[20081127] China Economy - "Inflation in 2008, Deflation in 2009"

Highlights:
u   Advanced economies are in deep recession and their growth rates are expected to be well below potential in coming years. Fiscal pump priming is the sole means of economic stimulation, since the credit crisis impedes transmission of monetary policies to terminal capital demand through financial intermediaries. Housing construction permits and real money supply are key leading indicators of US economic recovery with a 4~6 month leading effect
u   The Chinese economy faces much tougher challenges now than in 1998: The AFC hit only Asian economies, but the current global financial crisis has wreaked havoc on the US and Europe, China’s primary export markets. The weighted average economic growth of China’s main export destinations may be slower than that in 1998. Moreover, the multiplier effect of government infrastructure investment is much weaker than that a decade ago.
u   Declines in both domestic and external demand threaten government efforts to maintain 8% GDP growth, amplifying the risk of deflation. It will take years for investment demand to reach the bottom. 1) External demand may hit bottom in 2009 due to broad-based recessions expected in Europe and the US. Growth may stay below trend in 2010, with no major rally expected. Falling export orders in 2009 will likely undermine exports in 2010. 2) China’s export-oriented manufacturing industries and property investment have just begun to contract after many years of expansion. It takes years to absorb overcapacity and housing inventory. Considering the effects of policy responses so far, we project 8% economic growth for China in 2009 and 7.8% in 2010.
u   Maintaining rapid and stable economic growth will likely be the government’s main goal. To keep growth at 8%, it may introduce additional stimulus policies, including measures to encourage home purchases and lessen funding pressure on developers. To spot when the Chinese economy will bottom out, we compiled the CICC macroeconomic leading indicator (CLI), consisting of five components: power generation, cement output, automobile sales, housing sales GFA, and OECD leading indicator. Historical data show that CLI leads VAI by two months on average (Box 2).
u   Inflation in 2008, deflation in 2009: China faces increased risk of deflation due to overcapacity and unemployment pressure as the economic downturn accelerates and global commodity price bubbles collapse. We expect PPI deflation and non-food CPI deflation in 2009 and 2010, further eroding corporate profits.
u   High debts and aging demographics worsen the long-term global economic outlook. Besides counter-cycle policies to address near-term worries, China should introduce further reforms to deal with long-term challenges. These include improving its social security net, and reforming healthcare, education, land tenure, household registration, taxation, and energy and resource pricing.
u   China is still one of the most solid emerging economies. China’s healthy economic fundamentals (high household savings, low government debt, huge FX reserve) should help it better weather the financial tsunami.