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To: Jim Willie CB who wrote (6467)	9/16/2002 11:29:40 AM
From: TobagoJack	Respond to of 89467

China: Exporting More Deflation morganstanley.com Denise Yam (Hong Kong) Latest Economic Figures for August Paint a Consistent Picture Economic figures for August released in the past few days illustrate the comprehensive picture that we have been painting for China's globalization, the global outsourcing trend, and spreading deflationary pressure. Exports rose 25% year over year to a record monthly amount of US$29.4 billion, buoyed by the upsurge in outsourcing orders. Global consumers are becoming more price-sensitive. Fragile global demand and China's increasing openness are accelerating the outsourcing trend to the lowest-cost manufacturing producer. Foreign direct investment utilization in China totaled US$4.9 billion in August, up 52% YoY, while new contracts signed in the month came to US$8 billion, more than doubling YoY. The fast expansion of capacity and the improvement in efficiency in the manufacturing sector are boosting the supply of goods and putting downward pressure on prices. The CPI fell YoY for the sixth month, by 0.7%, reinforcing our view that China, and indeed East Asia as a whole, is becoming more competitive and gaining share in the global market, but increasing trade is also making Asia's deflation a global issue. Exhibit 1: August Economic Indicators Source: National Statistics Bureau, CEIC, Morgan Stanley Research Trade Growth Concentrated in Export Processing After rising 25% YoY in August, exports have gained 18% in the first eight months from a year ago, already reaching our full-year export growth target (18%). Machinery and electronics exports rose 27.2% YoY for first eight months, to US$95.3 billion, accounting for 47.5% of the total. The pickup in external trade has been concentrated in outsourced export processing. Foreign-invested enterprises account for more than half of both exports and imports. Although income growth in China is improving the affordability of imported consumer goods, the recent sharp rise in imports is concentrated in shipments associated with processing trade. China has taken up large quantities of foreign components destined for re-exports. Imports classified under "processing and assembly" and "processing with imported materials" represented 42% of total imports in 2Q02, up from 37% in 3Q01. A Closer Look at Prices in China In our view, it is understandable that foreign investment in China is not only targeted at export production, but also the attractive domestic market potential. Production capacity has been expanding rapidly with fixed investment at 38% of GDP in 2001. The adoption of foreign technology and management has greatly raised productivity, while efficiency at state-run companies has also improved amid accelerated reform. Under these conditions, oversupply of goods could only have deteriorated in the past year. Moreover, prices of certain goods were also pushed down by more competition from imported goods and reduced tariffs since WTO accession in January. Goods prices dropped 1.4% YoY in August. Food prices fell 0.4% with grain down 2.3%, aquatic products down 2.5%, meat and poultry falling 0.6%, offsetting the 3% gain in vegetables prices. Textile, clothing and footwear prices fell 2.5% YoY, while pharmaceuticals and personal hygiene goods saw prices slipping 1.1%. The recent hype in car sales has been partly supported by price cuts; the cost of vehicles was 5.3% lower than the year-ago level. Prices for telecom equipment dropped 16.4%. The drop in goods prices again more than offset the rise in the cost of services, at 1.6% YoY. Housing rent has risen 3.8% YoY, while utility charges are 2.8% higher. Health services cost 7.7% more than a year ago, while the price of general cultural and recreational services rose 4.3%. Consumers' inclination to saving amid job insecurity and shifting social security burden has also been blamed for prolonged deflationary pressure. The stock of household savings (in the form of deposits) has reached Rmb 8.3 trillion in August, up 18% YoY. The CPI has fallen YoY for the sixth month, by 0.7% in August. In fact, the YoY change in the CPI has been in the negative territory since November 2001 except in February where CPI was flat due to exceptional spending during the Lunar New Year. FDI and Exports Continue to Drive Growth In terms of export to GDP ratio, China is still relatively closed compared with its regional neighbors. Nevertheless, incremental export growth has contributed considerably to GDP growth in the past few years and has played a key role in creating jobs. China is becoming increasing external oriented and is relying on exports and foreign investment to fuel GDP growth that likely will outpace the rest of Asia. The bulk of China's growth is structural, which is relative resilient to cyclical fluctuations in the global economy. With the continuous outsourcing trend that led the 52% YoY rise in foreign direct investment in August and the 130% rise in signed contracts (which signals future intentions), China is becoming a dominant producer of key categories of goods, and we think its exports could grow by 7% even in a flat global economy. Nevertheless, we have to bear in mind that China's globalization remains a key source of deflation for the global economy.