the plan will run for years, underwritten by the culture that invented paper, ink, printing press, paper money, as well as banking and money transfer, and probably fire, air, water, ice, and where goldilocks apparently is redomiciling to :0)
just in in-tray, per ms
MORGAN STANLEY RESEARCH
(The complete report is attached)
CHINA ECONOMICS: A GOLDILOCKS SCENARIO IN '10 - November 22, 2009 GMT (11 pgs/ 109 kb)
Qing Wang +852 2848 5220 Morgan Stanley Asia Limited
Denise Yam
Steven Zhang
A Goldilocks Scenario in 2010...We expect China's economy to deliver stronger, more balanced growth with muted inflationary pressures in 2010, featuring 10% GDP growth and 2.5% CPI inflation. These baseline forecasts hinge on two key assumptions: a) that strong domestic demand in 2009 is largely sustained; and b) that recovery in G3 economies remains tepid.
...as a phase of China's super cycle in a globalized world economy:This comprises 'overheating in 2007', 'imported soft landing in 2008', and 'policy-induced decoupling' in 2009. Specifically, the 'imported soft landing' during most of 2008 was disrupted and derailed by the onset of the Great Recession in 4Q08. The subsequent aggressive and powerful policy responses by the authorities have managed to deliver a 'policy-induced decoupling' between China and other major economies since 2Q09.
Alternative scenarios in 2010 in the "fourseasons"framework: Adapting the "four seasons" framework that we employed in late 2007, we characterize the potential scenarios in 2010, depending on the mix of economic outlook in G3 and domestic policy stance. Autumn features the 'Goldilocks Scenario', Summer shows 'Overheating', Spring displays a 'Policy-induced Soft Landing', and Winter features a 'Policy-induced Double Dip'.
A post-crisis reflection on the Chinese economy: It would be imprudent to call for a cyclical Goldilocks scenario in an economy built on a growth model that is structurally flawed. In a post-crisis reflection on China's economy, we conclude that the popular concerns about such structural issues as 'over- investment' and 'under-consumption' in China are overdone and that China's growth model is generally sound.
Long-term challenges: The key challenge facing the Chinese economy in the long run is how to seize the window of opportunity of 'over-savings' to create quality wealth for the nation. To this end, we think China must get the structure of pricing and other incentives right.
A Goldilocks Scenario in ’10: Stronger Growth
We expect the Chinese economy to deliver stronger, more balanced growth with muted inflationary pressures in 2010, featuring 10% GDP growth and 2.5% CPI Inflation (Exhibit 2). This baseline forecasts hinge on two key assumptions: a) that strong domestic demand in 2009 is largely sustained; and b) that recovery in G3 economies remains tepid (see Global Forecast Snapshots: ‘Up’ without ‘Swing’, September 10).
Tight supply of raw materials and energy inputs has been a significant headwind to rapid expansion of the Chinese economy in recent years. When economies in the rest of the world are also in an expansionary phase of the cycle, any incremental demand from China tends to drive up the global prices of commodities, generating inflationary pressures and making it a challenge to deliver a Goldilocks scenario – a mix of high growth and low inflation.
If, however, the recovery of the rest of the global economy were to remain tepid in 2010, it would help China to benefit from relatively low commodities prices for a reasonably long period of time until the economies of its competitors for the same limited amount of supply of commodities recover. This potentially creates a ‘window of opportunity’ for China to deliver a Goldilocks scenario.
We forecast China’s GDP growth at 10% for 2010 and think that the growth drivers are likely to become more balanced. The aggressive policy responses so far this year will likely continue to fuel rapid investment growth in the remainder of 2009. Also, we expect property investment to accelerate in 2010, partly offsetting the slowdown in infrastructure investment expected to materialize because of the high base in 2009. Private consumption is likely to improve steadily through 2010 as consumer confidence and employment improve. We expect export expansion to resume in 2010 following a sharp contraction in 2009, which, together with a recovery in profits, should help underpin non-real estate private investment.
In terms of trajectory, while the 2Q09 rebound represents a sharp bounce from the cyclical trough, we expect the sequential growth rate to return to a more sustainable 2.0-2.5% in the quarters ahead (Exhibit 3). Nevertheless, we project that the YoY growth rate is set to accelerate further in the next few quarters, surging to double-digit rates by 4Q09 and peaking in 1Q10, before tapering off – on the base effect – toward a more sustainable high-single-digit level. The moderation in growth rate over the course of 2010 would reflect acceleration in private consumption and investment (e.g., property investment) and recovery in exports, partly offset by a smaller dose of policy stimulus.
A Goldilocks Scenario in ’10: Muted Inflationary Pressures
Despite strong headline GDP growth, concern about potentially high inflation in China in 2010 is unwarranted, in our view. We forecast average CPI inflation at about 2.5% in 2010. In particular, we caution that predicting high inflation in 2010, based on the strong growth of monetary aggregates so far this year, could err on the side of being too simplistic and mechanical.
· First, the strong headline M2 growth in 2009 substantially overstates the true underlying monetary expansion, as it fails to account for the change in M2 caused by the shift in asset allocation by households between cash and stocks. We estimate that the growth rate of adjusted M2 – the rate that truly reflects the underlying economic transactions – is much lower than suggested by the high growth of headline M2 (see China Economics: Worried About Inflation? Get Money Right First, October 19, 2009).
· Second, generally weak export growth, which we think could be a proxy for the output gap in China, will remain a strong headwind containing inflationary pressures. These two demand-side factors combined would suggest that the 2000-01 situation – featuring relatively high money growth but relatively low inflation – is likely to be repeated in 2010.
· Third, from the supply side, while Morgan Stanley’s commodities research team expects commodities prices to rise steadily in 2010, they do not foresee significant spikes in prices. They project average prices for crude oil at about $85 per barrel in 2010 (see “Crude Oil: Balances To Tighten Again by 2012,” September 13). Assuming the cost pressures stemming from these supply-side shocks are able to pass through the supply chain to be reflected in the corresponding price increase of downstream products without much constraint from the demand side, we forecast a trajectory of CPI inflation for 2010 that is similar to the one derived from demand-side analysis (Exhibit 4) (see China Economics: Inflation Outlook in 2010: A Supply-side Perspective, November 1, 2009).
A Goldilocks Scenario in ’10: Policy Normalization
The super-loose policy stance is to normalize but remain generally supportive in 2010. In view of the inflation outlook, we expect the current policy stance to turn neutral at the beginning of 2010 as the pace of new bank lending creation normalizes from about Rmb10trn in 2009 to Rmb7-8trn in 2010. The M2 growth target will likely be set at 17-18%, in our view.
Policy tightening in the form of reserve requirement ratio (RRR) hikes and base interest rate hikes is unlikely before mid-2010, in our view. If, however, excess liquidity stemming from large external balance of payment surpluses were to emerge earlier than expected, we would not rule out the possibility of the RRR hike cycle starting as early as the beginning of 2Q10. Indeed, with inflationary pressures likely muted, the monetary policy priority in 2010 is likely to be on liquidity management through RRR hikes.
Specifically, we expect the PBoC to hike base interest rates in early 3Q10, when we expect CPI inflation to have exceeded 3.0% YoY in some months. However, since we forecast CPI inflation to moderate in 2H10, we expect no more than two 27-bp rate hikes over 2H10, the primary purpose of which is to manage inflation expectations. In view of the current de facto peg of the Rmb against the USD, the timing of China’s rate hike will also hinge on that of the US Fed, in our view. In particular, we do not expect the PBoC to hike interest rates before US Fed does. Incidentally, our US economics team expects the US Fed to raise interest rates in Q3 2010 (see US Economic and Interest Rate Forecast: Hiring Still Poised to Improve Early in 2010, November 9, 2009, by Richard Berner and David Greenlaw).
We maintain our longstanding view that the current Renminbi exchange rate arrangement will remain unchanged through mid-2010. While we believe an exit from the current regime of a de facto peg against the USD may occur in 2H10, any subsequent Renminbi appreciation against the US dollar is, in our view, likely to be modest and gradual (see China Economics: An Exit Strategy for the Renminbi? and China Economics: A Dialogue on the Renminbi, November 11, 2009).
Looking ahead, China is likely to repeat a situation similar to that during 2005-2008, featuring strong expectations of renminbi appreciation, ‘hot money’ inflows, abundant external-surplus-driven liquidity (as opposed to the current abundant liquidity due to loose monetary policy), and the attendant upward pressures on asset prices.
Indeed, against a Goldilocks macroeconomic backdrop, coping with rising asset price inflation pressures will likely become an important challenge to policymakers in 2010. To this end, ‘containing financial leverage’ in the economic system is likely to be a top policy priority with a view to minimizing systematic risks in the event of a bursting of an asset price bubble. This will entail a variety of measures:
· Strict mortgage rules for homebuyers,
· Enforcing restrictions on margin trading in the stock market,
· Strict capital adequacy requirements for banks,
· Asymmetric liberalization of external capital account controls that induce capital outflows (e.g., through QDII programs) and discourage capital inflows, and
· Attempting to prevent one-way plays on the Rmb exchange rate against the US dollar that would induce hot money inflows.
China’s Super-Cycle in a Globalized World Economy
The Goldilocks scenario in 2010 should be considered as a phase of China’s super-cycle in a globalized world economy that comprises ‘overheating in 2007’, ‘imported soft landing in 2008’, and ‘policy-induced decoupling’ in 2009 (Exhibit 1).
The Chinese economy was overheating in 2007, with GDP growth of 13% and CPI inflation of about 5%. We envisaged an ‘imported soft landing’ scenario in 2008, which hinged on two key calls:
a) A US-led global downturn that would slow the rapid expansion of China’s exports, thereby helping the economy to cool off; and
b) A muddling-through style for macroeconomic management –i.e., as external demand weakened, domestic policy tightening would not be followed through consistently and would even be eased over the course of the year (see China Economics -- Journey into Autumn: An Imported Soft Landing in '08, December 3, 2007).
The ‘imported soft landing’ indeed played out in most part of 2008. However, it was disrupted and derailed by the onset of the Great Recession, such that China’s economy suffered a hard landing in 4Q08-1Q09 (see China Economics: Outlook for 2009: Getting Worse Before Getting Better, December 9, 2008). Indeed, when a crisis of such global scale hit, there was an initial, indiscriminately strong negative effect from the shock on every economy that is deeply integrated into the global economy.
The strength and speed of policy responses in the immediate aftermath of the crisis were, however, quite uneven among countries, resulting in different patterns of post-crisis recovery. China is a case in point. The aggressive policy response by Chinese authorities helped translate China’s ‘strong balance sheet’ into a ‘decent-looking income statement’, which distinguishes China from those countries that either suffer from a paralyzed financial system or are unable to launch strong pro-growth fiscal or monetary policy responses because of weak fiscal and / or external balance of payments positions. This makes China the first major economy to recover from the crisis with strong momentum, effecting a policy-induced economic decoupling between China and the rest of the world (see China Economics: Policy-driven Decoupling: Upgrade 2009-10 Outlook, July 16, 2009).
Specifically, a ‘Goldilocks recovery scenario’ has indeed played out: the government’s growth supporting policies enable asset reflation, which underpins consumer and investor confidence and prevents the harsh adjustment in domestic consumption and private investment (e.g., real estate) in 1H09 (see China Economics: Property Sector Recovery is For Real, May 15, 2009). The shallower trough in the economic cycle is then followed by recovery in activity initially spearheaded by fiscal stimulus (3Q09), and then by a tepid recovery in external demand (4Q09) (see China Economics: Policy-driven Decoupling: Upgrade 2009-10 Outlook, July 16, 2009).
In the aftermath of the Great Recession, if the strength of China’s domestic demand in 2009 can be sustained into 2010 and meanwhile, the recovery of the rest of the global economy were to remain tepid, it would make China a potential beneficiary of relatively low commodities prices for a relatively long period of time until other major economies – which compete for the same limited amount of supply of commodities – recover. This potentially creates a window of opportunity for China to deliver a goldilocks scenario.
Sustaining the Goldilocks scenario beyond 2010 would be a tall order, however. Against the backdrop of a potentially stronger recovery in global economy in 2011, the balance between growth and inflation in the Chinese economy will be more difficult to strike. This is a key reason that we tentatively forecast a mix of lower growth and higher inflation for 2011, while noting the tremendous uncertainty at the current juncture (Exhibit 2).
Alternative Scenarios in a “Four Seasons” Framework
The Goldilocks scenario is our base case. The risk to this base case forecasts relates to two types of uncertainties: a) the economic outlook in G3 nations; and b) domestic policy stance. Along the two dimensions of uncertainty, we envisage four potential scenarios in 2010 by adapting the “four seasons” framework that we employed before (Exhibit 5).
Autumn features a combination of tepid G3 recovery and normalized policy stance in China that would deliver a ‘Goldilocks Scenario’. We assign a 70% subjective probability to this scenario.
Summer features a combination of vigorous G3 recovery and normalized policy stance in China that would result in ‘Overheating’. If the G3 economic recovery in 2010 were to be much stronger than expected, China’s export growth and thus industrial capacity utilization, as well as global commodity prices, could both surprise to the upside, likely resulting in higher GDP growth and stronger inflationary pressure if the policy stance were to remain unchanged. We think this is the most likely alternative scenario and assign a 15% subjective probability.
Spring features a combination of vigorous G3 recovery and aggressive tightening that would help achieve a ‘Policy-induced Soft Landing’. To realize this scenario, the timing and modality of policy tightening would be absolutely the key. However, this tends to be difficult to achieve in China. Administered interest rates and an inflexible exchange rate arrangement mean that Chinese authorities have few available policy tools that allow for discretionary tightening with engineering precision. We therefore assign only a 5% probability to this scenario.
Winter features a combination of tepid G3 recovery and aggressive tightening in China that would lead to a ‘Policy-induced Double Dip’. The key headline macroeconomic indicators (e.g., the YoY GDP and export growth) may improve rapidly because of the low-base effect in the coming quarters (Exhibit 2). Policymakers may turn complacent and launch a round of aggressive tightening for fear of economic overheating despite a tepid G3 recovery. This would likely derail a recovery, causing a double-dip in economic growth. We assign a 10% probability to this scenario. On the other hand, the National Bureau of Statistics (NBS) has decided to start publishing quarter-on-quarter GDP growth rate data in 2010. If the official data release were to show a relatively low QoQ growth rate despite a relatively high YoY growth rate in 1Q10, it would help guide the policy debate and therefore lower the risk of potential premature policy tightening, in our view.
A Post-crisis Reflection on the Chinese Economy
It would be imprudent to call for a cyclical goldilocks scenario in an economy built on a growth model that is structurally flawed. The typical concerns about the sustainability of China’s economic growth are based on several key structural imbalances in the economy, including over-investment, under-consumption, and large and persistent current account balances. Some China observers even predict that if these structural imbalances are left unaddressed, the Chinese economy will eventually implode.
However, in a post-crisis reflection on China’s economy, we conclude that the popular concerns about such structural issues as ‘over-investment’ and ‘under-consumption’ in China are overdone and that China’s growth model is still generally sound.
First, with “over-investment” the current buzzword in the policy debate, much attention has been paid to the high investment-GDP ratio. However, we believe a more important phenomenon in this regard is the high national savings rate in China. To the extent that the high investment ratio is a function of the high national savings ratio in China, discussing over-investment without discussing the high saving ratio loses sight of the big picture, in our view.
Second, China’s high national savings rate is a generational phenomenon. It is primarily a function of such secular forces as Chinese demographics, largely shaped by China’s ‘one-child’ policy and slow adjustment in households’ spending habits against the backdrop of rapid economic growth. The ‘one-child’ policy artificially compresses the demographic evaluation in a window of some 30-40 years and lowers the dependence ratio sharply in a much shorter period of time in China than in other countries where aging is a natural, multi-decade process. The low dependence ratio substantially raises the saving ratio. While households’ income increases rapidly in line with overall economic growth, personal consumption habits may take years and even decades to change. This results in a high savings ratio, which is often attributed to ‘cultural factors’. While other structural factors such as lack of social security and policy at SOEs may have also contributed to the high saving ratio in China, we view their impact as either marginal or an indirect reflection of the abovementioned secular forces.(see China Economics: The Virtues of 'Over-savings': A Post-crisis Reflection on Chinese Economy, September 27, 2009).
Third, a popular argument of ‘over-investment’ in China is the high growth rate of fixed-asset investment. However, the rapid investment growth is driven primarily by infrastructure investment rather than investment in manufacturing sectors that suffer from overcapacity. Infrastructure investment actually lagged other types of investment by a wide margin in the past few years. Moreover, the investment projects mainly involve railways, intra-city subways, rural infrastructure, low-income housing, and post-earthquake reconstruction, which are quite different from the infrastructure projects that were carried out in the context of the Asian financial crisis a decade ago.
Both rounds of infrastructure investment boom helped boost domestic demand in the face of negative external shocks in the short run. However, their medium-term implications are quite different: while investment in the immediate aftermath of Asian financial crisis laid the foundation for a subsequent takeoff in China’s manufacturing sector and hence exports, the current investment boom should facilitate urbanization and help lay the groundwork for a potential consumption boom in the years to come, in our view (see China Economics: The Virtues of 'Over-savings': A Post-crisis Reflection on Chinese Economy, September 27, 2009)
Fourth, much of the concern about over-investment is based on the notion that investment is derived demand (e.g., investment to build a factory that produces widgets) instead of final demand (e.g., consumer demand for the widgets). When final demand like private consumption or exports is weak, it will eventually translate into weak investment demand. However, the line between derived demand and final demand is blurred when it comes to such urbanization-related infrastructure investment as intra-city subways, rural infrastructure, and low-income housing. For a rapidly growing, low-income country like China, the nature of these investments is final demand, as faster and more convenient travel is as desirable now as more food and clothing, in our view.
Fifth, we argue that a more meaningful cross-country comparison in this regard should be about the capital-labor ratio in the economy. On this score, China’s capital-labor ratio, or the capital stock per capita, is, not surprisingly, way below that in more advanced emerging market economies (e.g., Korea, Taiwan), let alone the industrialized economies (e.g., US, Japan), suggesting much upside for investment expansion. A key question in this context is: if it were to take China much less time to reach the same capital-labor ratio as in industrialized economies because of China’s consistently higher investment growth, would this suggest over-investment? The answer is far from conclusive, in our view.
Last but not least, we believe Chinese official statistics substantially understate the share of consumption, overstate the share of investment, and understate the share of the service sector as a percentage of overall GDP. As such, we believe the true underlying structure of the economy is more balanced than is commonly perceived based on the official national account statistics.
Specifically, China’s ‘under-consumption’ has to do with underestimation of China’s consumption of services, in our view. According to official statistics, the service sector (i.e., tertiary sector) accounted for 40% of China’s GDP in 2008, and we estimate consumption of services represents 26% of total personal consumption. The consumption of services in China is substantially lower than that not only in industrialized countries but also in China’s peers among emerging market (EM) economies. For instance, while consumption of services in industrialized countries like the US, EU, and Japan accounts for about 66%, 40%, and 57% of their respective overall personal consumption, the shares of service consumption in total personal consumption in China’s EM peers in the region such as India (39%), Korea (57%), and Taiwan (56%) are also significantly higher than that in China (see China Economics: China's Under-consumption Over-stated, September 13, 2009).
A key source of underestimation of service consumption in China is the consumption of housing, in our view. Based on official statistics, we estimate that consumption of housing accounts for only about 3-4% of personal consumption in China. This seems to us too low to be even close to the reality. As a comparison, consumption of housing represents about 16% of personal consumption expenditure in the US and 6.6% in India. We think an important reason for the seemingly low housing consumption in China is that the imputed rent of owner-occupied housing is not appropriately accounted for. In other words, the statistical methods used in the US and China to estimate the consumption of housing are quite different. The fact is that the house ownership ratio in China is over 80%.
Another important source of underestimation of service consumption in China is personal spending on health care, in our view. While the share of spending on health care in the US is 15-16% of total PCE, this share in China is only about 6%. However, there is no shortage of anecdotal evidence suggesting that there are substantial gray and black markets in health spending in China – which are not captured by official statistics.
Actually, the underestimation of the importance of the service sector was more serious before the substantial upward revision of GDP in 2005 following completion of the first nationwide economic census. In the 2005 GDP revision, China’s 2004 GDP level was revised up by 16.8%; 93% of the increase stemmed from a substantial upward revision in the service sector, such that the share of the service sector was lifted from about 32% to 41%. In explaining the revision, the NBS noted that China had long been using the Material Product System (MPS), which was developed under the centrally planned economic system in its national accounts statistics until the 1980s, resulting in ‘very weak’ statistics for the service sector.
The second nationwide economic census has reportedly been completed this year and the key results will likely start to be released next year. The potential revision of the historical national account data will likely result in another significant upward revision of the share of the services sector in GDP, in our view. Incidentally, the first nationwide economic census was completed in 2004 and the revised national data (e.g., GDP) were released in December 2005. With the benefit of hindsight, there appears to have been a re-rating in the H-share stock market, as investors realized that the structural imbalances in the economy were less serious than indicated by the pre-revision data.
Market Implications
Goldilocks cyclical conditions, together with structural soundness, should be positive for risk assets, in our view. Morgan Stanley’s Asia/GEMs Strategist, Jonathan Garner, gives China the biggest country Overweight (see Asia/GEMs Equity Strategy, APxJ 2010 Outlook: Headwinds Building but Further Upside Likely, November 9, 2009). Moreover, Morgan Stanley’s China Equity Strategist, Jerry Lou, is also bullish, citing potential further upward re-rating from the current fair levels as earnings accelerate (see China Strategy, 2010 Outlook: Equities in Transitional Goldilocks, November 11, 2009).
Challenges in the Long Run
Notwithstanding our generally positive outlook for Chinese economy in the near term, we are also mindful of various challenges facing the Chinese economy over the long run. We believe that China’s economy has and will likely continue to experience high growth and relatively low inflation with a cushion against external real or financial shocks, as long as the high savings ratio persists (China Economics: The Virtues of 'Over-savings': A Post-crisis Reflection on Chinese Economy, September 27, 2009). We do not subscribe to the notion that there are serious structural imbalances in China’s economy.
However, the ‘over-savings’ is not a permanent phenomenon but a function of China’s demographics. Population aging in China will likely kick off around 2020, according to projections made by the United Nations. The key challenge facing the Chinese economy is how to seize the window of opportunity of ‘over-savings’ to create quality wealth for the nation, in our view. The priority for China’s economic development is not about rebalancing the economy but rather, improving the quality of investment, or wealth creation, in our view.
To this end, China must get the structure of pricing and other incentives right by:
a) Deregulating the prices of energy and natural resources;
b) Deregulating interest rates;
c) Allowing unfettered adjustment of the real effective exchange rate (either through more flexible nominal exchange rate or domestic inflation, or a combination of both);
d) Deregulating the land market;
e) Deregulating sectors that are still subject to state monopoly (e.g. services); and
f) Encouraging private capital outflows.
The full report also contains analyst certification and other important disclosures relating to the companies mentioned in this email.
END OF RESEARCH ABSTRACT
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