It’s Not the End of the World as We Know It

● Markets are overestimating China’s 2012 slowdown● There is still room to stimulate through monetary and fiscal policy● Loosening will first happen in credit controls – loan growth numbers should be closely watchedExtreme bearishness on China has broken out among global investors. The Hong Kong China Enterprise index was down 27% from 1 July to 1 October， and China credit default swaps (CDS) have risen to almost 200bps after being below 100bps in 2009-10. China fear has spread fast， even though the broad macro story has not changed much: the official manufacturing PMI is still above 50， consumer confidence is holding up， Beijing’s macro policy is still set at ‘tight’ (meaning there is room to loosen)， and no major real-estate developer has filed for bankruptcy yet. The big China sell-off， however， suggests that much worse news than this – a sharp slowdown in China’s real economy and ineffectual policy loosening – is now being discounted. We recently witnessed China fear in full bloom during a twoweek US roadshow with clients – corporate， real and leveraged funds. This note outlines the arguments and attempts to show the sunlight shining through the end-of-the-world clouds.There was also an outbreak of investor fear about China in late 2008. China CDS rose to almost 300bps. The fear then took the form of panic triggered by the Lehman shock to Western economies and banking systems， along with deep scepticism about Beijing’s ability to cope. China’s forceful policy reaction triggered a V-shaped recovery， and by end-2009， worries about infla- tion were taking hold. Today， China fear is more potent. It is not only mixed up with European and US concerns， but there is more reason to think Beijing’s stimulus policy tools are limited this time around. We still think that Beijing will muddle through， though.Our viewWe found two main views among investors in the last two weeks. Most are bearish on China in the short term (one to two months) given continued policy tightening and deteriorating external conditions， and accept the view that the authorities will loosen policy in Q4(though some argue that inflation is still too high to allow that). The difference in thinking turns on the reaction to the policy shift:1. The bears believe China’s 2012 real GDP growth will be below 8% owing to weak external demand throughout the year and limited stimulus options onshore. Inflation is too high and local government debt too big to allow Beijing to loosen， the bears assert. A massive housing-market bubble is already bursting， they argue， and policy makers are na?ve to think they can manage a gradual deflation of residential housing prices.2. Others – including ourselves– take the view that Beijing will react with loosening in Q4， policy will have an effect， and growth will be above 8% in 2012. Inflation is almost beaten， more infrastructure projects will be authorised， budgetary resources will be thrown at particularly hard-hit sectors， banks can leverage up more， budget spending can be boosted， and controls on residential housing will be loosened once developers have cut prices and eaten dirt for a few months. We look for a U-shaped recovery in H1-2012.When will China shift policy?The market’s mood could begin to lighten when policy loosening begins. Monetary policy remains tight; this is the clear message of the latest Standard Chartered China Monetary Conditions Index (SCMCI)， which we show in Chart 1.Many in the market (including us) had priced in mild monetary loosening starting in July/August 2011. In hindsight， the fact that this did not happen was probably a sell signal for China equities. Beijing’s reluctance to loosen was explained by high CPI inflation， as shown in Chart 7 (the market forecasts 6.0-6.2% y/y for September， still uncomfortably high) and a manageable slowdown in the real economy so far. The official PMI for September was 51.2， still expansionary; as Chart 2 shows， the slide in manufacturing PMIs in H1-2011 was much smoother than in H1-2008. The labour market still appears pretty tight， and there have been no stories of significant layoffs so far. Despite some stress in the SME econ- omy， we have not yet seen a verifiable wave of company closures or layoffs.We expect loosening in Q4， but the timing is difficult to predict. Loosening is likely to begin with a quiet relaxation of the bank credit quota， so monthly credit growth needs to be watched carefully. If the People’s Bank of China (PBoC) wanted to signal loosening， it would lower banks’ reserve ratio from the current 21.5%. We think the chances of a cut in the required reserve ratio (RRR) before year-end are now better than 50/50. The PBoC will resist cutting interest rates for as long as possible given its belief that they are still structurally too low.There are a few important dates to watch. In the second week of October， the State Council will meet to assess Q3 macro data and the global situation， and will release a short statement. This could signal a shift in how Beijing sees the balance of risks. In November， government officials from all the provinces will travel to Beijing for the National Economic Work Conference to hear about macro policy for 2012 and lobby for loosening. The balance of risks is clearly shifting – as Charts 5 and 6 show， there is likely to be little good news for exports in the coming months. We look for export growth of around 5-10% in 2012 (we will address the importance of the sector to the overall economy in a subsequent note).Still room for looseningThe bears argue that China cannot loosen much because of inflation and the bad debts generated by the previous round of stimulus.We expect y/y inflation to show clearer signs of moderation in Q4. Demand has slowed， as have import prices(particularly for oil， the biggest import). There is upside risk from another sharp increase in pork prices， as a clear supply response will probably take until Q1-2012. By November-December， we expect CPI inflation to fall to the 4.5-5.0% y/y range， which will allow for some loosening.Problems at local government investment vehicles (LGIVs) are more of a challenge， given that LGIVs account for some 20% of outstanding bank credit and there are serious doubts about repayment (see Special Report， 18 July 2011，‘China – Solving the local government debt problem’). Beijing’s current plan for LGIV loans is to pressure local governments to ensure that interest payments are made. (If the central government wanted to embark on a significant restructuring of the economy and sort out local finances， a big， co-ordinated push to sell off local state-owned firms would be a thrilling option.) We have argued that it would be helpful to bring some of these projects onto the central government’s books， and to finance more infrastructure through the budget rather than through the banks. Such a reform would clearly support confidence.In the meantime， we believe there is still room to stimulate by increasing infrastructure investment， allowing the banks to lend， and increasing fiscal expenditure. China still has many things to build – including more infrastructure in the southern， central and western regions， irrigation projects， and social housing， among others. China’s percapita capital stock is likely still below 10% of the US level， while urbanisation， at 50%， has a long way to rise. China today is Japan circa 1970， not 1989.A review of the 12th Five Year Plan suggests that there is much more still to do – and a recent visit to Beijing suggested that the National Development and Reform Commission(NDRC) has intentionally slowed down project approvals this year and could re-accelerate them if needed. Chart 3 shows that the fixed asset investment(FAI) cycle is ready to turn. Local government projects could get funding if bank lending was loosened. Clearly， though， there is less room for this kind of spending now than last time – and we recommend the enforcement of a hard loan quota of CNY 9-10trn in 2012 to prevent another lending blow-out.In the housing market， there is clearly a problem of excessive inventory(Special Report， 4 July 2011， ‘China –Our big real estate survey， Part 3’)， and the September sales numbers were not as good as some had hoped – flat on August， rather than up. The October sales numbers will be very important， as will be buyers’ reactions to price cuts. Little is currently known about the extent of price-cutting by developers and buyers’ reactions. The inventory problem is concentrated mostly in the Tier 2 cities; China’s hundreds of Tier 3 and 4 cities are not over-built. If the Ministry of Finance can be persuaded to fund social housing properly， this will boost construction as real-estate developers pull back in 2012. The central government could loosen its current strict controls on property purchases if prices fall too much， but it is likely to wait awhile to ensure that the goal of inflicting some pain on the developers is achieved. At some point， though， worries about falling local government land sales and their impact on overall growth will kick in， and localities will start loosening controls.Impact of the political cycle on policyClients in the US were interested in how the political cycle might impact policy. In the run-up to the 18th Congress of the Chinese Communist Party， thousands of party posts – including the top nine Politburo Standing Committee seats – are up for grabs. We have little to say about how this political cycle will affect policy; Beijing is still a very black box. All central government leaders want to balance inflation and growth – and as the balance of risks shifts from one to the other， policy will also shift. Leaders who need more support from the provinces (who are always more interested in growth than inflation) may well push for loosening earlier than central government technocrats. Future leaders will want to ensure that the economy is well positioned for sustainable growth from 2013-15， while the current leaders may focus more on making sure 2012 is a good year. So far， there are no identifiable splits within the central leadership over economic policy.CNY policy， on both sides of the PacificOn Chinese yuan (CNY) policy， there was broad agreement with our view of continued appreciation against the US dollar (USD). That said， appreciation is likely to slow from the 5-6% pace seen in 2011 so far unless there is an external shock; in that case， we think Beijing will re-peg the CNY to the USD. There was some discussion that now would be a good time to move to a basket exchange rate (which would allow some depreciation against the USD). We think the natural response to a weak global economy would be to re-peg. The policy focus would be on stimulating domestic demand. Exporters can be protected through subsidies or increases in VAT rebates， rather than by launching an overt currency war.Meanwhile， US Senator Charles Schumer and his colleagues have reintroduced the Currency Exchange Rate Oversight Reform Act of 2011 in the Senate. Given the current US political situation and the hurting job market， the bill is more likely than ever to be passed. The Democrat-controlled Senate could vote this week， which would leave the Republican-controlled House to decide whether to debate and table a vote， or to park the bill in committee. The Republican leadership may decide to push the bill through in order to dare the president to veto it， or it may determine that business opposition needs to be taken into account in an election season. The White House officially opposes the bill， but a veto would likely disappoint much of the Democratic base.The bill is a reincarnation of previous drafts. Some effort has been made to make it WTO-compliant. (There is a hole in international trade law where currencies are concerned – the US bill attempts to define undervalued currencies as subsidies， something trade law has been silent on. If China did bring a complaint， this would be a tricky call for the WTO dispute mechanism.) The bill allows CNY undervaluation to be considered as a subsidy， and would therefore allow US firms to file counterveiling duty (CVD) complaints against China’s exports to the US. The number of CVD complaints filed by US businesses would certainly rise， but they take time to investigate， and the fallout would likely be limited. Beijing would file a WTO complaint against the bill， claiming it illegal， which would take two to three years to complete; in the meantime， a few US multinationals would find business conditions in China more challenging.SummaryWe believe the markets have panicked unjustifiably about China. Economic data remains constructive overall， and while exporters will suffer in 2012， domestic growth and the room for policy loosening is being underestimated. The real-estate and shadow banking sectors need to be monitored， but stories of distress are very limited in scale so far. Once loosening comes， we expect growth to reassert itself after a quarter or so. This will likely be a U-shaped recovery， in contrast to the V-shaped one we saw in late 2008 and early 2009. But our bet is that by Q2-2012， China will be proving itself more resilient than the markets are currently pricing in.(Author: Economists at Standard Chartered Bank)