asia economics analyst · tushar poddar +91(22)6616-9042 [email protected] goldman sachs india...

December 8, 2014

Issue No. 14/43

Asia Economics Analyst

Economics Research

China 2015 outlook: A little less growth, a little more reform

A moderate but choppy growth deceleration…

We expect Chinese growth to moderate to 7% in 2015E from 7.3% in 2014E,

on the back of lower potential growth, decelerating credit, and ongoing

headwinds from housing market adjustment. As the government tries to

strike a balance between supporting growth and pushing forward reforms,

we see a fair likelihood of a repeat of 2014’s stop-and-go pattern in

economic momentum in the new year. The first quarter, in particular, may

see renewed downward pressure on growth.

…alongside a step-up in reforms

Still, we expect 2015 as a whole to be somewhat more conducive to the

new leadership’s reform drive, for two main reasons. First, external

conditions are likely to be more supportive for growth – with broader DM

growth than in 2014, continued easy global liquidity, and lower commodity

prices. Second, we believe the official growth target is likely to be lowered

to around 7%, reducing pressure for short-term stimulus.

Mild inflation and low interest rates

Slower growth and lower global commodity prices imply that inflation will

be mild in 2015. However, we see little risk of outright deflation, with

policy makers ready to respond quickly if growth or inflation slows

significantly. We expect rates to remain low, with a small benchmark cut

and modest RRR cuts (to offset the impact of lower capital inflows) more

likely than not in the first half of the year, but not a major easing cycle.

Stable CNY; tactical equity rally

We expect the renminbi to remain fairly stable versus the US dollar

(though appreciating slightly on a trade-weighted basis), with the focus of

policy easing on supporting domestic demand. However, risks are tilted

toward another bout of modest depreciation in the first half of the year.

The recent equity rally is in line with our strategy team’s expectation that a

boost in liquidity (mainly from household asset reallocation and inflows

from foreign investors) will likely be positive for Chinese equity markets in

the short term, despite the deceleration in economic growth.

Andrew Tilton +852-2978-1802 [email protected] Goldman Sachs (Asia) L.L.C.

Goohoon Kwon, CFA +852-2978-0048 [email protected] Goldman Sachs (Asia) L.L.C.

Tushar Poddar +91(22)6616-9042 [email protected] Goldman Sachs India SPL

Yu Song +86(10)6627-3111 [email protected] Beijing Gao Hua Securities Company Limited

MK Tang +852-2978-6634 [email protected] Goldman Sachs (Asia) L.L.C.

Reza Siregar +65-6889-2472 [email protected] Goldman Sachs (Singapore) Pte

Matthieu Droumaguet +852-2978-1084 [email protected] Goldman Sachs (Asia) L.L.C.

Jonathan Sequeira +852-2978-0698 [email protected] Goldman Sachs (Asia) L.L.C.

Maggie Wei +852-2978-0106 [email protected] Goldman Sachs (Asia) L.L.C.

Vishal Vaibhaw +91(22)6616-9376 [email protected] Goldman Sachs India SPL

Mallika Chawla +65-6654-5539 [email protected] Goldman Sachs (Asia) L.L.C.

Irene Choi +82(2)3788-1722 [email protected] Goldman Sachs (Asia) L.L.C., Seoul Branch

Investors should consider this report as only a single factor in making their investment decision. For Reg AC certificationand other important disclosures, see the Disclosure Appendix, or go to www.gs.com/research/hedge.html.

The Goldman Sachs Group, Inc. Global Investment Research

December 8, 2014 Asia Economics Analyst

Goldman Sachs Global Investment Research 2

China 2015 outlook: A little less growth, a little more reform

Lots of uncertainty in the 2015 outlook

In 2014 the year of the Horse, it seems fair to say that the Chinese economy did not quite

gallop. While we expect full-year real GDP growth to ultimately come close to the “around

7.5%” growth target for 2014, it was not without periods of marked growth scare and

ensuing bouts of policy stimulus (Exhibit 1). Tension between the objectives of mending

economic imbalances and delivering high growth has turned more evident, and gradually

declining potential growth does not make the trade-off any easier.

In the coming year of the Sheep, our macro team expects the global economy to

accelerate—with developed-market growth broadening beyond the US economy—and this

should give a meaningful boost to Chinese exports. Nevertheless, unlike the temperament

of next year’s zodiac animal, we expect Chinese domestic economic conditions to remain

relatively challenging. Ongoing headwinds from the housing market adjustment and

shadow banking tightening will likely continue weighing on growth. Moreover, the

government’s structural reform agenda adds risks to the outlook. Beijing has signaled

intentions of advancing further difficult reforms, such as on local government debt

management and interest rate liberalization. Although we expect these reforms to proceed

gradually and hence their short-term impact on the economy to be fairly mild, experiences

from the anti-corruption campaign and the recent crackdown on shadow credit suggest

that the impact of reforms could be highly uncertain, with the potential of posing

significant downside to growth.

Exhibit 1: A choppy but gradual deceleration

Source: Goldman Sachs Global Investment Research, NBS

Given this backdrop, we expect the government to lower the growth target to about 7% for

next year in order to facilitate the transition to a lower but more sustainable growth path.

But we may well see some major ups and downs on our way to getting there. In the past

couple of years, and particularly this year, the authorities have been measured in imparting

0

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8

12

16

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Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14

Percent Percent

IP quarter-over-quarter annualized growth(after seasonal adjustment)



policy support when growth turns weak and prompt to withdraw stimulus once growth

shows signs of strengthening; yet growth has often decelerated quickly after stimulus is

withdrawn (Q3 this year is a case in point). We think it is likely that a lower growth target

would ease the tug-of-war between delivering the growth objective on the one hand, and

policy restraints and reforms on the other.1 However, we still see a fair likelihood of a

repeat of the stop-and-go pattern in economic momentum in the new year.

Exhibit 2: GDP by expenditure breakdown

Source: NBS, Goldman Sachs Global Investment Research

Near-term growth pressures to the downside…

While we expect recent easing measures—such as quicker infrastructure project approval,

increased central government pressure on local governments to spend, and various

measures to lower borrowing costs—to mitigate some of the downside risks to growth, we

still see four main challenges for growth heading into 2015:

First, we expect housing activity to remain soft. Despite some recent signs of

stabilization in housing transactions and prices, the weak pre-sales and rise in inventories

earlier in the year will likely continue to put pressures on real estate investment in at least

the first half of 2015. As we have discussed previously, we expect the overall growth

contribution of housing (including via up/downstream industries as well as effects of

housing wealth and local government land sales) to decline by some 70bp from this year to

next (Exhibit 3).2 This could occur even if housing transactions pick up modestly: easier

1 In general, while we think many reforms can help trend growth over the medium to long-term, at least relative to a counterfactual of no reform, there is often a short-term cost involved. We discussed the oscillation between reform (during times when growth looks good) and forbearance/policy support (when economic or labor market stability are a concern) in prior publications, including “The China credit conundrum”, See “The China credit conundrum: Risks, paths and implications”, Portfolio Strategy Research, Jul 26, 2013.

2 See “China’s housing boom in international context”, Global Economics Paper 225, Oct 17, 2014.

2013 2014F 2015F 2016FGDP by expenditure % yoy 7.7 7.3 7.0 6.7

Domestic demand % yoy 8.2 7.7 6.8 6.5Consumption % yoy 7.4 7.3 7.3 7.3

Household % yoy 7.3 7.4 7.4 7.4Government % yoy 7.8 7.2 7.2 7.2

Gross capital formation % yoy 9.1 8.0 6.3 5.5Fixed investment % yoy 9.4 8.4 7.0 5.8Inventory PPT 0.0 0.0 -0.2 -0.1

Net exports PPT -0.3 -0.1 0.4 0.4

GDP by expenditure PPT 7.7 7.3 7.0 6.7Domestic demand PPT 8.0 7.5 6.6 6.3 Consumption PPT 3.7 3.7 3.7 3.8

Household PPT 2.6 2.7 2.7 2.7Government PPT 1.1 1.0 1.0 1.0

Gross capital formation PPT 4.3 3.8 3.0 2.5Fixed investment PPT 4.3 3.8 3.2 2.6Inventory PPT 0.0 0.0 -0.2 -0.1

Net exports PPT -0.3 -0.1 0.4 0.4



mortgage lending conditions and improved buying sentiment from households may offer

an opportunity for developers to unload excessive inventory, but do not guarantee an

acceleration in construction activity, particularly if “shadow lending” to developers

remains tight.

Exhibit 3: Estimated housing impact on growth Percentage points of GDP

* See “China: Growth hit from the housing market downturn still looks manageable,” EM Macro Daily, July 8, 2014. Source: Goldman Sachs Global Investment Research

Second, new credit flow has decelerated significantly. Tighter banking regulations,

alongside weaker demand from some areas of the economy, has sharply reduced shadow

credit in recent months, pushing down the overall credit flow (or TSF) on a seasonally

adjusted basis from an average of RMB1.5tn/month in H1 to about RMB1.0tn/month in the

past couple of months. While the slowdown in credit, especially the shadow banking

segment, is welcome from a structural standpoint, the adjustment has probably been too

rapid and exerted a taxing downward pressure on growth. Financial conditions have

tightened notably since midyear, especially alongside the recent strong trade-weighted

appreciation in the CNY. With shadow credit under more effective control given the bank

regulation, we see room for the PBOC to drive interbank rates lower (Exhibit 4). Indeed, the

recent cut to the benchmark interest rates and to a smaller extent the OMO interest rates—

while they alone probably have limited growth impact—has signaled the central bank’s

intention to bring down system funding costs and boost credit (particularly from the more

transparent sources, such as formal bank loans and corporate bond issuance).

Exhibit 4: We see scope for the PBOC to drive interbank rates lower to boost credit flow

Source: Bloomberg, PBOC, Goldman Sachs Global Investment Research

2013 2014F 2015F Explanation

Real estate investment 1.1 0.7 0.2 Weak sales (-11% ytd yoy), inventory overhang

Real estate services 0.4 0.2 0.2 Low historical sensitivity to housing transactions

Consumption 0.3 0.1 0.0 Wealth effect of 8%*

Local government spending (versus 2013 baseline)

0.0 0.0 -0.2 Land revenue drop similar to 2012; assumes 25% of drop not replaced by new borrowing

Total 1.8 1.0 0.3

Estimated contribution to real GDP growth by component

2.0

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Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14 Jul-14

Total social financing flow (after seasonal adjustment)

7d repo rate (right scale)

Trillion RMB Percent



Third, the policy reaction function has shifted away from maximizing growth, so support is likely to be relatively short-lived. Given the signs of decelerating growth

since the middle of the year, policy makers have clearly indicated the intention to loosen

policy and boost growth with the recent benchmark interest rate cut.3 We expect growth to

show a visible rebound in December as a result of the loosening and disappearance of the

negative effects from the APEC shutdowns. Although policy transmission via the interest

rate channel should have only a modest, lagged impact, rate cuts tend to coincide with

other more blunt measures such as putting administrative pressures on local governments

to boost FAI. Such measures tend to work with very short lags and often have large effects

on growth, though their impacts tend to be short-lived.4 The rate cut can be seen as an

indicator of policymakers’ urgency, rather than the main policy lever itself. Indeed, a quick

rebound is what we often saw in the past after benchmark rate cuts (Exhibit 5).

Exhibit 5: Growth usually rebounds soon after rate cuts

Source: NBS, PBOC, Goldman Sachs Global Investment Research

After growth shows a rebound, there is a significant likelihood that stimulus will be

withdrawn relatively quickly. Under the new leadership there has been a consistent

tendency to do so, as was the case in the fourth quarter of 2013 and the third quarter of this

year. The new leadership appears more focused on policy goals, such as containing

leverage/financial risks, reducing pollution, and reserving policy ‘ammunition’ for harder

times. Furthermore, a key motivation for the current round of loosening is to ensure

growth does not fall too much below this year’s official target; as a result, we see

significant likelihood that policy becomes incrementally less supportive going into 1Q2015.

In contrast to the popular belief that last week’s benchmark rate cut is the start of a

significant rate cut cycle, we see further easing as relatively data dependent. Past

experience suggests a tendency to cut multiple times in succession, but (1) Chinese

monetary policy making is less bounded by institutional constraints such as inflation

targeting, and the preference of the current leadership has generally been for more

cautious and discreet easing, (2) benchmark interest rates have become relatively less

3 See “China: The PBOC cuts benchmark interest rates; one small positive step in policy loosening”, Nov 21, 2014.

4 “China’s policy transmission mechanism means loosening tends to be effective in the near term but short lived,” EM Macro Daily, May 7 2014.

Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14-10

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Rate cutIP 3m/3m annualized

Percent Percent



important and market rates, such as interbank rates, much more important than in prior

administrations.

Exhibit 6: Benchmark lending rates were cut last month

Source: CEIC

Fourth, 1Q is also likely to see renewed downward pressures from the anti-corruption campaign. The campaign intensified this year and we expect it to remain

stringent for years to come. The incremental change this year is in the breadth of the areas

affected: the armed forces, SOE and other broadly defined state-owned entities (such as

schools and hospitals) are subject to closer scrutiny, and within the government the

seniority of officials charged reached the highest level since the founding of the PRC

(Exhibit 7). While this likely already impacted growth within this year, the impact on the

economy should show up more fully in 1Q, when traditionally gift giving and dining take a

disproportional share of the economy because of the Chinese New Year. This is the reason

why since the leadership handover 1Q sequential growth has tended to be on the weak

side (Exhibit 8).

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1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013

Percent Percent



Exhibit 7: Anti-corruption campaign picked up strength

Source: Xinhua net, Renmin website, Central Commission for Discipline Inspection of the CCP.

Exhibit 8: An intra-year cycle with weak Q1 in recent years

Source: NBS, Goldman Sachs Global Investment Research

So growth in 4Q2014 and 1Q2015 is likely to be on the relatively weak side, in our view.

Should growth surprise on the downside, policy makers will likely respond, leading to

another round of loosening and growth rebound. There seems to be a tendency for policy

makers to respond with a shorter lag, possibly reflecting the new policy makers’ learning

curve.

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7

2009 2010 2011 2012 2013 2014

Number of senior officials (deputy ministerial level or above) officially announced to be under investigation

Q1 09 Q1 10 Q1 11 Q1 12 Q1 13 Q1 14-10

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New administration took overConsumptionInvestment

Percent Percent

GDP by expenditure sequential growth:



…but overall, we see factors supporting a meaningful reform drive

in 2015

Despite the uncertainties, we view 2015 as a year that is likely to be more friendly for

reforms in China: more accommodative external environment will benefit exports and

therefore leave more room for domestic adjustment, and a lower growth target will also

relieve some pressures facing policy makers this year.

More accommodative external conditions come from the following areas:

DM growth recovery to broaden: In the US, our macro team expects above-

trend growth of around 3% to continue. In addition to that, they also expect growth

recovery to broaden to the Euro area and Japan given less fiscal drag, weaker

currencies and lower oil prices.5

Global financial conditions to stay easy: In general, monetary policy settings

will be kept loose in much of the world and in some cases loosened further. The

BOJ recently augmented the rate of its balance sheet expansion and reaffirmed its

commitment to a 2% inflation target; our European economics team expects the

European Central Bank to announce purchases of sovereign debt some time in the

first half of 2015. As for the Federal Reserve, our macro team expects it to start

lifting rates only in September of next year. Overall, global financial conditions

should remain easy throughout 2015, in their view.

Commodity prices to decline further: As per the US Energy Information

administration (EIA), China’s net imports of petroleum exceeded those of the US in

September 2013, making it the largest net oil importer in the world. With our

Commodities team’s expectation of low oil prices next year, consumers and

energy-intensive business should benefit and so should overall economic growth6.

So far this year, the government has been largely successful in delivering growth in line

with the target while keeping excesses in check. But at the same time, there is a lingering

sense that the broader structural policy agenda has been occasionally compromised by the

commitment to a high growth target. As the administration completes its first full year of

leadership this year, we believe the government will be more comfortable shifting down

the growth target after having demonstrated its ability to achieve continued economic

strength. More importantly, a lower growth target—likely to about 7.0%—would provide

the government with a greater scope to be more focused on reforms and less on shoring

up short-term growth.

A related supportive factor for reforms is the notably robust service sector, despite the

relatively soft industrial performance. In terms of yoy ytd growth, the service sector has

outpaced the industrial sector by about ½ pp in real terms and 5 ½ pp in nominal terms.

Given the service sector is by far the largest employer (in terms of both the number of

employees and payroll) in the economy, its resilience will likely continue to underpin

employment stability even amid the ongoing adjustment of the overcapacity sectors

(property and upstream industries) and lower overall GDP growth (Exhibit 9 below).

5 (see Global Economics Weekly, Keeping the faith, November 20, 2014)

6 For detailed discussion see our commodity team’s piece “The new oil order, OPEC loses pricing power, shale shifts to the margin”, October 26, 2014.



Exhibit 9: The resilient services sector will likely continue to underpin employment

stability and solid wage growth

Source: CEIC

These external and domestic factors should hopefully imply a reduced need to keep

cyclical policy accommodative to stimulate the economy, and correspondingly a wider

window to advance structural reforms. This would bring significant benefits to the long-

term growth and sustainability in the Chinese economy. In our baseline, we expect China’s

potential growth at 6 ½ percent on average in the next five years. This incorporates an

intermediate assumption between a “fast productivity convergence” scenario (a la that

experienced by the post-Communist European economies) and a more typical rate of

productivity growth for economies that have policy environments (as proxied by our

Growth Environment Score) similar to China’s.7 But structural reforms could unlock major

bottlenecks in the system and possibly raise China’s potential growth towards the “fast

convergence” scenario later in the forecast horizon.

7 See Exploring the limits to growth in emerging Asia, Asia Economics Analyst, August 22, 2014 and Our 2013 GES: Surprising the markets, Global Economics Paper: 223, Dec 18, 2013

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Dec-09 Dec-10 Dec-11 Dec-12 Dec-13

Secondary industry nominal ytd yoyService sector nominal ytd yoyAvg wage ytd yoyUrban employment growth yoy (right scale)

PercentPercent



Exhibit 10: Structural reforms could make a big difference to China’s potential growth

Source: Goldman Sachs Global Investment Research

The leadership’s overall reform plan is audacious in its scope, but some particular areas we

will be watching given their implications for the macroeconomy include:

Financial system liberalization. This involves (1) liberalizing part of the

financial market to improve efficiency and (2) changing regulations to control risks.

We have seen increased integration of onshore and offshore rates markets (as

evidenced by converging interest rates) and equity markets (via the recent launch

of the Shanghai-Hong Kong Stock Connect), progress on controlling shadow

banking activities (as shown by the recent draft rule from the CBRC to increase the

level of transparency and remove commercial banks' guarantee on WMPs) and

channeling credit via more traditional bank loans and bond issuance. We expect

further progress on these and other fronts in 2015. Further interest rate

liberalization especially the removal of deposit rate ceiling looks possible in the

new year, as the prospective launch of deposit insurance scheme (likely early in

2015) would provide a needed basis to promote market pricing of deposits and

proper risk control by banks.

Fiscal reform. Policymakers want to increase fiscal transparency, through

rotation away from “back door” off-balance sheet vehicles such as LGFVs towards

“front door” funding via formal municipal bonds. However, if not handled

delicately, this rotation could represent a net tightening in fiscal policy at a

vulnerable time for growth.

SOE reform. Pilot reforms have been launched, but the agenda here is long and

more likely to conflict with vested interests. Important reforms include

management incentives, resource pricing (including loan pricing), and the gradual

removal of implicit guarantees of many SOEs. Overcapacity in many sectors,

including housing, will need to be addressed.

Other key areas that could be important for the economy—especially consumption

growth—include rural land reform, hukou reform, and the general expansion of

social safety nets, to mention a few.

In practice, reform is not as straightforward as coming up with a grand blueprint and

rolling out everything in sequence, but involves some trial and error. Past reform progress

in China has often followed three basic stages. First, senior leadership has a strong desire

to make changes, and sets out an ambitious goal and high-level guidelines. Second, a

draft proposal, pilot or trial program is started by operational level officials; this leads to

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2010-2014 2015-2019 2020-2024 2025-2030

With convergence "boost"No productivity adjustment

Percent Percent

China potential GDP growth:



concerns by others about the risks and criticism about the pitfalls, and the reform process

goes back to the drawing board to make sure things are done in an orderly and safe

manner. Third, renewed pressures to move forward get reform moving again but with

important alterations to the detail.

One reason for the back and forth is the difficulty of reorganizing a complex system with

many interdependent policies; while it is easy to agree the current situation should be

changed, it is often much more difficult to reach agreement on what the alternative should

be. Another is the cautious tendency of the leadership to avoid committing “disruptive

mistakes” (in President Xi’s words).

One implication of this simple stereotyped process is that some of the early reform

attempts we are seeing now may not be a good guideline to the future. It is easy to

extrapolate the latest announcements (or lack thereof) and become overly optimistic or

bearish at different stages of the process. SOE, land, fiscal, financial, legal, social (hukou)

reforms will all likely move forward eventually, but it will be a hard and time consuming

learning process.

Not all reform initiatives are controversial, however. One notable example is the reduction

in administrative burdens on investments and companies, which we expect to continue in

the coming years and which should help lower the cost of business operation in China.

Policy reaction function remains key

The new administration has shown a different policy reaction function from its predecessor.

When the growth is weak and inflation is low, the new administration reacts to it fairly

quickly, like the last administration. But the current leadership appears (1) to prefer low

profile policy tools, which may also help to facilitate reforms to the structure of the

economy (targeted RRR cuts for SME lending, for example); and (2) to not focus on

maximizing growth, so tends to withdraw stimulus quickly once the economy shows clear

signs of recovery. Previously, the government would often “put the foot on the brake”

only after risks of overheating were evident. As a result, we are likely to see growth not too

far from the trend level with low or very low inflation. This shift in the policy reaction

function is an important reason why the risks to our growth and inflation forecasts are

tilted toward the downside.

Employment stability - an important but not necessarily binding constraint

Government officials sometimes express the view that employment is the focus of policy

and as long as employment conditions are fine, there is no need to loosen aggressively.

This is true in the sense of very large (2009-style) policy stimulus. But employment is not

as useful a gauge in explaining policy changes that have occurred under the new

leadership. Neither the unemployment rate (whether urban registered, or surveyed data

which is not officially published but sometimes quoted by senior officials) nor the number

of employment opportunities created showed meaningful worsening at times when policy

loosened significantly (e.g. mid-2012, March 2014, and September 2014; Exhibit 11).

This does not mean employment does not matter in principle, but it is less likely to be the

binding constraint on policy making in practice. Instead, the annual growth target and the

degree of macro credit stresses (reports on rising NPLs, defaults of financial products such

as trusts, bankruptcies) are likely to raise flags earlier. Part of the reason why this is the

case is demographic/education/social changes which have eased some employment

pressures; an increasing number of single children that have grown up in a reasonably well

off environment and finished tertiary education may refuse to work for jobs they do not

regard as appropriate for them and end up neither officially employed nor unemployed.



The low/unskilled end of the labor market is the most politically sensitive segment and it is

relatively tight because there are fewer young people who are willing to take up the work,

despite the fact that the salaries are often higher than that of office jobs.

Exhibit 11: Policy change is not always the result of weaker employment conditions

Source: CEIC

Interest rates to remain low, but high-profile monetary easing to be restrained

To contain financial risks and support a moderate (in the Chinese context) level of growth,

policymakers will likely keep interest rates low in 2015. We expect much of this interest

rate management to be done via flexible tools such as open market operations and new

targeted lending tools, such as PSL and MLF.8

The new administration has generally avoided broad-based tools like required reserve ratio

(RRR) cuts because they have the strongest color of “flooding the market with liquidity”

and have potential substitutes such as targeted cuts, relending, etc. This does not mean

RRR cuts will not be used—in fact, we now expect 50bp of such cuts in 2015 as discussed

later—but we expect them to be employed primarily to keep the policy stance at a desired

level (e.g. to offset technical factors such as FX outflows that would otherwise tighten

liquidity) rather than to shift the policy stance significantly looser. Another benchmark

interest rate cut is more likely than not, though by no means guaranteed, because it is not

the main policy lever and the government can decide to use other more administratively

based tools. While we agree that the recent benchmark rate cut is likely a signal that

policymakers intend to ease in other ways, we suspect the easing will be relatively modest

and short-lived. Our sense is that market participants may be overly optimistic about the

magnitude of monetary loosening that policymakers intend to deliver in early 2015.

In 2015, the PBOC may continue to roll out new policy tools which tend to be more discreet.

Interest rates charged on these loans can be lowered which will help to lower cost of

financing.

8 See “Rummaging through the PBOC’s toolbox: Downside bias on interbank rates, but high-profile moves less likely”, Emerging Markets Macro Daily, October 22, for an explanation of the various easing options.

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2005 2007 2009 2011 2013

Recent policy easing episodes

Unemployment rate

Percent Percent



Exhibit 12: RRR changes are closely related to changes in FX flows, though in recent years

there has been a tendency to use alternative tools

Source: CEIC

Some help from fiscal policy and other tools

Fiscal policy is likely to become genuinely more pro-active in 2015. Fiscal policy has been

fairly stable over the past years as the deficit-to-GDP ratio remained stable around 2.0%.

Instead, there were larger amount of quasi fiscal tools, such as LGFV borrowing. Reining

this in will require a shift to on-balance sheet borrowing (municipal bonds, in particular)

and alternative non debt based financing, such as equity raising and Public-Private

Partnerships (PPP), to play a more important role.

The level of equity financing has been very low in recent years, partially because of the

practical difficulty from concerns about the impact of more supply on an already-weak

equity market. With the equity market showing stronger performance recently, it will be

easier to allow more listings. In this regard, PPP is something that fits the need of the

government well. However, in the past private participants have had mixed experiences,

with local governments or other partners “requesting” assistance with other projects

should the initial investment prove to be profitable, and thereby limiting the upside in

some cases. With greater emphasis on rule-based governance, a key theme of the 4th

Plenum of the 18th Party Congress, these risks for private investors may be reduced over

time. One method the government can use is to bundle other rights, especially land, in the

partnership. So instead of a local government borrows bank loan via a LGFV to build a

project (say a subway project), then sell nearby land (strictly speaking the right to use it) at

higher prices to pay back the loan, the land can be given as a part of the incentives.

Administrative tools such as central government inspection (to ensure fiscal outlays occur

in a timely manner) and window guidance/credit quota (to manage credit growth) will likely

continue to be used. While there is a consensus that resource allocation should be more

market-based in the future, the transition will likely be a very gradual one.

Implications for markets

Our views on the Chinese economy in 2015, and the nature of policymakers’ reaction

function, have implications across asset markets.

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200

400

600

800

Jan-06 Jan-08 Jan-10 Jan-12 Jan-14

RRR change (right scale)FX purchase

Billion RMB Percent



Interest rates to remain low, but policymakers to eschew high-profile cuts

On rates, we expect the 7-day repo interest rate to reverse its slight upward trend in the

past couple of weeks as the liquidity freeze from IPO activities dissipates and the PBOC

more forcefully injects liquidity in the interbank to boost growth. Specifically, we expect the

7d rate to drop to 3.0% at year-end, and see further downside risk to this level. We expect

some room for the short-term interest rate to normalize to a more neutral level later next

year given a likely lower growth target, an expected improvement in external demand and

the recent decisive decline in long yields in the bond market (which should gradually feed

through to financing conditions). But given headwinds of the ongoing and expected

domestic adjustment (due to the housing slowdown and likely reform advancement), we

project the 7d rate to inch up only very gradually to 3.25% at year-end 2015. In tandem, we

expect M2 growth to decelerate slightly to 12.3%yoy next year from 13% this year (Exhibit

13).

Exhibit 13: We expect 7d repo rate to remain low and M2 to decelerate slightly

Source: Bloomberg, Goldman Sachs Global Investment Research

As noted above, we think the government is relatively cautious about broad-based

monetary easing. This is because another cut in the benchmark rates could exacerbate

pressure on deposit outflows (as market returns to non-deposit saving products are already

quite a bit higher than deposit interest rates) and there are more nimble tools (such as MLF,

OMOs) to inject liquidity in lieu of a system-wide RRR cut. With November monetary data

and December activity likely to show a meaningful rebound (this is mainly because of the

administrative tools the government has been using and the disappearance of the negative

effects of the APEC shutdowns, rather than the rate cut itself) the need to cut interest rate

or RRR before yearend appears to be relatively low. However, the potential of such high-

profile easing actions (e.g. to send a strong dovish signal and bolster confidence) would

increase, if meaningfully lower interbank rates fail to jumpstart growth to a level consistent

with at least a 7-7.5% GDP growth in the coming months.

In 2015, there are a couple of factors that make high-profile cuts somewhat likelier, in our

view. First, with our expectation that Q1 growth will be weak, we think a small (25bp)

10

11

12

13

14

15

16

17

18

2

3

4

5

6

7

8

9

2011 2012 2013 2014 2015

7d repo rate

M2 yoy (right scale)

Percent Percent

Forecast



benchmark rate cut is slightly more likely than not. Second, if FX inflow weakness persists

and/or non-bank financial institution deposits are included in the computation of regulatory

loan-to-deposit ratio and also become subject to RRR, RRR would likely be reduced as an

effective offset against the adverse liquidity implications of those factors. Primarily because

of our expectation that weak FX inflows persist, we are penciling in 50bp of RRR cuts in the

first half of 2015, though our conviction here is relatively low and it is entirely possible that

the PBOC sticks to targeted and lower-profile tools.

Broadly stable dollar-renminbi rate, though with risk of weakness early in 2015

We expect the dollar-renminbi exchange rate to be broadly flat in 2015 as a whole but

some temporary engineered weakness is a real risk to that baseline view. The CNY has

appreciated rapidly on a trade-weighted basis in recent months, a combination of its

appreciation against the USD and the rapid USD TWI appreciation. This pace of

appreciation has not been seen since 2008 (Exhibit 14).

Exhibit 14: The pace of trade weighted currency appreciation has been the among most

rapid in history

Source: Bloomberg, CEIC, Goldman Sachs Global Investment Research

We believe the initial rise in exchange rate over the last few months reflected policy

makers’ desire to tighten monetary conditions following rapid monetary expansion in June

(they might have not been very active in driving this result but this was at least consistent

with the policy desires at the time). However, as the economy has weakened towards 4Q,

the further appreciation against the USD may have reflected concerns about foreign

perceptions as well, given the high level of reported exports/surplus (often double digit

export growth and near record level of trade surplus) coinciding with high level

international summits (APEC and G20).

There is strong evidence which suggests the level of exports growth has been overstated.

For example, import growth reported by Hong Kong has been much slower than export

growth to Hong Kong reported by the mainland. But in contrast to other recent occasions,

the over-reporting of exports may not be motivated mainly by financial arbitrage

opportunities, but rather by administrative and financial encouragement by local

governments to reach local export growth goals. As export and growth targets for 2015 will

likely be lowered, in our view, over-reporting concerns could recede after the turn of the

-5

0

5

10

-5

0

5

10

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Percent Percent

China nominal trade-weighted exchange rate (3-month change)



year. This means exports growth may fall meaningfully, and all else equal, that trade

surplus would be lower as well.

But all else is not equal, because the level of trade surplus tends to be highly seasonal. It

tends to be low at the start of the year and high towards the end of the year. Depreciating

the currency while running a large surplus is something difficult to do, which could be the

reason why the only two occasions of CNY deprecation against USD both happened

relatively early in the year (April 2012 and February 2014). Thus the macro picture we may

see at the start of next year may be similar to that of this year with relatively weak GDP

growth, low inflation, low export growth and low surplus.

Having said that, there are also factors which can be meaningfully different from 1Q of this

year, notably the level of FX flows was high at the start of this year. FX flows are hard to

predict, though historically the sequential growth momentum in China in the preceding

period and interest rate spread are closely related to the level of FX flows. Judging from

our growth and rate expectations, it seems unlikely that we will see large amount of FX

inflows early in 2015. This means the motive to introduce more volatility to drive out FX

flows will no longer be as important for policymakers.

Still overweight Chinese equities

Based in large part upon the expectation of increased liquidity (mainly coming from

household asset allocation demand and overseas fund allocation demand), our portfolio

strategy team is staying overweight China equities. While we remain constructive on

overall growth, the stop-and-go pattern will likely continue in 2015 as the economy tries to

balance between delivering growth and pushing forward reforms, which points to

persistent intra-year macro and market volatility. Thematic investment opportunities will be

mainly driven by reforms, with a special focus on SOE reforms, financial markets reforms,

local government/fiscal reforms and social reforms (a detailed list of reform/policy

beneficiaries list is available in our strategy team’s outlook pieces: 2015 Outlook: Reforms

and new liquidity drive more upside and 2015 Outlook: Fat but less flat, Nov 25, 2014).

Yu Song

MK Tang

Maggie Wei

Andrew Tilton



Forecast Tables

Real GDP Growth (year-over-year)

GS Consensus GS ConsensusAsia ex-Japan 6.1 6.0 4.7 6.2 6.3

China 7.7 7.3 7.4 7.0 7.1

India 4.7** 5.6** 5.6** 6.5** 6.3**

South Korea 3.0 3.5 3.5 3.8 3.7

Hong Kong 2.9 2.1 2.2 2.7 2.8

Taiwan 2.1 3.4 3.6 3.5 3.6

ASEAN 5.0 4.3 4.3 4.9 5.1

Singapore 3.9 2.9 3.1 3.1 3.6

Malaysia 4.7 5.8 5.7 5.1 5.2

Thailand 2.9 0.7 1.1 3.7 4.1

Indonesia 5.8 5.1 5.1 5.4 5.5

Philippines 7.2 6.5 6.2 6.0 6.2

USA 2.2 2.3 2.2 3.1 3.0

Euro area -0.4 0.8 0.8 0.9 1.1

Japan 1.5 0.3 1.0 0.9 1.3*GS estimates for annualized growth rate of potential output from 2015-19

**Fiscal year basis, 2013 is India FY14 (Q2 2013-Q1 2014).

Source: Consensus Economics, Goldman Sachs Global Investment Research.

3.5

4.0

3.2

5.2

6.3

6.5

2.3

1.1

0.8

6.56.0

3.6

2.9

20132014 2015 Potential

Growth*

Consumer Prices (year-over-year)

GS Consensus GS ConsensusAsia ex-Japan 4.1 3.3 3.4 3.2 3.4

China 2.6 2.1 2.1 2.0 2.4

India 9.5* 6.7* 7.3* 5.8* 6.5*

South Korea 1.3 1.5 1.4 2.3 2.0

Hong Kong 4.3 4.3 3.9 3.0 3.4

Taiwan 0.8 1.4 1.4 1.5 1.7

ASEAN 3.9 4.0 4.1 4.6 4.2

Singapore 2.4 1.3 1.3 1.5 1.5

Malaysia 2.1 3.3 3.3 3.9 4.0

Thailand 2.2 2.1 2.1 2.2 2.2

Indonesia 6.4 5.7 6.1 7.4 6.2

Philippines 2.9 4.4 4.3 3.0 3.7

USA 1.5 1.7 1.7 1.3 1.6

Euro area 1.4 0.5 0.5 0.6 0.9

Japan 0.4 2.8 2.8 1.6 1.9*Fiscal year basis: 2013 is India FY14 (Q2 2013-Q1 2014); RBI inflation target 8.0% in January 2015 and 6% in Jan 2016.

**ECB aims to maintain inflation rates "below, but close to, 2% over the medium term"

^ Reportedly approved by Finance Ministry as new headline CPI inflation target range but not yet official.

^^ BSP inflation target 4% +/- 1% for 2014 then 3% +/- 1% for 2015-2016.

Source: Consensus Economics, Goldman Sachs Global Investment Research.

-

-

1.5-4.5^

3.0-5.0

20132014

2.0

2.5-3.5

-

2.0-4.0^^

2.0

2.0**

2015 Inflation Target/Range

3.5

6.0*

-



Forecast Tables (continued)

Policy Interest Rates (percent)

CurrentDec 7 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q

Asia ex-JapanChina 4.60 3.20 3.30 3.43 3.00 3.06 3.13 3.19 3.25India 8.00 8.00 8.00 8.00 8.00 7.75 7.50 7.50 7.50South Korea 2.00 2.50 2.50 2.25 2.00 2.00 2.00 2.00 2.00Hong Kong - - - - - - - - -Taiwan 1.88 1.88 1.88 1.88 1.88 1.88 1.88 1.88 2.00ASEAN

Singapore - - - - - - - - -Malaysia 3.25 3.00 3.00 3.25 3.25 3.25 3.25 3.50 3.50Thailand 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00Indonesia 7.75 7.50 7.50 7.50 7.75 7.75 8.00 8.00 8.00Philippines 4.00 3.50 3.50 4.00 4.00 4.00 4.00 4.25 4.25

USA 0.07 0.08 0.10 0.09 0.13 0.13 0.13 0.38 0.63Euro area 0.05 0.25 0.15 0.05 0.05 0.05 0.05 0.05 0.05Japan 0.07 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10

Policy interest rates: China: 7-day repo, India: repo rate; Korea: 7-day repo; Malaysia: overnight policy rate;

Thailand: 1-day repo, Philippines: repo rate, Indonesia: 1-month SBI rate, Taiwan: rediscount rate; USA: Fed funds effective rate;

Euro Area: Main refinancing operations: fixed rate; Japan: Overnight call rate.

Source: Goldman Sachs Global Investment Research.

2014F 2015F

Exchange Rates (local currency units per USD)

Current 3-Month Horizon 6-Month Horizon 12-Month Horizon

Dec 7 Forward Forecast Forward Forecast Forward Forecast

Asia ex-Japan

China 6.14 6.18 6.16 6.21 6.16 6.27 6.16

India 61.91 62.69 62.00 63.57 63.00 65.31 63.00

South Korea 1115 1120 1100 1123 1130 1125 1140

Hong Kong 7.75 7.75 7.80 7.75 7.80 7.75 7.85

Taiwan 31.1 31.1 30.9 31.0 30.9 30.9 30.9ASEAN

Singapore 1.31 1.31 1.32 1.31 1.33 1.31 1.34

Malaysia 3.45 3.48 3.35 3.50 3.37 3.54 3.45

Thailand 32.9 33.1 33.5 33.3 34.0 33.5 34.5

Indonesia 12305 12495 12250 12698 12400 13103 12750

Philippines 44.6 44.8 44.8 44.9 44.7 45.1 46.5

Euro area* 1.23 1.23 1.23 1.23 1.20 1.24 1.15

Japan 119.8 119.7 120.0 119.6 125.0 119.1 130.0* USD per Euro

Source: Goldman Sachs Global Investment Research.



Highlights of Recent Goldman Sachs Global Macro Research

Asia ex JapanShowtime for regional reform Nov 23, 2014Building from the bottom up: current accounts in emerging Asia Nov 17, 2014

Macro drivers of Asian FX Volatily - our initial assessment Oct 23, 2014

Putting inflation forecasting models to the test in emerging Asia Oct 20. 2014

How much slack: Measuring output gaps in emerging Asia Sep 19, 2014

Exploring the limits to growth in emerging Asia Aug 22, 2014

Nowcasting economic growth in emerging Asia Jul 18, 2014

Seperating cyclical signal from seasonal noise Jun 27, 2014

China’s changing growth: Trade spillovers to the rest of Asia May 8, 2014

Global expansion cycles and Asian exports—Now versus then Apr 17, 2014

Shock therapy: How EM Asia central banks respond to capital outflow pressures Apr 4, 2014

Low EM export beta? - Most likely nominal, not real Mar 13, 2014

The unwritten "rules" of EM Asia monetary policy Feb 21, 2014

Policy proactivity lies behind the resilience of the INR and IDR Feb 19, 2014

Export-led growth in Asia: Better short-term, challenged long-term Feb 7, 2014

Questions for the 2014 Asia-Pacific economics outlook Jan 3, 2014

Greater China

China: Q&A on the recent PBoC rate cut Nov 25, 2014China: November IP growth may trend back towards the August level because of APEC restrictions Nov 10, 2014

China: Rummaging through the PBoC's toolbox: Downside bias on interbank rates, but high profile moves less likely Oct 21, 2014 China: China's housing boom in international context Oct 16, 2014

Hong Kong's economic outlook: Quantifying the challenges Oct 10, 2014China: Forecasting a lower speed limit for Chinese growth Sep 24, 2014

China: China’s capital account liberalization: Game plan, road map & implications Sep 12, 2014

China: The long and short of Chinese financing conditions Sep 5, 2014China: China’s statistical adjustments are likely to make it easier to reach the GDP growth target Sep 2, 2014

China: Monetary easing is no panacea Aug 19, 2014Jul 16, 2014

China: Growth hit from the housing market downturn still looks manageable Jul 8, 2014

China: Dissecting the prospects of the Chinese exports: lower alpha, higher beta, and solid delta Jun 24, 2014China: Can China's economy move back to a sweet spot? Jun 11, 2014

China: China bond market: great long-term potential, tricky near-term challenges Jun 2, 2014China: Macro at a cross-roads May 28, 2014

China: Higher term premium challenging monetary easing May 16, 2014

KoreaKorea: 2015 Macro Market Outlook Nov 30, 2014Korea: Key elements of Korea's new economic stimulus Aug 7, 2014

Korea: The CNK could weaken the KRW, just as the CNT weakened the TWD Jul 30, 2014Korea: Revising our USDKRW forecasts—the won appreciation could reverse in 2H2014 Jun 29, 2014

Korea: KRW and the current account: Contrarian views—loosening links May 30, 2014 Korea: Global expansion cycles and Asian exports—Now versus then Apr 17, 2014

Korea: Exposure of Asian EM to China is much less than you might think Apr 2,2014

Korea: Low inflation recovery bodes well for a rate cut Jan 24, 2014

India

India Moves up a Gear Dec 1, 2014India: We remain positive on the INR Nov 26, 2014

India: Good Governance for Growth Nov 9, 2014India: Why are rates markets surprised by RBI? Oct 13, 2014

India: India's Digital Dividend Sept 24, 2014India: How to have your cake and eat it too Aug 5, 2014

India: The Path to Fiscal Reform Jul 4, 2014India: How Much Energy? Jun 20, 2014How India can become the next Korea Mar 28, 2014

India: Adding 110 million jobs Mar 26, 2014

ASEAN

Close-run Indonesian election, both candidates declaring victory Jul 10, 2014

Indonesia's tricky fiscal-monetary tradeoffs Jun 6, 2014Indonesia’s rebalancing progressing at a faster pace Feb 12, 2014Thailand’s political turmoil and its economic consequences Jan 16, 2014

Japan (this section is provided by our Japan Economics team based in Tokyo)

Japan: FY2015 outllok: Economy struggling, but VAT deferral gives breather Nov 20, 2014Japan: Utokyo Index suggests slow but steady post-hike recovery Nov 5, 2014

Japan: Blind spot from the outset in "weak yen = export recovery" scenario? Oct 17, 2014Japan:Growing disparities in consumer sentiment by income bracket Oct 10, 2014

Japan: Large gap between the BOJ's growth forecast and its economics assessment Sep 19, 2014Japan: How do rising part-time hourly wages affect macro basic wages? Sep 12, 2014

Japan: Can the BOJ rely on :Money Illusion"? Sep 5, 2014

China: Very loose fiscal policy stance in May and June likely contributed to the growth recovery, policy to normalize but maintain a loosening bias



Disclosure Appendix

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We, Goohoon Kwon, CFA and Irene Choi, hereby certify that all of the views expressed in this report accurately reflect our personal views about the

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