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Key Risks of China

05-16 14:54 Caijing Magazine

The forces in the way of continued economic growth are diminishing.

Frank Gong, chief China economist at JPMorgan Chase & Co.


The Chinese economy has maintained solid growth momentum amid the unfolding slowdown in global demand, rising a sturdy 10.6 percent in 1Q08. Meanwhile, profitability in corporate sectors (excl oil refining and electricity generation) continues to expand at a remarkable pace. More importantly, inflation, which topped out during February in our view, has become less a concern for policy makers. Macro policy is moving towards a more growth-friendly direction, with more emphasis on social stability and supporting the equity market. Although external risk still remains, we believe that China’s favorable “twin surplus” (current account surplus and fiscal surplus) position has provided a strong cushion for China to manage the external slowdown and inflation pressure caused by external energy/commodities.

Overall, the risk of investment in China today is much lower than 6-12 months ago, and the valuation has become attractive. With the A-share market having declined more than 50 percent and the property price stabilizing, China has successfully deflated two asset bubble risks without hurting economic growth – an outcome not often seen in the world’s economic history. In fact, with the real Chinese economy continuing to grow solidly with low risk of asset bubbles, it has become a better time to invest in China now.

Inflation is less of a concern
Inflation is gradually easing, confirming our view that inflation has topped out in February. Meat/Pork prices are declining; now back to the level in mid-January. With the higher base starting to kick in going into the mid-year, we expect inflation to average 7 percent in 2Q, 6 percent in 3Q and 5 percent in 4Q. This reflects our view that with food inflation likely normalizing in 2H08, the government may start to liberalize price mechanisms for various basic inputs, including oil and electricity tariffs, which may lift up the non-food inflation to 4 percent going towards year-end, averaging 2.5 percent for 2008, compared to the current level of 1.5-1.8 percent.

Although there is still concern about increasing pipeline inflationary pressure, as seen in the recent pickup in PPI and import prices. Policy-wise, we believe that currency appreciation would be the most effective tool to fight against the high global oil/commodity prices. Meanwhile, if global commodity markets start to correct in the coming months, PPI could ease as well.

Twin surplus cushioning global slowdown
We believe that China’s favorable “twin surplus” (current account surplus and fiscal surplus) position has provided a strong cushion for China to manage inflation pressure caused by external energy/commodity inflation and the external slowdown. With inflation not a top concern, policymakers continue to be concerned about the downside risk to growth. In particular, with US growth to remain low and the Euro area expected to follow suit in 2H08, China’s exports to the Euro area, where growth has been most impressive recently, may slow more notably going forward. The Chinese government is ready to use its favorable fiscal position to offset the negative drag from the external side. Indeed, the government has a sizable budget surplus. In 1Q08 after the CIT cuts, tax revenues went up by around 35 percent year on year, much higher than the budgeted 14 percent as in the government’s report to the NPC in March. With the fiscal surplus standing at 0.7 percent of GDP in 2007, if the government raises fiscal deficit to 3 percent, which is still tolerable by any international standard, it can provide a powerful boost to the economy. Indeed, the government has started to act: the Beijing-Shanghai high-speed railway, which was scheduled to commence in 3Q08, has been brought forward to current quarter and started in mid-April. Investment for this project amounts to 220 billion RMB, which is around 1 percent of GDP.

Corporate profitability
At the micro level, corporate profits have been rising robustly. The banking sector has reported better 1Q08 earnings, validating our call in March to buy banks ahead of earnings announcements. We are not surprised with the good performance of Chinese banks despite global slowdown, as they are mostly exposed to large SOEs, which are mainly monopolists in very profitable sectors. Investors may still be concerned about the asset quality due to the margin squeeze in the industrial sector given the elevated raw material prices and the vulnerability of low-end export sectors to external slowdown. However, note that the industrial sector is only 12 percent of MSCI China, and the corporate sector is only experiencing a cyclical profit downturn, with its balance sheet hardly hurt (given their 20 trillion RMB corporate deposits in the banking system). There is a reason why China’s industrial sector has only a small representation in MSCI China. The sector, especially those small & medium enterprises involved in the export business, has been very profitable throughout the years and has not been relying on the stock market or bank finance. They have been operating mostly on their own cash flows. For many years China has seen US$25 billion trade surplus a month. Who made this money? Mostly China’s industrial sector, and many of the small & medium enterprises. On the external slowdown, China’s industrial sector will experience a cyclical slowdown in profit growth. However, their balance sheet is very strong and there isn’t much leverage in the industrial sector and in the economy overall. As such, bank’s asset quality will not be impacted as much as the market expected if there is a cyclical slowdown in industrial’s earnings/profit growth - this is one of the key arguments behind our call in March to buy Chinese banks. The banking sector has outperformed since March, and we would stay with this call.

A-shares market has stabilized
In previous bear markets, the A-shares index has tumbled more in a few occasions, but none of the previous sell-offs saw the index falling so much in such a short period of time (merely 6 months). It has been very painful for many urban residents who put their money into the market last year. The top political leadership made the call to cut the stamp duty tax recently to provide strong support to the market, in order to address the issues of market confidence and stock share over-supply. We argued that more market boosting measures could be in store if the A-shares market does not stabilize.

Although the A-shares market can stay volatile and remain fragile, the worst of the sell-offs in the A-shares might be over. For the Shanghai Composite Index, it is likely to trade in 3000 to 5000 for the near to medium term. The key is that its valuation has become attractive to the extent that foreign investors had started to buy even before the government’s recent market boosting measures. Domestic investors who have been fire-selling the market often used the excuse of the increased shares supply due to the expiration of lockup period of non-tradable shares. We, however, believe that the key issue is confidence, instead of the incremental supply through the unlocked floatable shares. The state is unlikely to sell down much of its holdings even if they can sell. For the so-called "legal persons" who may want to cash out their unlocked shares, they would likely recycle the cash back in the market when they try to actively diversify their investments and manage their wealth – they are unlikely to just leave the cashed out money in bank accounts with negative real returns. Indeed, it is not simply a supply problem. There are two sides of the coin – supply and demand.

The bottom line is that, China’s fundamental problem of excess liquidity and excess cash level would remain for a long time. Once there is confidence, we believe the liquidity will mostly stay in the market. In any case, we believe that the supply of unlocked shares in the A-share market should not have any significant impact on the H-shares, which are much cheaper and have a much broader global investor base, thus making H-shares outperform A-shares in 2008.

The possibility of one-off large appreciation of RMB is higher
There is consensus that in terms of monetary policy, allowing RMB to appreciate, especially on REER terms, is the best policy tool to fight the global/externally caused inflation pressure on China, it is also the best policy tool (rather than by hiking interest rates) to control money supply growth in China (given most of the money supply growth can be attributed to fast FX reserve accumulation on a ballooning current account surplus).

However, it is very surprising that policy makers and think-tanks in Beijing are seriously debating the issue of doing one-off, large step revaluation of RMB, around 10-15 percent, in the coming months. Although we still believe the odds of such move is small (less than 50 percent probability), it is much higher than the 10-20 percent odds we had put on it before. They can continue on the path of accelerated appreciation seen in 1Q08, but the negative aspect of it is hot money inflow. With global crude oil prices where it is now and continued rising global resource and commodity prices, the government is weighing the pros and cons of a one-step, large revaluation of RMB (this is probably why RMB appreciation is temporarily pausing here in the last couple of weeks). At the very least, we expect RMB to continue on its accelerated pace of appreciation to reach 6.3 against the USD by the end of this year.

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