bmi china business forecast report q3 2014

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Published byBUSINESS MONITOR INTERNATIONAL LTD

BUSINESS FORECAST REPORT

Q3 2014www.businessmonitor.com

China

INCLUDES 10-YEAR FORECAST TO 2023

Beijing Walking A Tightrope

ISSN 1744-8778

Published by Business Monitor International Ltd.

Copy Deadline: 13 June 2014


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2 Business Monitor International Ltdwww.businessmonitor.com

CHINA Q3 2014

CHINA

MACROECONOMIC

INDICATORS

2013e

2014f

2015f

2016f

2017f

2018f

2019f

2020f

2021f

2022f

2023f

NominalG

DP,USDbn

9,201.1

10,019.8

10,745.4

11,770.6

12,793.9

13,904.1

15,108.5

16,410.6

17,828.0

19,373.0

21,050.9

NominalG

DP,EURbn

6,970.5

7,477.4

8,596.3

9,808.8

10,661.6

11,586.7

12,590.4

13,675.5

14,856.6

16,144.1

17,542.4

GDPperc

apita,USD

6,640

7,188

7,666

8,354

9,036

9,777

10,581

11,452

12,403

13,443

14,576

GDPperc

apita,EUR

5,030

5,364

6,133

6,961

7,530

8,147

8,818

9,544

10,336

11,203

12,146

RealGDP

growth,%y-o-y

7.7

7.1

6.0

5.8

5.8

5.8

5.8

5.8

5.8

5.8

5.8

Privatenalconsumption,

%o

fGDP

35.1

35.5

36.2

37.0

37.8

38.5

39.3

40.2

41.0

41.9

42.7

Privatenalconsumption,realgrowth%y

-o-y

8.0

8.4

8.2

8.0

8.0

8.0

8.0

8.0

8.0

8.0

8.0

Governme

ntnalconsumption,

%o

fGDP

13.8

14.0

14.3

14.6

14.9

15.2

15.6

15.9

16.2

16.6

16.9

Governme

ntnalconsumption,realgrowth%y

-o-y

9.0

9.0

8.5

8.0

8.0

8.0

8.0

8.0

8.0

8.0

8.0

Fixedcapitalformation,

%o

fGDP

43.5

42.6

42.0

41.3

40.6

39.9

39.2

38.6

37.9

37.3

36.6

Fixedcapitalformation,realgrowth%y

-o-y

4.5

5.0

4.5

4.0

4.0

4.0

4.0

4.0

4.0

4.0

4.0

Population

,mn

1,385.6

1,393.8

1,401.6

1,408.9

1,415.8

1,422.1

1,427.8

1,432.9

1,437.3

1,441.1

1,444.2

Unemployment,%o

flabourforce,eop

5.0

5.0

5.0

5.0

5.0

5.0

5.0

5.0

5.0

5.0

5.0

Consumer

priceination,

%y

-o-y,ave

2.6

2.6

2.8

2.7

2.7

2.7

2.7

2.7

2.7

2.7

2.7

Lendingra

te,%,ave

3.0

3.0

3.2

3.5

3.7

4.0

4.0

4.0

4.0

4.0

4.0

Centralba

nkpolicyrate,%eop

6.00

6.00

5.75

5.75

5.75

5.75

5.75

5.75

5.75

5.75

5.75

Exchange

rateCNY/USD,ave

6.15

6.20

6.30

6.25

6.25

6.25

6.25

6.25

6.25

6.25

6.25

Exchange

rateCNY/EUR,ave

8.12

8.31

7.88

7.50

7.50

7.50

7.50

7.50

7.50

7.50

7.50

Budgetbalance,USDbn

-118.8

-90.7

-55.7

-26.2

-2.7

-5.7

-9.4

-13.6

-18.5

-24.2

-30.8

Budgetba

lance,

%o

fGDP

-1.3

-0.9

-0.5

-0.2

0.0

0.0

-0.1

-0.1

-0.1

-0.1

-0.1

Goodsandservicesexports,

USDbn

2,452.4

2,657.9

2,907.5

3,195.5

3,512.4

3,861.2

4,245.2

4,663.8

5,124.3

5,631.1

6,183.3

Goodsandservicesimports,

USDbn

2,240.8

2,498.8

2,799.4

3,094.7

3,421.6

3,783.7

4,184.8

4,629.1

5,121.5

5,667.3

6,272.3

Balanceoftradeingoodsandservices,

USDbn

211.6

159.1

108.1

100.8

90.8

77.5

60.5

34.7

2.8

-36.2

-89.1

Balanceoftradeingoodsandservices,

%o

fGDP

2.3

1.6

1.0

0.9

0.7

0.6

0.4

0.2

0.0

-0.2

-0.4

Currentac

countbalance,USDbn

224.8

167.8

111.1

97.1

81.3

59.9

32.2

-7.3

-57.6

-125.8

-217.1

Currentac

countbalance,

%o

fGDP

2.4

1.7

1.0

0.8

0.6

0.4

0.2

0.0

-0.3

-0.6

-1.0

Foreignreservesexgold,

USDbn

3,820.0

3,800.0

3,700.0

3,800.0

3,700.0

3,600.0

3,500.0

3,400.0

3,300.0

3,200.0

3,200.0

Importcov

er,months

20.5

18.2

15.9

14.7

13.0

11.4

10.0

8.8

7.7

6.8

6.1

NationalS

ources/BMIe=estimate,

f=BMIforecaste/f=

BMIestimate/forecast.Source:Nationalsou

rces,

BMI


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Contents

Executive Summary ................................................................................................................................. 5

Core Views ......................................................................................................................................................................................5

Major Forecast Changes ................................................................................................................................................................5

Key Risks To Outlook ....................................................................................................................................................................5

Chapter 1: Political Outlook .................................................................................................................... 7

SWOT Analysis .......................................................................................................................................................... 7

BMI Political Risk Ratings ........................................................................................................................................ 7

Domestic Politics ...................................................................................................................................................... 8

Political Purge Bolsters Xi's Reform Credentials ........................................................................................................................8

The Chiese gvermet's case agaist frmer Plitbur Stadig Cmmittee member Zhu Ygkag represets a majr shift awayfrm past precedet i Chiese plitics, as such high-rakig fcials have lg bee csidered safe frm prsecuti. Likewise, wete that the targetig f Zhu, alg with the purge f frmer State-wed Assets Supervisi ad Admiistrati Cmmissi bssJiag Jiemi, reect a grwig tide agaist high level state-wed eterprise bsses, ad we see this blsterig the ecmic refrmcredetials f presidet Xi Jipig.

TABLE : POLITICAL OVERVIEW .............................................................................................................................................................................8

Long-Term Political Outlook .................................................................................................................................... 9

Major Challenges Over The Coming Decades .............................................................................................................................9

Chia faces myriad ecmic, scial ad evirmetal challeges ver the cmig decades that culd seriusly test the CmmuistParty f Chia's ability t gver. The best-case sceari fr ay evetual plitical trasiti wuld etail a elite-led liberalisati f theauthritaria system, while the wrst-case sceari wuld ivlve a vilet chage f regime.

Chapter 2: Economic Outlook ............................................................................................................... 13

SWOT Analysis ........................................................................................................................................................ 13

BMI Economic Risk Ratings ................................................................................................................................... 13

Economic Activity ................................................................................................................................................... 14

Cooling Property Market To Exacerbate Economic Downturn ................................................................................................14

Beijig faces a icreasigly challegig ladscape i which t implemet its plaed ecmic refrms, as a rapidly clig atialprperty market is a icreasigly saliet threat t Chia's slwig ecmy. Eve as the prspect f a vicius cycle f fallig prpertyprices ad lwer ecmic grwth becmes mre likely, hwever, we ce agai te that the gvermet will be uwillig ad uablet uleash the scale f stimulus measures ecessary t reverse the declie.

TABLE : ECONOMIC ACTIVITY .............................................................................................................................................................................14

Fiscal Policy ............................................................................................................................................................. 16

Piecemeal Stimulus Does Not Alter Core View .........................................................................................................................16

Beijig's effrts t stimulate Chia's slwig ecmy have thus far bee extremely targeted i cmparis with previus packages,

icludig a relatively small-scale rail package as well as a prgramme aimed at cuttig taxes fr small ad medium sized busiesses.

TABLE : FISCAL POLICY .......................................................................................................................................................................................16

Monetary Policy ...................................................................................................................................................... 17

More Targeted Easing Ahead ......................................................................................................................................................17

Recetly auced measures by the Chiese gvermet t lwer the reserve requiremet rati (RRR) fr selected baks chime withur expectatis fr brader RRR cuts ver the cmig quarters, as the Peple's Bak f Chia lks t balace risks stemmig frmthe cutry's real estate ad credit bubbles with slwig ecmic grwth.

TABLE : MONETARY POLICY................................................................................................................................................................................ 17

Currency Forecast/BoP .......................................................................................................................................... 18

CNY: Still At Mercy Of Downside Risks .....................................................................................................................................18

I lie with ur lg-held expectatis, the Chiese yua's appreciatry tred came t a halt at the begiig f this year. While webelieve that the currecy's mst aggressive depreciati is w behid it, we te that cetral bak plicy as well as market frces

suggest that the yua will likely ed 2014 slightly weaker tha its curret level befre stabilisig ver the lg-term.TABLE : BMI CHINA CURRENCY FORECAST......................................................................................................................................................19

TABLE : CURRENT ACCOUNT ..............................................................................................................................................................................20


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CHINA Q3 2014

Chapter 3: 10-Year Forecast .................................................................................................................. 21

The Chinese Economy To 2023.............................................................................................................................. 21

6.0% Is The New 10.0% ................................................................................................................................................................21

Chia's ecmic grwth i the cmig decade will be much slwer tha i the last, as the savigs rate declies, the ecmicliberalisati prcess slws, ad ppulati grwth falls. These dyamics will result i real GDP grwth averagig 5.9% ver the extdecade as ppsed t the 10.1% average see ver the past decade. Private csumpti will be a majr utperfrmer, averagiggrwth f 8.1% ad risig i imprtace as a share f GDP.

TABLE : LONG-TERM MACROECONOMIC FORECASTS ................................................................................................................................... 21

Chapter 4: Business Environment ........................................................................................................ 25

SWOT Analysis ........................................................................................................................................................ 25

BMI Business Environment Risk Ratings ............................................................................................................. 25

Institutions ............................................................................................................................................................... 26

TABLE : BMI BUSINESS & OPERATION RISK RATINGS.....................................................................................................................................26

TABLE : BMI LEGAL FRAMEWORK RATING ........................................................................................................................................................27

Infrastructure ........................................................................................................................................................... 28

TABLE: LABOUR FORCE QUALITY ......................................................................................................................................................................28

TABLE: ASIA ANNUAL FDI INFLOWS ................................................................................................................................................................29

TABLE: TRADE & INVESTMENT RATINGS ..........................................................................................................................................................30Market Orientation ................................................................................................................................................... 31

TABLE : ToP EXPoRT DESTInATIonS ............................................................................................................................................................... 31

Operational Risk ...................................................................................................................................................... 33

Chapter 5: Key Sectors .......................................................................................................................... 35

Defence..................................................................................................................................................................... 35

TABLE : DEFEnCE EXPEnDITURE, 2011-2018 ...................................................................................................................................................35

Freight Transport..................................................................................................................................................... 39

TABLE : ROAD FREIGHT .......................................................................................................................................................................................40

TABLE : INLAND WATERWAY FREIGHT ..............................................................................................................................................................41

TABLE : RAIL FREIGHT .........................................................................................................................................................................................42

TABLE : AIR FREIGHT ...........................................................................................................................................................................................42

Other Key Sectors ................................................................................................................................................... 43

TABLE : OIL AND GAS SECTOR KEY INDICATORS ............................................................................................................................................43

TABLE : PHARMA SECTOR KEY INDICATORS ................................................................................................................................................... 43

TABLE : INFRASTRUCTURE SECTOR KEY INDICATORS ..................................................................................................................................43

TABLE : TELECOMS SECTOR KEY INDICATORS ............................................................................................................................................... 44

TABLE : FOOD AND DRINK SECTOR KEY INDICATORS....................................................................................................................................44

TABLE : AUTOS SECTOR KEY INDICATORS ...................................................................................................................................................... 44

Chapter 6: BMI Global Assumptions .................................................................................................... 45

Global Outlook ......................................................................................................................................................... 45

Emerging Market Deceleration ....................................................................................................................................................45TABLE: GLOBAL ASSUMPTIONS..........................................................................................................................................................................45

TABLE: DEVELOPED STATES, REAL GDP GROWTH, % ...................................................................................................................................46

TABLE: BMI VERSUS BLOOMBERG CONSENSUS REAL GDP GROWTH FORECASTS, % ............................................................................46

TABLE: EMERGING MARKETS, REAL GDP GROWTH, % ..................................................................................................................................47


6/49

Core Views Beijig faces a icreasigly challegig ladscape i which t im-

plemet its plaed ecmic refrms, as a rapidly clig atial

prperty market is a icreasigly saliet threat t Chia's slwig

ecmy. The prspect f a vicius cycle f fallig prperty prices

ad lwer ecmic grwth is becmig icreasigly likely i ur

view, ad we maitai ur cre real GDP grwth frecast f 7.1%

fr 2014.

Beijig's effrts t stimulate Chia's slwig ecmy have thus

far bee extremely targeted i cmparis with previus packages,

icludig a relatively small-scale rail package as well as a prgramme

aimed at cuttig taxes fr small ad medium sized busiesses. Give

gvermet rhetric regardig the cutry's slwig grwth rate, as

well its massive ecmic imbalaces, we d t evisage large-

scale scal stimulus measures ver the cmig quarters. Istead,

we believe that a ctiued rll-ut f measures targeted at specic

idustries is the likely path frward.

The Chiese gvermet's case agaist frmer Plitbur Stadig

Cmmittee member Zhu Ygkag represets a majr shift away

frm past precedet i Chiese plitics. Likewise, we te that the

targetig f Zhu, alg with the purge f frmer State-wed Assets

Supervisi ad Admiistrati Cmmissi bss Jiag Jiemi, reect

a grwig tide agaist high level state-wed eterprise bsses, ad

we see this blsterig the ecmic refrm credetials f presidet

Xi Jipig.

Major Forecast Changes I lie with ur lg-held expectatis, the Chiese yua's ap-

preciatry tred came t a halt at the begiig f this year. While

we believe that the currecy's mst aggressive depreciati is

w behid it, we te that cetral bak plicy as well as market

frces suggest that the yua will likely ed 2014 slightly weaker

tha its curret level befre stabilisig ver the lg-term. As such,

we have dwgraded ur ed-2014 frecast t CnY6.3500 frm

CnY6.2000 previusly.

Key Risks To Outlook The mai dwside risk t ur ecmic utlk remais ather cl-

lapse i exteral demad, such as the e that ccurred at the height

f the glbal acial crisis. This wuld seriusly udermie grwth i

trade-depedet idustries ad haste a fall i the prperty market,

ptetially leadig t a utright recessi. There is als a risk that

greater-tha-expected scal ad metary stimulus by gvermet

ad the Peple's Bak f Chia culd usher i stagati.

The majr plitical risk cmes frm a rise i scial urest ad a surge

i public demstratis agaist gvermet crrupti, iati ad

husig affrdability, which culd be triggered by verseas evets r

a ecmic slump. While we d t see the rule f the Cmmuist

Party f Chia (CPC) as beig at risk, such evets wuld still have a

detrimetal impact the busiess evirmet ad culd see the

CPC stregthe its grip the ecmy t the detrimet f grwth.


Executive Summary


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8/49

Brief Methodology

7Business Monitor International Ltd www.businessmonitor.com 7Business Monitor International Ltd www.businessmonitor.com

SWOT Analysis

Strengths The CPC, which has gvered fr ver 60 years, remais secure i

its psiti as the sle plitical party i Chia.

Chia's expadig ecmy is givig it greater clut i iteratial

affairs, which will allw it t build plitically imprtat ties, especially

with the developing world.

Weaknesses As with ay ther e-party state, Chia's plitical system is iher-

etly ustable ad uable t respd t the wider chages takig

place i sciety.

Prvicial fcials fte fail t efrce cetral gvermet directives.

Althugh bilateral ties have warmed i recet years, Chia's relati-

ship with Taiwa remais prblematic, with Beijig refusig t rule

ut the threat f frce i the evet f a declarati f idepedece

by Taiwan.

Opportunities

Chia is actively expadig its plitical ad ecmic ties with majremergig markets i Lati America, Africa ad the Middle East.

A ew geerati f leaders (the 'fth geerati') tk pwer i 2012.

This shuld esure the ctiuati f refrm ad mderisati.

Threats Grwig crrupti, wideig iequalities, icreasig rural pverty

ad evirmetal degradati have led t a icrease i scial

urest i recet years.

The Cmmuist Party is facig factial rifts based idelgy ad

regialism. While greater plitical debate wuld be welcmed by

may, iteral regime schisms culd prve plitically destabilisig.

BMI Political Risk RatingsChia's Shrt-Term Plitical Risk Ratig f 77.3 reects the high degree

f plicy ctiuity ad chesi with regard t the plicymakig prcess

assciated with e-party rule. Hwever, while this is a b i the ear

term as reected by the high scre it acts as a drag the cutry's

Lg-Term Plitical Risk Ratig f 62.9. The absece f a strg c-

stitutial framewrk ad the tight ctrl ver plitical freedms hurt

Chia's lg-term ratig particularly sharply, with the 'characteristics f

plity' subcmpet scrig a feeble 33.1 ut f 100.

Chapter 1:

Political Outlook

S-T Political Rank Trend

Singapore 94.8 1 =Bruei Darussalam 90.6 2 =Hong Kong 84.8 3 =Taiwan 81.7 4 -Las 80.4 5 =South Korea 77.7 6 =China 77.3 7 =Sri Lanka 77.1 8 =Vietnam 76.9 9 -India 76.5 10 +Malaysia 76.2 11 =Philippies 71.2 12 =Mongolia 70.4 13 -North Korea 69.8 14 =Idesia 68.8 15 =Cambodia 62.7 16 =Bagladesh 62.1 17 =Bhutan 61.0 18 +Thailand 60.8 19 -Myanmar 56.9 20 =Pakista 51.7 21 +Papua New Guinea 45.2 22 =

Regional ave 72.6 / Global ave 64.7 / Emerging markets ave 62.0

L-T Political Rank Trend

South Korea 84.2 1 =Singapore 80.6 2 =Taiwan 75.4 3 =Hong Kong 72.9 4 =India 71.9 5 +Mongolia 67.7 6 =

Malaysia 66.7 7 =Bruei Darussalam 65.6 8 =China 62.9 9 =Philippies 62.8 10 =Bagladesh 62.6 11 =Sri Lanka 60.2 12 =Idesia 60.0 13 =Thailand 59.8 14 =Cambodia 59.3 15 =Vietnam 57.7 16 =North Korea 55.2 17 =Papua New Guinea 54.8 18 =Pakista 53.7 19 =Bhutan 51.0 20 =Las 50.9 21 =Myanmar 40.9 22 =



9/49

Domestic Politics

Political Purge Bolsters Xi's ReformCredentials

BMI VIEW

The Chinese government's case against former Politburo Standing

Committee member Zhou Yongkang represents a major shift away

from past precedent in Chinese politics, as such high-ranking of-

cials have long been considered safe from prosecution. Likewise, we

note that the targeting of Zhou, along with the purge of former State-

owned Assets Supervision and Administration Commission boss

Jiang Jiemin, reect a growing tide against high level state-owned

enterprise bosses, and we see this bolstering the economic reform

credentials of president Xi Jinping.

The ongoing purge of former Politburo Standing Committee

(PSC) member Zhou Yongkang's associates, family members,

and allies represents a major development in China's political

scene. Zhou, who once held the reins of the powerful state security

apparatus, is the highest prole politician to be targeted by such

a campaign in the People's Republic of China (PRC)'s 64-year

history. Although wide-scale political purges date back to the

Mao Zedong era, and are generally not uncommon in one-party

systems, it is customary for former PSC members to be allowed

to fade into the background once their term has been completed.

New Precedent In Targeting StandingCommittee MembersWhile Zhou himself has not yet been formally charged, this

remains a genuine possibility. Zhou rose to power through asuccessful career in China's petroleum industry, which culmi-

nated in his appointment as general manager, and later chair-

man, of China National Petroleum Corporation (CNPC),

parent of PetroChina. During his eventual rise to the PSC,

he formed powerful connections throughout the state-owned

enterprises (SOE) that boast a substantial measure of control

over the economy, and is said to have been closely allied with

former rising star Bo Xilai. Bo, once considered a lock for the

PSC himself, was abruptly removed from the wider Politburo

(which consists of 25 members, of which the seven most senior[formerly nine] are elected to the standing committee) in April

2012 following revelations of massive corruption and a cover-

up involving the murder of British businessman Neil Heywood.

He was eventually sentenced to life imprisonment following a

heavily publicised trial.

Xi's Consolidation ContinuesAfter this point, Zhou's connection to Bo became a substantial

liability, and his downfall has been expedited by Xi Jinping's


CHINA Q3 2014

TABLE : POLITICAL OVERVIEW

System f Gvermet Sigle-party scialist republic

Head f State Presidet Xi Jipig (servig rst f a maximum tw ve-year terms)

Head f Gvermet Prime Miister Li Keqiag (servig rst f a maximum tw ve-year terms)

Last Electi Presidetial ad parliametary March 2013

CPC cgress nvember 2012

Cmpsiti f Curret Gvermet Cmmuist Party f Chia

Key Figures The Plitbur Stadig Cmmittee acts as the de fact highest decisi-makig bdy i Chiaad cmprises the tp leadership f the rulig party. Its members, i rder f prtcl, are: XiJipig (ccurretly geeral secretary f the Cmmuist Party), Li Keqiag, Zhag Dejiag, YuZhegsheg, Liu Yusha, Wag Qisha, Zhag Gali

other Key Psts Fiace Miister Lu Jiwei; Freig Miister Wag Yi; Defece Miister Chag Waqua;

Miister f Public Security Gu Shegku; Cetral Bak Gverr Zhu Xiachua

Mai Plitical Parties (umber f seats i parliamet) Cmmuist Party f Chia (CPC): The fudig ad rulig plitical party f the Peple's Republicf Chia, whse paramut psiti as the supreme plitical authrity is guarateed by Chia's

cstituti ad realised thrugh ctrl f all state apparatus. The CPC was fuded i 1921 adcame t rule all f mailad Chia after defeatig its rival, the Kumitag (KMT), i the ChieseCivil War.

Next Election Presidetial ad parliametary March 2018

CPC cgress Autum 2017

ogig Disputes ogig dispute ver Taiwaese svereigty ad Tibeta autmy; sme mir territrydisputes with Asia eighburs, icludig with Japa ver the Sekaku Islads i the East ChiaSea ad with Taiwa, Malaysia, the Philippies ad Vietam ver the Spratly Islads i the Suth

China Sea.

Key Relatis/ Treaties Clse Lik With ASEAn, WTo member, permaet seat the Un Security Cucil, fudigmember f the Shaghai Cperati orgaisati (SCo).

BMI Shrt-Term Plitical Risk Ratig 77.3

BMI Structural Plitical Risk Ratig 62.9

BMI Source


10/49

accession to the presidency. It is widely speculated that Bo/

Zhou's faction was seen as a serious threat to Xi within the

party's top leadership, with allegations even emerging that Zhou

was personally involved in an assassination attempt against

Xi following Bo's ouster. While these allegations cannot be

conrmed (and most likely never will be), the evidence pointstowards the potential for a serious rift within the upper-echelons

of the Communist Party.

It is our core view that the takedown of Bo, along with the on-going campaign against Zhou, reect the fact that Xi Jinping is

rmly in control of the government. That said, the targeting of a

former PSC member suggests that Xi may still be consolidating

his power, necessitating that he undermines any last vestiges of

the rival faction's leadership while also sending another warning

shot to any remaining rivals. The government, via state media,

has largely spun Zhou's purge as a result of Xi's highly publicised

anti-corruption campaign, in which the president has vowed to

bring down both 'tigers' and 'ies'. According to some reports,

the government has already seized assets totaling as much asUSD14.5bn from Zhou's family and associates.

Purge Tied To Economic ReformAgendaWhile there is certainly some substance to the anti-corruption

campaign, it is also notable that a number of Xi's targets hap-

pen to hail from China's SOE oligarchy. This was also the case

with the recently purged Jiang Jiemin, who was, like Zhou, the

chairman of CNPC. Jiang, however, was also the director of the

State-Owned Assets Supervision and Administration Commis-

sion (Sasac), further crystallising his position as a key ally for

China's high-level SOEs. These links point towards a targeted

purge of not only Xi's political rivals, but also those who might

stand in the way of economic reform. While the current admin-

istration has yet to prove itself in terms of the implementation

of hard-hitting economic reforms, both Xi and premier Li Ke-

qiang's rhetoric on the subject has been substantially stronger

than that of their predecessors. In order to achieve such reforms,it will be necessary to remove or substantially weaken the well-

entrenched vested interests within China's SOE structure, and

this appears to be a key objective of the political purge that we

are witnessing in the country.

For this reason, we believe that the targeting of high level poli-

ticians as well as SOE bosses is unlikely to have reached its

conclusion. Likewise, we note that Xi's actions suggest that he

may be on his way to becoming a more powerful (and certainly

more reform-minded) leader than outgoing president Hu Jintao,which could have critical ramications for China's economic

reform trajectory. While we maintain that the economic re-

forms proposed in last year's Third Plenary session would not

be sufcient to avert a near-term slowdown (and would likely

be growth negative), their implementation would nevertheless

be a positive for the economy's medium to long-term outlook.

Long-Term Political OutlookMajor Challenges Over The ComingDecades

BMI VIEW

China faces myriad economic, social and environmental challenges

over the coming decades that could seriously test the Communist Party

of China's ability to govern. The best-case scenario for any eventual

political transition would entail an elite-led liberalisation of the authori-

tarian system, while the worst-case scenario would involve a violent

change of regime.

Perhaps the biggest question concerning China's future is whether

the country will eventually move towards a democratic system

of government. This question has received greater attention

following the political upheaval in the Middle East and North

Africa in 2011. China is increasingly an anomaly in that it is

the only major emerging economy that has not yet experienced

a transition to democracy. Other countries as diverse as Russia,

Poland, Mexico, Brazil, South Africa, South Korea and Indonesia

all moved away from one-party rule to democracy once they at-

tained a certain level of economic development, suggesting that


POLITICAL OUTLOOK

Policy Continuity Still Not A ConcernBMI Lg-Term Plitical Risk Ratigs

Source: BMI

0

10

20

30

40

50

60

70

80

90

100

Characteristics

ofPolicy

Characteristics

ofSociety

ScopeofState

Policycontinuity

Total


11/49

China will too. For now, the Communist Party of China (CPC)

derives its legitimacy from delivering rapid rates of economic

growth, which has lifted hundreds of millions of people out of

poverty over the past 30 years. While Chinese state planners

previously regarded an annual real GDP growth rate of 8.0%

to be the minimum necessary to create enough jobs to maintainsocial stability, this notion has since been abandoned. Still, the

weak global economy presents the most immediate test of the

CPC's governance, and the government will keep a watchful eye

on employment levels. Even without the anticipated slowdown,

however, China will continue to face many challenges.

Threats And Challenges To StabilityRising Inequality: As China's economy surged during the 2000s,

inequality widened sharply. Although comparisons between dif-

ferent organisation's calculated gini coefcients are inexact, due

to differing methodologies, most observers agree that inequality

is rising. In December 2012, the gini coefcient was estimated

at 0.61 in 2010, based on a survey of 8,438 households by the

Survey and Research Center for China Household Finance, abody set up by the Finance Research Institute of the People's

Bank of China and Southwestern University of Finance and

Economics. This is an exceptionally high gure, far above a

government estimate of 0.41 in 2000, a World Bank estimate

of 0.42 in 2005, and a China Academy of Social Sciences gure

of 0.54 in 2008. Moreover, ongoing revelations that China's po-

litically connected elites have accumulated vast wealth through

corrupt practices are bound to raise public anger.

Regional Economic Imbalances: The eastern seaboard has

beneted disproportionately from China's rapid expansion. In

particular, there is a relatively wealthy coastal belt consist-

ing of Tianjin, Shandong, Jiangsu, Shanghai, Zhejiang, Fujian

and Guangdong provinces where urban household per capita

GDP was higher than CNY21,000 (the average for urban China)

in 2010. Unsurprisingly, these provinces are also where most

of China's industry and foreign direct investment (FDI) are

concentrated. By comparison, rural household per capita GDPwas roughly CNY8,100. Much of the western and interior parts

of China remain poor and underdeveloped. Consequently, the

eastern seaboard provinces are receiving migration inows from

other parts of China, although these were temporarily reversed in

the 2008-2009 slowdown. Although the government has under-

taken massive development plans to address these imbalances,

and new factories are gradually being built further inland, this

will be a long drawn-out process in a country of China's size.

Employment And Working Conditions: The past decade or sohas seen an increase in labour unrest. Job losses from economic

restructuring have generated some resentment towards the CPC,

which is ofcially a party of the workers. There is also rising

discontent over harsh working conditions, particularly in China's

coal mines, where deaths typically number thousands every year.

Environmental Issues: China's rapid economic growth has

come at the cost of environmental degradation. In 2005, of-

cials acknowledged that more than 70% of rivers and lakes

were polluted. In July 2010, the Ministry of EnvironmentalProtection stated that 24% of China's surface water was unt

for any purpose, including industrial use. Furthermore, many

parts of China experience water shortages, and these are likely

to increase as urbanisation rates rise. China's cities are also

notoriously polluted as a result of coal power plants. In addi-

tion, villagers have taken to violent protests against pollution or

forced land clearing for new projects. The issue of land seizure

has led to major unrest in the countryside. Chinese leaders are

well aware of the risks to economic growth and social stability

posed by pollution. However, the implementation of tougherenvironmental laws is being subverted by vested interest groups

and corruption.

Religions And Ethnicity: Chinese leaders are fearful of the pos-

sibility of religious- or ethnic-based rebellions, which convulsed

the country in the 19th and 20th centuries. For example, the

emergence of the Falun Gong sect in 1999 caught the Chinese

leadership by surprise; the popularity of the group was seen as

a threat to the CPC, prompting a harsh (and ultimately success-

ful) crackdown. Meanwhile, Christianity is reportedly growing

rapidly in China. The government recognises an ofcial state-

sanctioned church, but underground churches and sects are on


CHINA Q3 2014

Policy Continuity Scores HighlyLg-Term Plitical Risk Ratigs

Source: BMI


12/49

the rise. While neither Falun Gong nor Christian groups pose

a direct threat to the government, any crackdown against them

risks creating a broader backlash against the authorities.

China has 18 nationalities with populations of more than 1.0mn,

out of 56 recognised in total. The most well-known minoritiesare the Tibetans and the Muslim Uighurs of Xinjiang province.

The Tibetans staged a major uprising in 2008 and may rebel

again in the event of the Dalai Lama's death, as the younger

generation is considered more militant. The Uighurs clashed

with the Han Chinese in July 2009, leaving around 150 dead.

Aside from these two groups, violence has erupted between

minorities and the majority Han population from time to time.

The government plays down the ethnicity issue, yet it nonethe-

less has the ability to create instability.

Gender Imbalance: As a result of the one-child policy (adopted

in 1980) and a general bias in favour of sons, China has a pro-

nounced gender imbalance, particularly in the under-30 age

bracket. The Chinese Academy of Social Sciences stated in

2009 that more than 24mn Chinese men of marrying age could

nd themselves without spouses in 2020. A noteworthy book

('Bare Branches: The Security Implications of Asia's Surplus

Male Population') points out that such imbalances are potentially

destabilising for societies, since most crimes are committed by

single males under 30.

Financial Stresses: Although the banking sector has avoided a

long-predicted crisis, there are concerns that it remains opaque

and that lending is still largely policy-driven. In addition, the

surge in bank lending since early 2009 could yet create more

non-performing loans for banks.

Internal Regime Fault Lines: Within the CPC, there are report-

edly factional schisms. These reect differences over ideology

(namely between those who favour more neoliberal reforms andthose who favour a more statist model), geographical regions

within China, the 'generations' within the party and the debate

over whether China should behave more assertively abroad.

All CPC factions favour a continuation of its rule, meaning that

they are unlikely to challenge the system outright. Nonetheless,

factional rivalry could complicate decision-making, thereby

leading to slower reforms.

Foreign Confict: Although Chinese ofcials have emphasised

the country's 'peaceful rise', the People's Liberation Army (PLA)

has been sounding a more nationalistic tone. Beijing's increasing

assertiveness over its claims to the South China Sea and East

China Sea could lead to naval skirmishes or conict with Viet-

nam, the Philippines, Japan or even the US. In addition, China

continues to claim Taiwan as a province, and has considerable

interests in neighbouring North Korea and Myanmar, which

may eventually necessitate intervention. Chinese military as-

sertiveness could play well with nationalistic elements in society,but could harm its international image and lead to intra-regime

tensions between 'hawks' and 'doves'.

BMI's Long-Term Political Risk Rating for China stands at

62.9. The weakest score, of 33/100, is in the 'characteristics of

polity' subcomponent, which carries a 30% weighting. This score

reects China's authoritarian one-party system of government,

which tolerates virtually no dissent. The 60/100 score in the

'characteristics of society' subcomponent (30% weighting) is

constrained by China's very high gini (inequality) coefcient.China scores a respective 85/100 and 90/100 in the 'scope of

state' and 'policy continuity' subcomponents (each with a 20%

weighting). Overall, the country's problems are by no means

unique to China. Rather, they are symptomatic of emerging

countries in general. However, they are on a scale never seen

before, which arguably gives them a qualitative dimension.

Furthermore, unlike citizens of other emerging nations, the

Chinese public do not have the opportunity to change their

government via the ballot box. This leaves open the possibility

of increased public unrest.

Scenarios For Political ChangeAlthough China's former paramount leader, Deng Xiaoping,

stated in 1987 that elections would be possible in 50 years,

Chinese leaders continue to reject moves to adopt Western-style

democracy, fearing that this would lead to chaos. In 2005, the

CPC released its rst white paper, 'The Building of Political

Democracy', which stated that 'democratic government is the

Chinese Communist Party governing on behalf of the people

while upholding and perfecting the people's dictatorship'. Ratherthan developing a Western-style liberal democracy, the CPC

believes that 'China's socialist political democracy has vivid

Chinese characteristics'. The Chinese leadership became par-

ticularly worried about the possibility of revolution in China

following the upheaval that shook the Middle East in 2011, and

moved to suppress internet coverage of events there. China's

impressive economic achievements over the past 30 years have

given Chinese citizens less reason to resent their leadership

compared with Egyptians, Syrians, Yemenis, etc. Nevertheless,

we would expect to see greater calls for democratisation over

the next 10-20 years.


POLITICAL OUTLOOK


13/49

Best-Case Scenario: Elite-LedTransitionAgainst this backdrop, the best-case scenario for political change

in China would be a stable, elite-led transition, under which a

reformist-minded CPC phases in free, multi-party elections at

city, provincial and national level over a period of several years.Possible role models include South Korea and Taiwan, both of

which enacted democratic reforms in the late 1980s and early

1990s after decades of one-party rule. In both countries, the

governing party was able to hold on to the elective presidencies

for 10 and 12 years respectively and control the democratically

elected legislatures until the early 2000s. Should China follow

this pattern, the CPC could retain substantial political inuence

even after a putative transition to democracy. An alternative

to the multi-party model would be a system whereby the CPC

remains the sole political party, but allows multiple candidatesfrom its ranks to run for election to key administrative posts.

Under the best-case scenario, rapid economic growth would

remain on track and the liberalisation process should reassure

foreign investors that China is on the road to becoming a 'nor-

mal' country. However, South Korea (population 45mn) and

Taiwan (23mn) are far smaller and much more homogeneous

than China, and were considerably richer in the late 1980s than

China is today. As such, their experiences may not be easy to

emulate at the present time.

Worst-Case Scenario: Indonesia-StyleChaosThe worst-case scenario for Chinese politics would be an ex-

tended period during which the growing contradictions within

the economy foster more and more 'incidents of mass unrest'

especially organised unrest to the point that foreign investors

withdraw their capital and the government is forced to carry

out a harsh crackdown. The trigger for accelerated unrest could

come from a full-scale meltdown of the economy or a multi-year period of growth substantially below what China has been

accustomed to (for example, 5% or less annually). We feel that

both of these developments are unlikely at this stage, but they

cannot be ruled out entirely at the present time.

Were the economy to experience such stresses, the CPC could

nd itself in a similar position to Indonesia's Suharto regime in

1997-1998, when civil unrest caused foreign investors to ee

and eventually toppled the government. Indonesia subsequently

democratised over a six-year period, but real GDP growth has yet

to return to pre-1997 levels and the economy is still considered a

somewhat risky investment destination (although it has received

renewed interest in recent years). An 'Indonesia scenario' in

China would set the latter's growth story back years and could

entail regional separatism or even a military coup. China has

experienced several periods in its history during which central

government authority has been reduced to only nominal control

over the provinces and warlords have held sway.

Democracy No Quick FixThe above scenarios are not the only paths available to China,

and any transition could incorporate elements of both outcomes.

Overall, though, while a democratic government in China should

be more responsive to popular demands and allow greater politi-

cal transparency, it would by no means provide a rapid panacea

for China's myriad problems. Beyond democratisation, there

would also be the issue of centre-periphery relations would

China remain a centralised state or would it adopt a federalmodel that would allow greater autonomy for its provinces?

Furthermore, the political and economic culture resulting from

decades of one-party rule will linger in China, and issues such

as corruption and close links between business and government

will not go away quickly. Finally, in a democratic China, popular

pressures could force the government to go slow on economic

liberalisation, as has happened in many emerging economies.


CHINA Q3 2014


14/49


SWOT Analysis

Strengths Chia has a massive trade surplus ad its huge freig exchage

reserves serve as a majr cushi agaist exteral shcks.

Chia's ecmic plicymakers are cmmitted t ctiuig their

gradual refrm f the ecmy.

Weaknesses

Chia's ecmic grwth bm has led t majr imbalaces adenvironmental degradation.

The cutry's depedecy ivestmet t bst grwth has made

it vulerable t a slwdw i credit grwth. Private csumpti

remais weak at less tha 40% f GDP.

The clse relatis betwee prvicial leaders ad lcal busiesses

are fsterig crrupti, makig it harder fr the cetral gvermet

t efrce its plicies.

Opportunities Chia's ecmic grwth is slwly becmig mre brad-based, with

dmestic csumpti likely t rise i imprtace vis--vis exprtsad ivestmet.

As Chia mves up the value chai, it will develp its w glbal

brad ame cmpaies, fsterig ivati ad grwth.

Threats We believe that we have witessed a permaet ed t Chia's

double-digit annual growth rate.

The ecmy will face difculty i ctiuig t icrease its share

f the glbal exprt market, ad effrts t mve up the value chai

will be fraught with prblems.

BMI Economic Risk RatingsChia scres strgly acrss the bard i ur Shrt-Term Ecmic

Risk Ratigs, securig a impressive verall scre f 86.0, placig it

ear the tp f ur glbal shrt-term ratigs. The cutry als perfrms

well i ur Lg-Term Ecmic Risk Ratigs, securig a tp 20 spt

with a scre f 77.4, buyed by Chia's strg grwth prspects, lw

ad stable iatiary evirmet ad a very secure exteral psiti.

Hwever, a ver-reliace cmmdity imprts ad the maufacturig

sectr drag Chia's lg-term ratig, as des the paltry amut fgvermet spedig health ad educati.

Chapter 2:

Economic Outlook

S-T Economy Rank Trend

South Korea 90.2 1 =Singapore 89.6 2 -China 86.0 3 =Taiwan 85.6 4 =Malaysia 77.9 5 =Philippies 75.6 6 =Hong Kong 74.8 7 =Thailand 72.5 8 -Vietnam 71.5 9 +Idesia 67.3 10 =India 62.1 11 =Bagladesh 57.5 12 =Bruei Darussalam 56.9 13 =Sri Lanka 55.4 14 =Mongolia 50.2 15 =Cambodia 49.4 16 =Papua New Guinea 49.2 17 =Pakista 46.5 18 =Myanmar 46.0 19 =Las 45.4 20 =Bhutan 26.9 21 =North Korea - 22 -


L-T Economy Rank Trend

South Korea 81.5 1 =Singapore 81.2 2 =Malaysia 77.5 3 =China 77.4 4 =Hong Kong 74.3 5 =Taiwan 74.1 6 =Thailand 71.5 7 =Philippies 66.8 8 =Idesia 65.0 9 =Vietnam 62.7 10 =Bagladesh 57.5 11 =Bruei Darussalam 56.0 12 +India 55.6 13 -Sri Lanka 53.9 14 =Pakista 49.3 15 =Las 43.8 16 =Mongolia 42.5 17 =Cambodia 42.0 18 =Papua New Guinea 41.8 19 =Myanmar 40.9 20 =Bhutan 33.8 21 =North Korea - 22 -



15/49

Economic Activity

Cooling Property Market To ExacerbateEconomic Downturn

BMI VIEW

Beijing faces an increasingly challenging landscape in which to imple-

ment its planned economic reforms, as a rapidly cooling national prop-

erty market is an increasingly salient threat to China's slowing econo-

my. Even as the prospect of a vicious cycle of falling property prices

and lower economic growth becomes more likely, however, we once

again note that the government will be unwilling and unable to unleash

the scale of stimulus measures necessary to reverse the decline.

The residential property market is rapidly cooling across China,

with anecdotal evidence pointing towards falling sales volumesamid increasingly widespread price cuts from developers. Even

ofcial data, which tend to paint a more conservative picture than

what is actually happening on the ground, reect prices in tier

one cities growing by just 10.6% year-on-year (y-o-y) in April,

marking the category's slowest rate of growth since March 2013.

Tier two cities have witnessed a similar phenomenon, with price

increases retreating to 6.5% y-o-y in April (the slowest rate of

growth since May 2013) versus 7.5% in March.

Such a slowdown comes as little surprise given the ongoingretrenchment in both China's credit environment, as well as

the broader economy, and further corroborates our view that

the Chinese economy is in the midst of a substantial slowdown

as investment spending cools. In April, aggregate total social

nancing (a measure of broad liquidity and thus a proxy for

credit creation) expanded by just 15.8% y-o-y, its slowest clip

since July 2005, as Beijing continued to clamp down on new

credit creation as part of its nascent efforts to steer the economy

towards a less investment-driven growth model.

More Cities To Witness Price DeclinesThe downturn has also been reected in overall xed asset

investment (ex-rural), which expanded in April at its slowest

rate of growth since December 2001. The slowdown in invest-

ment spending has been acutely felt in the residential real estate

space, with growth in the source of funding for property projects

plummeting to 9.2% y-o-y in March against February's gure of

37.3%. Meanwhile, in the 70 medium and large cities tracked by

China's National Bureau of Statistics, real estate prices increased

in just 44 cities in April, a notable decline from 56 in March

and 57 in February. In light of the increasingly negative data

that we have witnessed in both the real estate market and the

broader economy, we believe that the likelihood of a wide-scale

real estate correction (implying nominal price declines in the

majority of locales across the country) is high.

The implications of such a correction will likely take a toll on

developers, many of which are reportedly highly leveraged.

Given the increasing likelihood of price cuts in order to move

inventory over the coming quarters, we therefore believe that

bankruptcies are on the horizon for those developers with the

highest levels of leverage, as their ability to roll over their out-

standing loans also declines. Likewise, a real estate correction

has potentially major implications for the broader economy, aseverything from land prices (a major part of local government

scal revenues) to private consumption will be hit, along with

the associated retrenchment in investment.


CHINA Q3 2014

Coming Back Down To EarthTier 1 ad 2 Residetial Real Estate Prices, % chg y--y

Source: BMI, NBS

TABLE : ECONOMIC ACTIVITY

2009 2010 2011 2012 2013e 2014f 2015f 2016f 2017f 2018f

Nominal GDP, USDbn 5,069.4 5,952.5 7,200.4 8,117.9 9,201.1 10,019.8 10,745.4 11,770.6 12,793.9 13,904.1

Real GDP growth, % y-o-y 9.2 10.6 7.6 7.7 7.7 7.1 6.0 5.8 5.8 5.8

GDP per capita, USD 3,751 4,377 5,261 5,895 6,640 7,188 7,666 8,354 9,036 9,777

Population, mn 1,351.2 1,359.8 1,368.4 1 ,377.1 1,385.6 1,393.8 1,401.6 1,408.9 1,415.8 1,422.1

Idustrial prducti, % y--y, ave 11.1 14.4 10.8 7.8 8.3 8.5 8.0 8.0 8.0 8.0

Uemplymet, % f labur frce, ep 4.3 4.1 4.1 4.1 5.0 5.0 5.0 5.0 5.0 5.0

e/f = BMI estimate/forecast. Source: National sources, BMI


16/49

Government, PBoC Likely To TweakPoliciesGiven its high level of involvement in the sector following the

implementation of progressively stricter controls over recent

years, the government's response to the potential decline in

real estate prices will be similarly crucial. While a moderate

correction is likely palatable to the government in the sense

that it will increase affordability and thereby reduce social and

political pressure from China's burgeoning middle class, the

impact on economic growth and, most importantly, employment

levels will play an equally large role in decision making. As we

have stated previously, we believe that modest monetary easing

measures are an increasingly likely scenario as both the property

market as well as the economy continue to cool, with a cut to

the reserve requirement ratio (RRR) being the most likely action

to be taken by the People's Bank of China (PBoC) in H214. Atthe same time, the central bank can also tweak its limitations

on rst-time home buyers, and has reportedly already begun to

encourage lenders to ease mortgage lending to owner-occupiers.

Economic Reforms Another HeadwindNevertheless, more sweeping reforms such as interest rate lib-

eralisation, which the leadership has repeatedly stressed is near

the top of its policy-making agenda, will only serve to tighten

credit markets in the near-term as bank funding becomes more

expensive. Given that this will y in the face of the aforemen-

tioned growth (and property price supportive) measures, we

maintain our below consensus forecast for real GDP growth

for both this year (7.1%) and next (6.0%).

Indeed, despite the recent outperformance in HSBC's FlashPurchasing Managers' Index (PMI), we also note that the

indicator remains mired in contractionary territory, as

depicted in the above chart, and we see little impetus for a

marked pick-up in growth over the coming quarters absent a

considerably stronger policy response from the government.

Expenditure BreakdownPrivate Consumption: We forecast private consumption to rise

by 8.4% in 2014, following an 8.0% performance in 2013, as the

economy continues to rebalance towards greater consumption.

Government Consumption: We expect government consump-

tion growth to remain steady at 9.0% in 2014, as the Chinesegovernment looks to offset the slowing economy with targeted

scal spending measures.

Investment Outlook: We expect total investment growth to

hit 5.8% in 2014, up slightly from 5.4% in 2013 but still wellbelow overall economic growth as the economy continues to

rebalance away from the investment-led growth model.


ECONOMIC OUTLOOK

Total Floor Space Still In ContractionTtal Residetial Flr Space Cmpleted (YTD), % chg y--y

Source: BMI, NBS

FAI A Sign Of The TimesFixed Asset Ivestmet (ex-rural), % chg y--y

Source: BMI, NBS

Not Out Of The Woods Just YetHSBC Flash & ofcial PMI

Source: BMI, NBS


17/49

Net Exports: In line with greater private consumption, we see

import growth (+7.5%) outpacing export growth (7.0%) in 2014.

Fiscal PolicyPiecemeal Stimulus Does Not AlterCore View

BMI VIEW

Beijing's efforts to stimulate China's slowing economy have thus far

been extremely targeted in comparison with previous packages, in-

cluding a relatively small-scale rail package as well as a programme

aimed at cutting taxes for small and medium sized businesses. Given

government rhetoric regarding the country's slowing growth rate, aswell its massive economic imbalances, we do not envisage large-scale

scal stimulus measures over the coming quarters even as the econ-

omy continues to slow towards our full-year real GDP growth forecast

of 7.1%. Instead, we believe that a continued roll-out of measures tar-

geted at specic industries is the likely path forward.

The Chinese government has announced measures to expedite

approved rail projects while at the same time increasing the

total length of new lines by 18% versus 2013. Additionally, the

government added supportive measures for small businesses byeasing the qualifying criteria for tax rebates. The announcement

follows softening rhetoric from government ofcials, but is in line

with our expectations for small, targeted stimulus efforts. The

government will likely need to introduce more of such measures

in order for the economy to achieve its real GDP growth target

of 7.5% for the year, and we would therefore not be surprised

to see additional announcements over the coming weeks.

Such measures will likely look to prop up xed asset investment,

where growth fell to a nearly 12-year low of 17.9% y-o-y in

February. Meanwhile, Beijing will also be particularly sensitive

towards any deterioration in labour-intensive industries, with

the potential for a slowing economy to lead to rising unemploy-

ment. In order to address these areas, some form of monetarystimulus is becoming increasingly likely, and a move to more

broadly lower banks' reserve requirement ratios (RRR) may be

in the ofng in order to support credit creation. That said, we

maintain that a 2008/9-style 'big-bang' stimulus is not on the

cards, as this would undermine the Xi Jinping government's

efforts to reinforce its economic reform credentials.

While we cannot guarantee that Beijing will not respond to fur-

ther economic weakness with increasingly aggressive stimulus

measures, we strongly believe that any positive impact of such

measures on near-term growth would be outweighed by the

negative impact on the medium term economic outlook. Past

stimulus packages have been instrumental in exacerbating the


CHINA Q3 2014

TABLE : FISCAL POLICY

2010 2011 2012 2013e 2014f 2015f 2016f 2017f 2018f

Reveue, % f GDP 20.6 20.4 20.7 20.9 21.2 21.6 22.0 22.2 22.3

Fiscal expediture, CnYb 8,987.4 10,326.5 11,462.5 12,539.9 13,706.1 14,967.1 16,314.2 17,766.1 19,382.8

Expediture, % f GDP 22.3 22.2 22.4 22.2 22.1 22.1 22.2 22.2 22.3

Current expenditure, CNYbn 8,067.6 9,252.4 10,284.5 11,244.4 12,284.3 13,414.3 14,625.1 15,932.1 17,390.8

Curret expediture, % f ttal expediture 89.8 89.6 89.7 89.7 89.6 89.6 89.6 89.7 89.7

Curret expediture, % f GDP 20.0 19.9 20.1 19.9 19.8 19.8 19.9 19.9 20.0

Capital expenditure, CNYbn 919.8 1,074.1 1,178.0 1,295.5 1,421.8 1,552.8 1,689.0 1,834.0 1,992.0

Capital expediture, % f ttal expediture 10.2 10.4 10.3 10.3 10.4 10.4 10.4 10.3 10.3

Capital expediture, % f GDP 2.3 2.3 2.3 2.3 2.3 2.3 2.3 2.3 2.3

Budget balance, CNYbn -677.3 -853.0 -852.1 -730.6 -562.3 -351.2 -163.5 -16.6 -35.8

Budget balace, % f GDP -1.7 -1.8 -1.7 -1.3 -0.9 -0.5 -0.2 0.0 0.0

e/f = BMI estimate/forecast. Source: National Bureau of Statistics, BMI

FAI Hitting Decade-Plus LowsFixed Asset Ivestmet Ex-Rural, % chg y--y

Source: BMI, NBS


18/49

unbalanced nature of China's economy, and we believe that

they have created growth at the expense of wealth. The surge in

property prices over recent years, which has supported economic

growth by boosting construction spending, supporting local gov-

ernment revenues, and generally keeping the huge credit boom

rolling on, appears to be coming to an end. With this in mind,we maintain that the trend of weakening credit growth is only

just beginning, and efforts to halt this trend will not bear fruit.

Monetary Policy

More Targeted Easing Ahead

BMI VIEWRecently announced measures by the Chinese government to lower

the reserve requirement ratio (RRR) for selected banks chime with

our expectations for broader RRR cuts over the coming quarters, as

the People's Bank of China looks to balance risks stemming from the

country's real estate and credit bubbles with slowing economic growth.

The Chinese government has announced fresh measures aimed

at supporting credit creation at selected banks, headlined by a

proposed reserve requirement ratio (RRR) cut for those banks

with a signicant portion of lending to agricultural and small tomedium sized enterprise (SME) interests. The decision, which

follows a State Council meeting in which broad economic plans

are generally updated, chimes with our ongoing expectations for

the government and monetary authorities at the People's Bank of

China (PBoC) to gradually ease credit conditions in the country

as lending and economic growth continue to slow. It will be

the second selective reduction of reserve requirement ratios inas many months, following a 200 basis point (bps) cut to the

RRR for county-level rural commercial banks in April (along

with a 50bps cut to the ratio for rural cooperative credit unions).

Real Estate/Credit Bubble ComplicatesPolicyIn April, aggregate total social nancing (a measure of broad

money supply, and thus a proxy for credit growth) fell to just

15.8% y-o-y, its slowest clip since December 2005. Compound-

ing the situation has been the rapidly cooling real estate market,where transaction volumes have been plummeting along with

price growth amid reports of oversupply across a large swath of

tier 1 and 2 cities (see 'Cooling Property Market To Exacerbate

Economic Downturn', May 27). However, elevated property

prices that have undermined middle class housing affordability

across the country have placed the government in an increasingly

challenging position, and we believe that a correction is not only

long overdue, but also necessary in order for the government to

achieve its broader political objectives.

As such, we do not envisage a wholesale easing of credit con-


ECONOMIC OUTLOOK

TABLE : MONETARY POLICY

2010 2011 2012 2013e 2014f 2015f 2016f 2017f 2018f

Csumer price iati, % y--y, ave 3.3 5.4 2.7 2.6 2.6 2.8 2.7 2.7 2.7

Prducer price iati, % y--y, ep 3.9 3.2 2.9 2.6 2.6 2.6 2.6 2.6 2.6

Prducer price iati, % y--y, ave 3.7 3.2 2.9 2.6 2.6 2.6 2.6 2.6 2.6

Whlesale price iati, % y--y, ave 3.9 3.8 3.6 3.0 3.1 2.9 2.7 2.7 2.7

Whlesale price iati, % y--y, ep 4.0 3.8 3.6 3.0 3.1 2.7 2.7 2.7 2.7

M1, CNYbn 26,662.0 28,985.0 31,883.5 35,071.9 38,579.0 42,436.9 46,680.6 50,881.9 54,952.4

M1, % y-o-y 21.2 8.7 10.0 10.0 10.0 10.0 10.0 9.0 8.0

M2, CNYbn 72,585.0 85,159.0 96,229.7 105,852.6 116,437.9 128,081.7 140,889.9 153,569.9 165,855.5

M2, % y-o-y 19.7 17.3 13.0 10.0 10.0 10.0 10.0 9.0 8.0

Central bank policy rate, % eop 5.81 6.56 6.00 6.00 6.00 5.75 5.75 5.75 5.75

Lending rate, %, eop 2.2 3.5 3.0 3.0 3.0 3.5 3.5 4.0 4.0

Lending rate, %, ave 2.2 2.8 3.2 3.0 3.0 3.2 3.5 3.7 4.0

Real lending rate, %, eop -2.4 -0.6 0.5 0.5 0.4 0.8 0.7 1.3 1.3

Real lending rate, %, ave -1.1 -2.6 0.5 0.4 0.4 0.4 0.8 1.0 1.3

3-month money market rate, % eop 2.3 3.1

Real 3-month money market rate, %, eop -2.4 -1.0

3-month money market rate, %, ave 1.8 2.9

Real 3-month money market rate, %, ave -1.5 -2.5



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ditions to the extent that lending growth will be revitalised in

a major way, as this would contradict efforts to boost housing

affordability and curb excessive real estate investment.

This means that a benchmark interest rate cut (the PBoC's

benchmark rate has remained steady at 6.00% since June 2012)

is not in the cards, as reected by our end 2014 forecast for the

rate to be held at 6.00%.

More Targeted Easing Measures On TheWayNevertheless, economic realities are likely to continue to press

the PBoC to enact a gradual easing agenda. Recent data have

continued to reect tepid growth in China's all-important

manufacturing sector, with the ofcial Purchasing Managers'

Index (PMI) once again barely posting in expansionary territory

(50.8) in May, while the parallel gure from HSBC (May's ash

estimate) remains mired in contraction at 49.7. In an attempt to

support economic growth without further stoking China's credit/

real estate bubble, we see further cuts to the reserve requirement

ratios for a broader swath of banks, as well as a continuation of

the PBoC's complicity with weakness in the Chinese yuan as the

two main policy thrusts from the central bank. As of yet, it is notpossible to ascertain the group of banks that will be affected by

the latest RRR cut, as it is yet to be seen exactly how the PBoC

will interpret the government's mandate. Should the RRR cut

apply to only a small group of banks, we would expect to see

further measures introduced over the coming months aimed at

larger national lenders.

At the same time, ofcials will likely continue to pursue more

qualitative easing measures in the vein of the government's

recent efforts to encourage banks to loosen up lending to rst-time home buyers, as well as owner-occupiers. Still, given

that consumer credit remains a relatively small proportion of

overall credit in China, we believe that overall credit growth

will continue to retreat over the coming months as the sagging

real estate sector, as well as the slowing economy, weigh on

demand for new lending.

Currency Forecast/BoPCNY: Still At Mercy Of Downside Risks

BMI VIEW

In line with our long-held expectations, the Chinese yuan's apprecia-

tory trend came to a halt at the beginning of this year. While we believe

that the currency's most aggressive depreciation is now behind it, we

note that central bank policy as well as market forces suggest that the

yuan will likely end 2014 slightly weaker than its current level before

stabilising over the long-term. As such, we have downgraded our end-

2014 forecast to CNY6.3500 from CNY6.2500 previously.

Short-Term OutlookFollowing the exhaustion of the Chinese yuan's long-term ap-

preciatory trend earlier this year, we believe that forces on the

currency are still weighted to the downside over the near-term.

As such, we see the unit trading modestly lower over the coming

months, with a six-month target of CNY6.3500/USD.

Long-Term OutlookFollowing a particularly strong performance in 2013, the Chi-

nese yuan has reversed course in a notable fashion so far in


CHINA Q3 2014

Credit Growth Nearing Decade LowsAggregate Total Social Financing, % chg y-o-y

Source: BMI, NBS

Holding FastPBoC 1-Year Lending Rate, %

June 2014-Dec 2014 = BMI forecast


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2014. Indeed, the currency was resilient last year in the face of

a widespread rout of Asian currencies, appreciating by 3.0%

over the course of the year. On the contrary, the yuan has shed

3.3% so far in 2014 after its extended rally began to reverse in

January, and a conuence of factors suggests that the unit is

likely to remain in a neutral to bearish trading pattern over themedium term.

Firstly, China's economic slowdown is placing pressure on the

People's Bank of China (PBoC) to pursue more growth supportive

measures. However, the central bank is, in our opinion, bothunable and unwilling to ignite yet another credit boom in the

country, as this will only exacerbate the excessive investment

that has led to massive bubbles in areas such as the real estate

sector. Indeed, with credit growth still trending above nominal

GDP growth, China's credit-to-GDP ratio continues to expand,

making any wholesale easing of credit conditions an even bigger

risk to the country's long-term economic stability. As such, we

believe that the central bank is now willing to pursue a weaker

yuan policy in order to support the country's export-driven

manufacturing sector, which continues to hover on the cusp ofcontraction according to data from the most recent Purchasing

Managers' Indices (PMIs).

Despite the fact that the PBoC's foreign exchange pile soared

to an all-time high of USD3.95trn in March, reecting a y-o-y

expansion of 14.7%, this does not necessarily indicate that forces

on the yuan are to the upside. Still, in the case that the PBoC

were ghting to keep the currency stable, or to maintain its ap-

preciatory path, reserves would likely be falling. At the same

time, the spread between the CNY's spot rate and the PBoC's

daily midpoint (a reference point around which the yuan can

trade in a daily range of 2%) has also climbed to an all-timehigh, which suggests to us that market forces on the currency

may also be to the downside. In light of these factors, we have

downgraded our end 2014 forecast for the Chinese yuan to

CNY6.40/USD, from CNY6.20/USD previously.

Medium Term Stability Still LikelyWhile we remain decidedly below consensus on the yuan's

medium term prospects (with consensus expecting a consistent

appreciation in the unit over the next ve to ten years), we do

see scope for the currency to stabilise following its near-term

depreciatory trend. Crucially, we see inationary forces becom-

ing less of a concern for the currency over the medium term as

credit and money supply growth are tamed from the relentless

double-digit growth rates seen over the past decade. Likewise,economic growth, despite slowing, should still easily outpace

that of the US and other major economies. We have slightly

downgraded our end 2015 forecast for the yuan to CNY6.4000/

USD, after which point we expect the currency to trade near

this level.


ECONOMIC OUTLOOK

TABLE : BMI CHINA CURRENCY FORECAST

Spot 2014 2015

CNY/USD, ave 6.2625 6.2200 6.3800

CNY/EUR, ave 8.5018 8.3348 7.9750

CNY Rate, % eop 6.00 6.00 5.75

Source: BMI. Last Updated: June 5 2014

End Of The TrendExchange Rate, CNY/USD

Source: BMI, Bloomberg

Spread Still Near Record-HighExchange Rate, CNY/USD



21/49

Risks To OutlookRisks to our yuan forecast remain decidedly to the downside,

and the Chinese government's policy response with regards to

the country's slowing economy remains the key variable over

the short-to-medium term.

While our core view sees real GDP growth slowing to 7.1% in

2014, a more acute deceleration could spur the PBoC to pursue

more aggressive action with regards to the yuan. In this case,

a one-off devaluation of between 5-10% is not wholly without

precedent (famously, the PBoC devalued the yuan by 49.3%

in 1994), and is becoming an increasing possibility in order to

rapidly restore the competitiveness of Chinese goods against

those of regional peers whose currencies witnessed substantially

larger declines in 2013 (including Indonesia, India, and Japan).


CHINA Q3 2014

TABLE : CURRENT ACCOUNT

2010 2011 2012 2013e 2014f 2015f 2016f 2017f 2018f

Gds imprts, % f GDP 23.5 24.2 22.4 21.2 21.4 22.2 22.6 22.9 23.1

Gds exprts, USDb 1,578.3 1,899.2 2,050.0 2,220.2 2,397.8 2,613.6 2,861.8 3,133.7 3,431.4

Gds exprts, % f GDP 26.5 26.4 25.3 24.1 23.6 24.0 24.3 24.5 24.7

Gds exprts, % f imprts 113.0 109.0 112.8 113.7 110.6 108.2 107.7 107.2 106.7

Balace f trade i gds, USDb 182.1 156.3 232.0 267.6 230.5 197.0 203.6 209.7 215.0

Balace f trade i gds, % f GDP 3.1 2.2 2.9 2.9 2.3 1.8 1.7 1.6 1.5

Services imprts, USDb 194.0 238.9 258.8 288.3 331.5 382.9 436.5 497.6 567.3

Services imprts, % f GDP 3.3 3.3 3.2 3.1 3.3 3.5 3.7 3.9 4.1

Services exprts, USDb 171.5 184.8 206.8 232.3 260.1 294.0 333.6 378.7 429.8

Services exprts, % f GDP 2.9 2.6 2.5 2.5 2.6 2.7 2.8 3.0 3.1

Gds ad services exprts, USDb 1,749.8 2,083.9 2,256.8 2,452.4 2,657.9 2,907.5 3,195.5 3,512.4 3,861.2

Gds ad services exprts, % f GDP 29.4 28.9 27.8 26.7 26.2 26.7 27.1 27.5 27.8

Balace f trade i gds ad services, USDb 159.6 102.2 180.1 211.6 159.1 108.1 100.8 90.8 77.5

Balace f trade i gds ad services, % f GDP 2.7 1.4 2.2 2.3 1.6 1.0 0.9 0.7 0.6

Income account balance, USDbn -25.9 -11.9 -12.2 -15.7 -19.8 -24.6 -29.9 -33.2 -36.9

Icme accut balace, % f GDP -0.4 -0.2 -0.2 -0.2 -0.2 -0.2 -0.3 -0.3 -0.3

net trasfers, USDb 40.7 25.3 27.2 28.9 28.5 27.6 26.2 23.7 19.2

net trasfers, % f GDP 0.7 0.4 0.3 0.3 0.3 0.3 0.2 0.2 0.1

Current account balance, USDbn 174.3 115.6 195.1 224.8 167.8 111.1 97.1 81.3 59.9

Curret accut balace, % f GDP 2.9 1.6 2.4 2.4 1.7 1.0 0.8 0.6 0.4

opeess t iteratial trade, % 50.0 50.6 47.6 45.3 45.0 46.3 46.9 47.3 47.8


Spread Still Near Record-HighExchange Rate, Daily Midpoint & Spread



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The Chinese Economy To 2023

6.0% Is The New 10.0%

BMI VIEW

China's economic growth in the coming decade will be much slower

than in the last, as the savings rate declines, the economic liberalisa-

tion process slows, and population growth falls. These dynamics will

result in real GDP growth averaging 5.9% over the next decade asopposed to the 10.1% average seen over the past decade. Private

consumption will be a major outperformer, averaging growth of 8.1%

and rising in importance as a share of GDP.

The unprecedented growth boom in China over recent decades

has its foundations in the vast improvement made to productivity

through economic liberalisation. A major supportive tailwind

in the form of demographic trends provided additional support,

allowing savings to be accumulated at a rapid rate. Growth in

the coming decade will be much slower than during the last, asthe 'low hanging fruit' of liberalisation has already been under-

taken and further reforms are likely to be slow and piecemeal

as the Communist Party of China (CPC) would be reluctant to

give up too much economic power for fear of losing its politi-

cal dominance. A harshly deteriorating demographic situation

(slowing growth and an ageing population) will further weigh

on economic dynamism, resulting in real GDP growth of 5.9%

over the next decade compared with the 10.1% average of the

past 10 years. Consumption will rise as a share of GDP and, as

a result, services' share of GDP will rise, presenting signicantopportunities in consumer-related elds.

Lower Investment Rate, Slower GrowthIt is widely agreed that to encourage sustainable high rates of

growth in the coming years, China must lower its investment

rate and boost consumption. Looking at historical precedents, it

is clear that an investment share of GDP at nearly 50.0% is too

high. However, it is this high savings and investment rate that

has allowed the economy to grow so fast over the past decade. A

lower rate of savings and investment will mean slower growth.

Regarding the domestic imbalances that have built up as a result

of the high investment ratio, the problem is not high investment

itself but the lack of viability of such investment projectsin

theory, there is nothing wrong with a high investment rate if

all the investments make a prot. Excessive state involvement

has resulted in excessive unproductive investment in an all-out

attempt to boost headline growth. This has come at the expense

of private consumption, with the consequences likely to be a

sharp slowdown in growth over the coming years.

Policy Reaction To Coming SlowdownWill Be CrucialPolicies to 'boost' consumption using subsidies, wage hikes

and consumer loans, or persuading consumers to reduce their

savings rate by providing a more comprehensive social security

net, target the symptoms rather than the causes. Broad-based

structural reforms will be needed to rebalance the economy

and avoid a hard landing and, so far, these reforms have been

lacking. We believe the government missed a key chance to

accelerate economic reforms during the global nancial crisis,with the stimulus policy of forcing banks to extend record loans


Chapter 3:

10-Year Forecast

TABLE : LONG-TERM MACROECONOMIC FORECASTS

2014f 2015f 2016f 2017f 2018f 2019f 2020f 2021f 2022f 2023f

Nominal GDP, USDbn 10,142.4 10,874.9 11,770.6 12,793.9 13,904.1 15,108.5 16,410.6 17,828.0 19,373.0 21,050.9

Real GDP growth, % y-o-y 7.1 6.0 5.8 5.8 5.8 5.8 5.8 5.8 5.8 5.8

Population, mn 1,393.8 1,401.6 1,408.9 1,415.8 1,422.1 1,427.8 1,432.9 1,437.3 1,441.1 1,444.2

GDP per capita, USD 7,276 7,758 8,354 9,036 9,777 10,581 11,452 12,403 13,443 14,576

Csumer price iati, % y--y, ave 2.6 2.8 2.7 2.7 2.7 2.7 2.7 2.7 2.7 2.7

Curret accut balace, % f GDP 1.7 1.0 0.8 0.6 0.4 0.2 0.0 -0.3 -0.6 -1.0

Exchange rate CNY/USD, ave 6.13 6.23 6.25 6.25 6.25 6.25 6.25 6.25 6.25 6.25

f = BMI forecast. Source: National sources, BMI


23/49


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increase the share of consumption in GDP although they will

do so at the cost of reduced growth potential.

Demographic Dividend ReversingOver the past decade, the working population has risen at an

average rate of 1.26% a year, providing a supportive tailwind forgrowth. Over the next decade, we expect this gure to fall to just

0.71% a year, acting as a direct drag compared with the previous

decade, particularly towards the end of our forecast period when

we see the working age population actually shrinking slightly.


10-YEAR FORECAST

BMI's lg-term macrecmic frecasts

bmi china business forecast report q3 2014

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