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Macro Policy Support for Growth

10-31 15:51 Caijing Magazine

Weakening end demand is the root problem. It calls for more aggressive fiscal policy to rouse the domestic market.

By Frank Gong, Hong Kong-based chief China economist at JP Morgan Chase


Amid the faltering global economy and the negative shock from the financial market turmoil, the momentum of China's economic growth eased notably in the third quarter, as a combination of slowing export demand and previous policy restraints tempered its industries. Third-quarter real GDP growth came in below-expectations, rising at 9.0 percent year-on-year, bringing GDP growth for the first three quarters of the year down to 9.9 percent year-on-year. Seasonally adjusted, real GDP expansion eased notably to below-trend pace in the third quarter, to rise 6.4 percent over the last quarter’s annualized rate, the slowest pace of quarter-on-quarter growth since the second quarter of 2005.


With net exports becoming a notable drag in 2009, overall GDP growth in China is still widely expected to slow markedly from the red-hot 11.9 percent growth in 2007 to a more moderate pace of 8.7 percent next year (with the possible range between 8.5 and 9.3 percent), which can be, and only can be, achieved with the expected fiscal stimulus and monetary easing. There have been intensified concerns in the financial market that such a notable slowdown may lead to a material increase in the systematic risks in the overall economy. However, in our view, a slowdown to 8.5 to 9.3 percent represents a gradual normalization towards the economy’s medium-term sustainable trend growth, rather than a crash in the overall economic activities. During the course, there could be a number of adjustments in the economy responding to weaker final demand, especially in sectors with over capacity building up during the economic upturns. However, these adjustments tend to be modest with policymakers’ fiscal and monetary support in place. In our view, due to the absence of a period of sustained sub-trend growth, the chance of a significant increase in systematic risks is very low.


The direct financial impact of the recent weeks’ unprecedented events in global financial markets on China has been limited. A liquidity crunch is unlikely to happen in China given its strong “twin surplus” position – current account and fiscal surplus – abundant FX reserves, as well as its low leverage at household, corporate and government levels. Fundamentally, China is still an over-saved economy. However, the Chinese government is alert to the potential for economic fallout. Indeed, amid a broader and deeper downshift in global economy, economic growth in China is losing steam. IP registered two consecutive monthly declines in seasonally adjusted terms with power and electricity production tumbling. Meanwhile, housing investment decelerated markedly as expected, which has weighed on domestic steel demand and, in turn, the steel price. Indeed, during the State Council meeting on October 17, Premier Wen stressed a "flexible and cautious" macro policy, and highlighted the importance of upholding stable economic growth and social stability.


Stimulating End Demand to Support Growth


In our view, there is room for fiscal and monetary policy to ease further. More aggressive fiscal policy has to come out to stimulate and support domestic demand, as policies such as increasing export tax rebates, supporting and increasing loans to small- and medium-sized enterprises won't solve the end demand problem. If a company's cash flow runs into problem due to rising inventory on end demand, it would not help them by giving them more loans or tax rebates or even interest rate cuts. We believe that weakening end demand is the root problem, and policies need to come out to stimulate infrastructure investment, housing and property markets, and the capital and stock market. Tax cuts should also be implemented to boost consumption.


Indeed, the sluggish performance of domestic asset markets may have weighed on consumer sentiment and spending, especially on luxury goods such as autos and housing related items including furniture and decoration materials. However, overall domestic consumption should grow steadily given the government's strategic policy support, fiscal subsidy and stable income growth. Indeed, the government has vowed to encourage domestic consumption through tax cuts and increased spending on soft social infrastructure including education, medicare, and social security. With regard to the housing market, the authorities indicate that macro policies would target stabilizing real estate demand, the plan being to cut real estate transaction fees and employ other measures to boost the industry.


Based on consensus earnings forecast, the MSCI China is trading at the 8.2 times estimated earnings for 2009, one of the historical trough levels. However, we believe that the market is too optimistic about 2009 earnings. In our view, the risk for 2009 profit forecasts remain on the downside. We believe that the aggregated 2009 profit growth could be lowered to 11.5 percent. Under this more conservative stance, the MSCI China is trading Chinese companies at 8.4 times their forecasted earnings for 2009, which is similar the situation we saw during the 2003 and 2004 trough, assuming the price level remains unchanged.


Sector-wise, we see downside earnings risks in property, banking, materials and consumer discretionary sectors. The key investment strategy for 2009 would be to pick up the right sectors and stocks, which offer good earnings visibility under the current economic slowdown, and avoid the sectors with consistent earnings downward revisions.


It would not be a surprise to see declining profits in the coming months. According to a long-term historical trend, MSCI China usually recovers six months prior to a recovery in earnings revisions. In our worst-case scenario, even if the estimated 2009 earnings growth of MSCI China would show flat or negative growth, we believe there is limited downside risk to invest in the MSCI China in 2009 as long as there is no significant systematic risk in China. 2009 should see the nadir in earnings, after which they would rise.


As such, we suggest long-term investors avoid materials, commodities and consumer discretionary companies, and increase exposure in selected insurance- and fixed-asset investments, and refining companies.

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