail Sales Further pick-up, in line with expectations: Retail sales growth picked up further to 15.5%Y (+1.4%M SA, +15.4% in August, +15.1% year to date), in line with forecasts, although the acceleration was partly driven by easing deflation, suggesting that sales growth in real terms likely remained broadly stable. Autos (+44.5%Y in September), furniture (+34%) and construction and decoration materials (+30.2%) remain the leaders in terms of growth in sales, consistent with the domestic investment demand-driven nature of the current economic upcycle. Fixed Asset Investment Strong, and still a key growth driver... Although external demand is showing signs of recovery, while domestic consumption has surged ahead with robust growth, fixed investment, having kick-started the rebound from the recent recession, remains a key growth driver for the economy as a whole. Nationwide FAI grew 33.2%Y in 3Q (+33.4% year to date), while urban FAI grew 35.1% in September (+32.9% in 3Q, +33.3% year to date). ...and increasingly driven by private sector initiatives: Although policy-driven investment projects, such as those in infrastructure (e.g., railways +87.5% year to date), continue to record the strongest growth, the recovery in private sector investment, especially real estate development (+37.1%Y in September, +17.7% year to date), is helping to relieve the reliance on government initiatives to power growth. Monetary Data Expansion sustained at fast pace in September, supportive of economic recovery: September turned out to be another strong month for money and loan growth, defying fears in recent months that the authorities are adopting a noticeably tighter monetary stance upon realizing a cyclical rebound in the economy since 2Q09. New loan creation picked up for the second straight month, to Rmb517 billion (+38%Y). Nevertheless, this is still consistent with our belief that monetary growth is normalizing after the strong pace in 1H09. Year to date, new loans totalled Rmb8.67 trillion, up 149%Y. Meanwhile, broad money M2 growth reached 29.3%Y in September, the highest level since the high-inflation periods of the mid-1990s. Nevertheless, we expect normalization in monetary expansion towards a more sustainable level, so the slowdown in loan creation should not constrain real economic expansion, or be interpreted as policy tightening, in our view. Foreign reserves data suggest continued mild inflows of ‘hot money' in 3Q09: China's foreign reserves reached a new record-high of US$2.27 trillion in September. The US$141 billion increase over three months ago again exceeded the trade surplus (US$39.3 billion in 3Q) and FDI (US$12.9 billion in July-August) by a wide margin. Nevertheless, part of the reserves ‘accumulation' was again attributable to the increase in valuation of investments in USD terms, due to the appreciation of the euro (+4.4% in 3Q) and yen (+7.3%). Our proxy for ‘hot money' inflows, which is the incremental change in reserves, net of the trade balance and FDI and adjusted for exchange rate movements and interest income, shows positive inflows in all three months in 3Q09, totaling US$25.6 billion, albeit less than 2Q09's US$63.9 billion. Inflation Upstream deflation easing faster than expected: Producer and raw materials purchasing price indices showed an uptick in September, narrowing year-on-year deflation more substantially than forecast. PPI fell 7%Y (-7.9% in August), while RMPPI fell 10.1% (-11.4% in August). On a month-on-month seasonally adjusted basis, both indices sustained sequential gains for the fourth straight month, by 0.8% (+0.8% in August) and 0.7% (+1% in August), respectively. The uptick was driven primarily by smaller declines in energy prices. Although the faster-than-expected ease in upstream deflation and the ongoing rapid monetary expansion are fuelling fears for high inflation next year, we are not too concerned at the current juncture, as we argue that broad money growth is currently biased upwards by a shift in household financial asset allocation, while the output gap from weak exports should help to contain inflation pressure in the next 12 months (see China Economics: Worried About Inflation? Get Money Right First, October 20, 2009). ...while deflation at the consumer level is narrowing on the lowering base effect from food: Food inflation returned to positive territory in August (+0.5%Y) and accelerated further in September to 1.5%, in line with expectations, on the back of the lowering base effect. This helped to narrow overall consumer deflation to 0.8%Y in September (-1.2% in August), the mildest level since China dipped into deflation in early 2009. On a sequential basis (non-seasonally adjusted), consumer prices bottomed in June and July, and have since then risen by 0.5% in August and 0.4% in September. Conclusion Outlook and policy implications: Although slightly below our forecast, the pace of economic growth in 3Q09 is robust, in our view, characterizing the economic recovery as being on track, but not yet overheating, and calming fears of an imminent shift in policy stance towards tightening. We continue to believe that the authorities are committed to policy stability so as to uphold private sector confidence, and expect the growth-supportive policy stance to be maintained until mid-2010. Specifically, although the State Council gave a cautiously optimistic assessment of the current economic situation and struck a less dovish policy tone at a meeting held on October 21, the policy message remains broadly unchanged, namely to carry on "proactive fiscal policy and appropriately loose monetary policy" with a view to maintaining policy continuity and stability. The notable change in language at the press statement compared to previous ones was the new reference to "managing inflation expectations" as a policy objective during the remainder of the year. In our view, the authorities are unlikely to resort to a rate hike, RRR hike or renminbi appreciation to "manage inflation expectations" as it stands, given that current inflation remains low and the economic recovery has just started to gain momentum. Rather, we suspect that the authorities may more likely resort to verbal intervention to ease the public concern about potential inflation, aided by less frequent adjustment to the prices that are still regulated by the government. In any case, the authorities are clearly preparing the market for an inevitable slowdown in new bank lending growth in the coming months and next year. These changes in policy tone are broadly in line with our expectations. Therefore, our policy call remains unchanged: the current policy stance should remain broadly unchanged toward year-end and turn neutral at the beginning of 2010 as the pace of new bank lending creation normalizes from about Rmb10 trillion in 2009 to Rmb7-8 trillion in 2010. We believe that policy tightening in the form of a base interest rate hike, RRR hike or renminbi appreciation is unlikely until 2H10.