l li & fung china trade quarterly i – domestic and foreign ...3 domestic and foreign li &...

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IN THIS ISSUE :

Part One : Domestic Trade

I. Recent development 2

II. Highlights 10

III. Outlook 13

Part Two : Foreign Trade

I. Recent developments 16

II. Highights 22

III. Outlook 28

LI & FUNG China Trade Quarterly

– Domestic and ForeignAugust 2010 Issue 19

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Domestic TradeRetail sales of consumer goods reached 8,492.2 bn yuan in Jan-Jul, up nominally by 18.2% yoy. Chinese consumer confidence has continued to improve.

The cPI growth reached 3.3% yoy in July, the highest in twenty-one months. Looking ahead, China’s CPI will be supported by factors such as rising labour costs, pass-through of upstream price pressures, strengthening domestic demand, the buildup of inflationary expectations, tighter food supply, as well as speculation in agricultural commodities. We expect the CPI growth in FY10 to exceed the government target of 3.0% and hit 4%.

Labour unrest, labour shortages and upward adjustments of minimum wage levels are set to trigger rapid rise in wages of low income workers. We believe that wage increases will soon become prevalent among manufacturers in China.

The chinese government has started to extend the “old-for-new” (trade in) subsidies scheme for home appliances gradually to cover the whole country.

china’s economic growth softened to 10.3% yoy in 2Q10. The growth moderation was attributable to government tightening on real estate speculation and local government borrowing, as well as the higher comparison base in 2Q09. We predict that China’s GDP growth will moderate further to 9.0-9.5% yoy in real terms in 3Q10.

Foreign Tradechina’s export grew strongly by 35.6% yoy in Jan-Jul. Import growth decelerated to 22.7% yoy in July, due to the higher comparison base last year. Trade surplus hit US$ 28.7 bn in July, the highest in eighteen months.

The negative impact of the european debt crisis on china’s export has so far been limited. Export growth to the EU accelerated from 31.0% yoy in 1Q10 to 40.5% yoy in 2Q10 and 38.3% yoy in July.

The RMB has appreciated slightly against the us dollar since 19 June 2010, when the PBOC announced to proceed further with the reform of the RMB exchange rate regime. We expect a gradual appreciation of the RMB against the US dollar to take place in the near term.

The pilot program for using RMB for cross-border trade transactions has been expanded to cover all foreign countries and designated enterprises in twenty provinces/municipalities in China.

The economic cooperation Framework Agreement (ecFA) between the chinese Mainland and Taiwan was signed on 29 June 2010. The early harvest list includes tariff reduction/ removal and liberalization of trade in services. The ECFA is set to further advance cross-strait relations and give a major boost to two-way trade.

The chinese government announced to scrap export VAT rebates for 406 tariff items, effective 15 July 2010. The policy indicates the renewed efforts of the government to discourage undesirable industries.

Helen Chin, Timothy CheungTel: (852) 2300 [email protected] [email protected]

Li & Fung Research centre11/F, LiFung Tower,

868 Cheung Sha Wan Road,

Hong Kong

Tel : (852) 2300 2470

Fax : (852) 2635 1598

E-mail: [email protected]

http://www.lifunggroup.com/LI & Fung ReseARch cenTRe

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LI & FUNG China Trade Quarterly August 2010 Issue 19

LI & Fung ReseARch cenTReMeMBeR OF The LI & Fung gROuP

Part One: Domestic Trade

I. Recent Development

1. china’s economic growth softened to 10.3% yoy in 2Q10

China’s economic growth softened to 10.3% yoy in 2Q10, down from the recent high of 11.9% yoy in 1Q10. The growth moderation was attributable to government tightening on real estate speculation and local government borrowing, as well as the higher comparison base in 2Q09. Overall, China’s GDP amounted to 17.3 trillion yuan in 1H10, up 11.1% yoy in real terms. (See exhibit 1)

Among industries, the growth rate of the value added of the secondary industry was the fastest in 1H10, up by 13.2% yoy. Those of the tertiary industry and the primary industry reached 9.6% yoy and 3.6% yoy respectively in 1H10.

Particularly noteworthy is that investment still played the most important role in driving China’s economic growth in 1H10. The contribution of capital formation to the GDP growth was 59.1% in 1H10; that of final consumption expenditure was 35.1%; and that of net export of goods and services was 5.8%.

Looking forward, we predict that China’s GDP growth will moderate further to 9.0-9.5% yoy in real terms in 3Q10. We are not overly worried about an economic downturn, as the Chinese economy will continue to be supported by strong domestic demand, as well as improving global demand. (Detailed discussion can be found in the Outlook section.)

exhibit 1: china’s real gDP growth, 3Q09 - 2Q10

FY09 9.1%1

3Q09 9.1%4Q09 10.7%1Q10 11.9%2Q10 10.3%

Source: National Bureau of Statistics, PRC

1 On 2 July 2010, the National Bureau of Statistics of China (NBS) revised the real GDP growth in FY09 from 8.7% yoy to 9.1% yoy.

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Domestic and Foreign


2. Retail sales grew steadily in Jan - Jul 2010

According to the National Bureau of Statistics (NBS), the total retail sales of consumer goods reached 8,492.2 billion yuan in Jan - Jul 2010, up nominally by 18.2% yoy. By month, the nominal growth rate of retail sales stayed robust in April, May, June and July (18.5% yoy, 18.7% yoy, 18.3% yoy and 17.9% yoy respectively). (See exhibit 2) The real growth in 1H10 was approximately 15% yoy, moderated from 16.9% yoy in FY09.

exhibit 2: china’s total retail sales of consumer goods, Aug 2009 - Jul 2010


Urban retail sales registered stronger growth in Jan - Jul 2010. Urban retail sales were 7,331.5 billion yuan in Jan - Jul 2010, up nominally by 18.6% yoy.2 Meanwhile, rural retail sales were 1,160.7 billion yuan, up nominally by 15.6% yoy.

By mode of sales, in Jan - Jul 2010, the retail sales of commodities were 7,532.7 billion yuan, up by 18.3% yoy; and the retail sales of the catering industry were 959.5 billion yuan, up by 17.1% yoy.3 (See exhibit 3)

Retail sales of commodities of enterprises above designated size reached 3,100.5 billion yuan in Jan - Jul 2010, up by 29.4% yoy. (See exhibit 3) Among which, “gold, silver, and jewelry”, “petroleum and related products” and “furniture” achieved the most impressive growth in Jan - Jul 2010. The stunning 42.9% yoy growth of sales of “gold, silver, and jewelry” was partly attributable to consumers buying gold or jewelries as inflation hedge under rising inflation expectations. Sales of petroleum and related products grew by 37.3% yoy while those of furniture grew by 37.8% yoy. Exhibit 4 demonstrates the nominal growth rates of retail sales of enterprises above designated size by commodity.

2 Prior to 1Q10, urban area was defined as cities and rural area was defined as counties or below. Categories were recategorized to “city” and “town” in the NBS announcement since 1Q10.

3 Since Jan 2010, the National Bureau of Statistics of China has adopted new categories for total retail sales of consumer goods. “Retail sales of commodities” and “retail sales of the catering industry” replaced the previous categories of “retail sales in the wholesale and retail industries” and “retail sales in the accommodation and catering industries”.

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exhibit 3: china’s total retail sales, 2009 - Jul 2010

yoy growth (%) FY09 1Q10 1h10 Jul-10Total retail sales 15.5 17.9 18.2 17.9– Catering NA 16.7 16.9 18.2– Commodities NA 18.1 18.4 17.9 of which: enterprises above designated size NA 29.6 30.0 26.0


exhibit 4: china’s retail sales of enterprises above designated size by commodity, 2009 - Jul 2010

yoy growth (%) FY09 1Q10 1h10 Jul-10Clothing, shoes, hats and textiles 18.8 23.9 23.8 24.4Cosmetics 16.9 15.6 15.8 16.9Stationeries and offices accessories 6.7 18.3 21.5 22.7Goods for daily use 15.6 22.4 24.6 24.1Home appliances and video equipments 12.3 29.6 28.8 25.6Furniture 35.5 37.6 38.5 35.9Grain, oil, food, beverages, tobacco, and liquor 14.0 18.4 19.8 22.7Gold, silver, and jewelry 15.9 37.3 42.7 44.2Telecommunication equipments -1.3 18.0 18.8 11.2Automobiles 32.3 39.8 37.1 27.6Petroleum and related products 6.8 40.3 39.0 29.1Building and decoration materials 26.6 26.8 32.1 28.2Sports and entertainment products 9.1 13.3 18.2 14.6Chinese and western medicine 21.7 20.9 23.1 21.6


3. Consumer confidence continued to recover

Chinese consumer confidence has continued to improve. The consumer confidence index climbed to 107.9 in March, moderated to 106.6 in April, but then rose again to 108.0 in May and 108.9 in June. (See exhibit 5) The improved confidence bodes well for China’s consumer and retail sectors.

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Exhibit 5: China's consumer confidence index, Jul 2008 - Jun 2010

Jul-09 102.1 Aug 102.7 Sep 102.8 Oct 103.2 Nov 103.3 Dec 103.9 Jan-10 104.7Feb 104.2Mar 107.9Apr 106.6May 108.0Jun 108.9


4. Both urban and rural household income showed faster nominal growth in 1h10

Compared with 1Q10, both urban and rural household income showed faster nominal growth in 1H10. The per capita disposable income of urban households, which reached 9,757 yuan in 1H10, grew by 10.2% yoy in nominal terms, 0.4 ppt. higher than the yoy growth rate in 1Q10. The per capita cash income of rural households amounted to 3,078 yuan in 1H10. The nominal growth rate increased to 12.6% yoy in 1H10, up from 11.8% yoy in 1Q10.

With higher prices of goods and services, the growth rates of urban and rural household income in real terms were lower than in nominal terms in 1H10. The per capita disposable income of urban households rose by 7.5% yoy in real terms, while the per capita cash income of rural households gained 9.5% yoy in real terms in 1H10.

5. cPI growth rebounded, while the yoy growth rates of PPI and the purchasing price index of raw material, fuel and power continued to moderate in July

The yoy growth rate of China’s consumer price index (CPI)4 softened from 2.7% in February to 2.4% in March, and has been on an upward trend since then. The CPI growth reached 3.3% yoy in July, the highest in twenty-one months, due largely to higher vegetable prices triggered by the recent rainstorms in China. The price index of food, which weighs 33.2% in the CPI accounting, rose by 6.8% yoy, whilst that of non-food grew by 1.6% yoy in July. (See exhibit 6 & 7)

Nevertheless, the strong yoy growth of CPI in recent months was also attributable to the low comparison base in the same period last year. The CPI dropped by 0.1% and 0.6% on mom basis in May and June respectively.

4 The CPI, compiled by the National Bureau of Statistics of China, measures the price of a basket of 600-700 goods and services that a typical household purchases.

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Looking ahead, although the base effect is diminishing, the CPI growth is unlikely to fall much on yoy basis in the near term. China’s CPI will be supported by factors such as rising labour costs, pass-through of upstream price pressures, strengthening domestic demand, the buildup of inflationary expectations, tighter food supply due to the recent droughts and rainstorms in China, as well as speculation in agricultural commodities.

We expect the CPI growth in FY10 to exceed the government target of 3.0% and hit 4%.

exhibit 6: china’s cPI growth, Aug 2008 - Jul 2010

Aug-09 -1.2% Sep -0.8% Oct -0.5% Nov 0.6% Dec 1.9% Jan-10 1.5%Feb 2.7%Mar 2.4%Apr 2.8%May 3.1%Jun 2.9%Jul 3.3%


exhibit 7: china’s cPI growth by commodity, Feb - Jul 2010

yoy growth (%) Feb-10 Mar Apr May Jun JulFood 6.2 5.2 5.9 6.1 5.7 6.8Tobacco & Liquor 1.6 1.7 1.7 1.7 1.7 1.6Clothing -1.3 -1.1 -1.3 -1.2 -1.0 -0.8Household services, maintenance and renovation -0.8 -0.7 -0.5 -0.3 0.0 0.2Medical healthcare & personal care 2.4 2.5 2.8 3.2 3.2 3.3Transportation and communication 0.1 0.0 0.0 0.1 -0.3 -0.7Recreational, educational products & services 0.8 0.3 0.4 0.6 0.9 1.1Housing 3.0 3.3 4.5 5.0 5.0 4.8


The growth rate of China’s producer price index (PPI)5 rose from 5.9% yoy in March to 6.8% yoy in April, and accelerated further to 7.1% yoy in May, before softening to 6.4% yoy in June and 4.8% yoy in July. (See exhibit 8)

Despite the recent decline in PPI growth, we believe ex-factory prices will stay firm in the near future, bolstered by improving domestic and export demand, pass-through of upstream price pressures, and mounting labour costs. It is noteworthy that the minimum wage levels in twenty-two provinces in China such as Jiangsu, Guangdong, Hunan,

5 The PPI, compiled by the National Bureau of Statistics of China, measures the prices of industrial products when they are sold for the first time after production.

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Liaoning, Anhui, etc. were revised upward in the past few months. Besides, there have been a number of strikes in coastal provinces recently, with workers asking for salary increase. Many employers have offered considerable pay-rise to settle labour disputes. Detailed discussion can be found in Li & Fung China Sourcing Quarterly, Issue 4.

exhibit 8: china’s PPI growth, Aug 2008 - Jul 2010

Aug-09 -7.9% Sep -7.0% Oct -5.8% Nov -2.1% Dec 1.7% Jan-10 4.3%Feb 5.4%Mar 5.9%Apr 6.8%May 7.1%Jun 6.4%Jul 4.8%


The yoy growth rate of China’s purchasing price index of raw material, fuel and power6 picked up from 10.3% in February to 11.5% in March, and then reached 12.0% in April and 12.2% in May, the highest in twenty months, before declining to 10.8% in June and 8.5% in July. (See exhibit 9 & 10)

The accelerated growth of the price index reflected the increase in prices of production inputs, underlining the problems of production cost pressure and squeezed margins for Chinese manufacturers. It also suggests stronger inflationary pressure on downstream prices in the near and medium term.

exhibit 9: china’s purchasing price index of raw material, fuel and power, Aug 2008 - Jul 2010 (% yoy growth)

Aug-09 -11.4%Sep -10.1%Oct -8.4%Nov -3.6%Dec 3.0%Jan-10 8.0%Feb 10.3%Mar 11.5%Apr 12.0%May 12.2%Jun 10.8%Jul 8.5%


6 The purchasing price index for raw material, fuel and power, compiled by the National Bureau of Statistics of China, measures the prices of production inputs such as raw materials, fuels and power purchased by industrial enterprises.

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exhibit 10: china’s purchasing price index of raw material, fuel and power by selected commodity, Feb - Jul 2010

yoy growth (%) Feb-10 Mar Apr May Jun JulFuel & power 25.4 25.6 24.0 23.4 19.5 12.0Ferrous metals -2.3 1.4 8.3 10.9 10.2 8.4Non-ferrous metals 30.1 32.8 29.1 26.0 21.1 19.5Chemical materials 5.4 6.9 7.4 7.8 7.2 6.7


6. china’s industrial production growth declined throughout March - July 2010

The yoy growth of value-added of industrial output (VAIO) in China fell all the way from the recent peak of 20.7% yoy in Jan-Feb 2010 to 13.4% yoy in July. This was largely due to the government’s credit tightening measures and actions to curb excess capacity, as well as the rising comparison base in Jan - Jul 2009. (See exhibit 11)

Overall, China’s industrial production registered growth of 17.0% yoy in Jan - Jul 2010, compared to 11.0% yoy in 2009. Of which, the industrial output of heavy industry rose by 18.4% yoy; and that of light industry increased by 13.6% yoy in Jan - Jul 2010.

Particularly noteworthy is that power production, a figure highly associated with industrial production, recorded negative growth of -1.83% yoy in June on a seasonally-adjusted basis. This is consistent with the growth trend of the heavy industry sector – growth of industrial output of heavy industry declined from 17.8% yoy in May to 14.5% yoy in June and 13.3% yoy in July. Besides, auto production fell by 8.8% mom, 2.0% mom and 6.2% mom in May, June and July respectively.

On the other hand, the growth rate of the export delivery value of industrial products stayed robust at 28.2% yoy in Jan - Jul 2010, up strongly from -10.1% yoy in 2009, suggesting that export demand played a more important role in driving China’s industrial production.

Looking forward, we expect the growth momentum of China’s industrial sector to continue to moderate. China’s manufacturing PMI, a key leading indicator of the manufacturing sector, has decreased for three consecutive months. The July reading of 51.2 was the lowest in seventeen months. Moreover, the recent property tightening measures are set to reduce the demand for steel, cement, home appliances, etc. and the negative impact on the output of related sectors will gradually unfold.

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exhibit 11: china’s industrial production growth, Aug 2008 - Jul 2010

Aug 09 12.3%Sep 13.9%Oct 16.1%Nov 19.2%Dec 18.5%Jan-Feb 10 20.7%Mar 18.1%Apr 17.8%May 16.5%Jun 13.7%Jul 13.4%


7. china’s urban FAI growth has continued to soften

Supported by huge public investment and private real estate investment, China’s nominal fixed asset investment (FAI) hit 11,418.7 billion yuan in 1H10. The growth rate was 25.0% yoy in 1H10, edged down from 25.6% yoy in 1Q10. Urban FAI amounted to 11,986.6 billion yuan in Jan - Jul 2010, up by 24.9% yoy, compared to the growth rate of 26.4% yoy in 1Q10. Taking a closer look at the monthly figures, the urban FAI growth softened all the way from 26.1% yoy in April to 22.3% yoy in July.

Among different industries, the tertiary industry recorded urban FAI growth of 27.4% yoy in Jan - Jul 2010, higher than that of the secondary industry (22.1% yoy).

Despite the fact that the Chinese government has taken a series of measures to cool the property market since mid-April, growth of urban FAI in real estate development accelerated from 35.1% yoy in 1Q10 to 37.2% yoy in Jan - Jul 2010.

In the past few months, many commercial banks have tightened credits to new infrastructure projects, local-government financing vehicles, the property market, as well as a number of sectors with overcapacity. As these measures continue to take effect, FAI growth will ease further in the coming months.

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II. highlights

1. Labour unrest, labour shortages and upward adjustments of minimum wage levels are set to trigger rapid rise in wages of low income workers

Following a spate of suicides at Foxconn, on 2 June 2010, Foxconn announced to raise the salary for its workers by 30% or above. Then on 6 June, it announced to increase salary of most assembly line workers, line managers and supervisors to 2,000 yuan per month, effective from 1 Oct 2010. In another scene, as a result of the strike and wage negotiation at its parts factory in Foshan, Honda offered a 24% pay rise to the workers at this plant.

Labour disputes in China have been on the rise and wages have been on an upward trend in recent years. The Foxconn and Honda events are only triggers for the widespread collective bargaining over wages to come in the future. With the news of sizable pay rise of Foxconn and Honda spreading across China through media reports, workers in other regions are encouraged to ask for similar wage increases. Labour unrest is showing signs of spreading from the Pearl River Delta (PRD) to other parts of the country. Strikes were reported at a Taiwan-owned sporting goods supplier in Jiangxi province, and at the Japanese sewing machine maker Brother Industries in Xian, to name just a few examples. It is observed that many employers have offered sizable pay rises in order to settle labour disputes.

On the other hand, there have been numerous reports on serious labour shortages in the coastal provinces since early 2010. Enterprises in the coastal provinces have to pay higher salaries in a bid to hire or retain workers.

We believe that wage increases will soon become prevalent among manufacturers in China. This in fact coincides with China’s macro policy objective to adjust its economic structure and accelerate industrial upgrading, as well as to change its growth model from export-oriented to consumption-driven. In this regard, improving household income is one of the major keys. The Chinese policymakers have vowed to boost labour income lately. In recent months, local governments in twenty-two provinces/municipalities in China such as Jiangsu, Guangdong, Hunan, Liaoning, Anhui, etc. raised the minimum wage levels in their jurisdictions by significant amounts. (See Li & Fung China Sourcing Quarterly, Issue 4 for more details)

2. The chinese government has started to extend the “old-for-new” (trade in) subsidies scheme for home appliances gradually to cover the whole country

On 3 Jun 2010, the Ministry of Commerce, the Ministry of Finance and the Ministry of Environmental Protection jointly announced to extend the “old-for-new” (trade in) subsidies scheme for home appliances gradually to cover the whole country.7 The extension started on 1 Jun 2010. The scheme will end on 31 Dec 2011.

The pilot program of the “old-for-new” (trade-in) subsidies scheme was first launched in Aug 2009 in nine relatively affluent provinces/municipalities/cities in China, namely Beijing, Shanghai, Tianjin, Fuzhou, Changsha, Jiangsu, Zhejiang, Shandong and Guangdong. Under the pilot program, home appliances buyers would receive subsidies of up to 10% of the prices of the new products for replacing old TV sets, refrigerators, washing machines,

7 http://syggs.mofcom.gov.cn/aarticle/ae/201006/20100606947643.html?1452763062=2380288546

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air-conditioners or computers. As of 31 May 2010, the sales of home appliances under this pilot program totaled 54.0 billion yuan.

The Ministry of Commerce forecast that the latest measure will further raise the total sales of home appliances in China by 200 billion yuan. We believe the scheme will play a bigger role in promoting China’s domestic consumption and recycling industries.

3. The government reduced the fuel prices by around 3% on 1 June, in response to the recent drop in global crude prices

On 1 June 2010, the Chinese government reduced the maximum retail prices of gasoline and diesel by around 3%. The drop in the fuel prices would reduce transportation costs, as well as energy costs on manufacturers which run their own electrical generators in China.

The purpose of the price adjustments was to allow domestic fuel prices to reflect the downward movement in global crude prices since 14 Apr 2010, the previous time when fuel prices were raised by 4-5%.

4. The growth rates of broad money supply and RMB loans continued to decelerate in recent months

The yoy growth rates of both money supply and RMB loans continued to decelerate in recent months, due largely to the tightening measures taken since early 2010, as well as the high comparison base last year. As of end-Jul 2010, the broad money supply (M2) rose by 17.6% yoy, slower than the 22.5% yoy growth registered as of end-Mar 2010. The amount of total outstanding RMB loans increased by 18.4% yoy as of end-Jul 2010, compared to the 21.8% yoy growth as of end-Mar 2010. Overall, banks increased their RMB lending by 4.6 trillion yuan in 1H10 and 532.8 billion yuan in July, equivalent to around 68% of the new RMB loans target for FY10 set by the government (i.e. 7.5 trillion yuan). (See exhibit 12)

In 2009, the People’s Bank of China (PBOC), China’s central bank, adopted an extremely loose monetary policy to stimulate the Chinese economy. Indeed, the monetary stimuli have greatly boosted China’s economic growth, which rebounded all the way from 6.2% yoy in 1Q09 to 11.9% yoy in 1Q10. Afterwards, in response to growing concerns about overheating of the economy, rising inflation, as well as the looming property bubble, the central bank has taken a series of tightening measures to mop up excess liquidity from the market.8 For example, banks’ reserve requirement ratio (RRR) was raised by 50 bps on 10 May, for the third time this year.

However, it is observed that the central bank has recently become more accommodative and flexible in its monetary policies. The Agricultural Bank of China’s initial public offering (IPO)9 has resulted in tight liquidity situation then. The central bank, thus, injected a net 851.0 billion yuan into the money market through open-market operations in May - July 2010.

8 The moves included banks’ reserve requirement ratio (RRR) hikes, implementation of monthly loan quotas, upward adjustments of interest rates of its newly-issued central banks bills, etc. Detailed discussion can be found in Li & Fung Trade Quarterly, Issue 18.

9 The Agricultural Bank of China Ltd. was listed on both the Shanghai Stock Exchange and the Hong Kong Stock Exchange in mid-July 2010. The bank is the world's largest IPO issuer.

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The liquidity injection shows the flexibility of central bank policies in response to the latest situations, and should not be interpreted as a significant shift in the monetary stance. The latest economic data suggests that the Chinese economic growth has been moderating, but the inflation risk in China is still high. We believe that the Chinese policy makers are trying to strike a difficult balance between controlling inflation and preventing economic slowdown, and therefore are very cautious about raising interest rates.

exhibit 12: Broad money supply (M2) and RMB loans

As of Broad money supply (M2) Total outstanding RMB loans Amount (trillion yuan) yoy growth Amount (trillion yuan) yoy growthEnd-Aug 09 57.7 28.5% 38.5 34.1%End-Sep 58.5 29.3% 39.0 34.2%End-Oct 58.7 29.4% 39.3 34.2%End-Nov 59.5 29.7% 39.6 33.8%End-Dec 60.6 27.7% 40.0 31.7%

End-Jan 10 62.6 26.1% 41.4 29.3%End-Feb 63.6 25.5% 42.1 27.2%End-Mar 65.0 22.5% 42.6 21.8%End-Apr 65.7 21.5% 43.4 22.0%End-May 66.3 21.0% 44.0 21.5%End-Jun 67.4 18.5% 44.6 18.2%End-Jul 67.4 17.6% 45.1 18.4%

new RMB loans (trillion yuan) FY08 4.9 FY09 9.6

Aug 09 0.4Sep 0.5Oct 0.3Nov 0.3Dec 0.4

Jan 10 1.4Feb 0.7 Mar 0.5 Apr 0.8May 0.6Jun 0.6Jul 0.5

Source: People’s Bank of China

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III. Outlook

1. china’s economic growth showed signs of moderation

There are a number of signs that China’s economic growth has been moderating. The yoy growth rates of some major indicators, including GDP, FAI, VAIO, etc. could have already peaked: 1. China’s GDP growth moderated from 11.9% yoy in 1Q10 to 10.3% yoy in 2Q10.2. China’s nominal fixed asset investment (FAI) increased by 25.0% yoy in 1H10, lower than 30.1% yoy growth in

2009.3. The growth rate of China’s value-added of industrial output (VAIO) declined all the way from the recent peak of

20.7% yoy in Jan-Feb 2010 to 13.4% yoy in July.4. China’s PMI decreased from 55.7 in April to 53.9 in May, and further went down to 52.1 in June and 51.2 in July,

suggesting that the Chinese manufacturing sector was expanding at a slower pace.

These figures indicated the weaker growth momentum of the Chinese economy, caused by the government’s crackdown on real estate speculation, local government borrowing and industries with overcapacity. The decline in the yoy growth rates of the abovementioned indicators could also be attributed to the rising comparison bases in the same period of the previous year.

Looking forward, China’s economic growth is set to further moderate to around 9.0-9.5% yoy in 3Q10. But we are not overly worried about an economic downturn, or a “W-shaped” recovery in China, as both domestic demand and export demand are still strong. The real GDP growth in FY10 is widely expected to be higher than that in 2009 (9.1%). Various institutions have recently revised upward their forecasts for China’s GDP growth in FY10. (See exhibit 13)

exhibit 13: Forecasts for china’s gDP growth in 2010 by various organizations

Institution Previous forecast Latest forecastWorld Bank 9.0% (Jan 2010) 9.5% (Jun 2010)International Monetary Fund (IMF) 10.0% (Apr 2010) 10.5% (Jul 2010)Chinese Academy of Social Sciences 9.1% (Dec 2009) 9.9% (Apr 2010)

Quoted from various public sources

However, downside risks remain. First, the negative impact of the European debt crisis on China’s export sector will gradually unfold. Second, a number of sectors in China will soon face a serious problem of overcapacity, especially after the completion of projects currently under construction. As the global financial crisis and economic slowdown dealt a hard blow to the Chinese economy in late 2008, the government has put in great effort to boost investment to prop up the economy. Such action led to overinvestment, and in turn overcapacity in some sectors in China. The likely scenario is that there will be waves of factory closures, job losses and non-performing loans, once the advanced economies move into a double-dip recession.

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2. chinese entrepreneurs, in general, were optimistic about the prospects for their industries

Entrepreneurs, in general, remained optimistic about the prospects of their respective industries, as China’s Entrepreneur Confidence Index (ECI) stayed high at 133.0 in 2Q10, down slightly from the recent high of 135.5 in 1Q10.10 (See exhibit 14)

Nevertheless, 4 of the 8 sectors surveyed recorded lower readings in 2Q10, compared with 1Q10. Particularly noteworthy is that the ECI of the property sector slumped by 23.8 points from the previous quarter, reflecting the impact of property tightening measures on business sentiments. On the other hand, the ECI of the wholesale & retail sector remained high at 139.4 in 2Q10, still above the national average. (See exhibit 15)

Among various regions, the ECI in the eastern region recorded the smallest qoq drop in 2Q10, down by 0.5 points. Meanwhile, ECIs in the central and the western regions declined by 5.1 points and 3.7 points respectively from the previous quarter. (See exhibit 15)

Exhibit 14: Entrepreneur Confidence Index

3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10123.8 94.6 101.1 110.2 120.1 127.7 135.5 133.0


Exhibit 15: Entrepreneur Confidence Index: By sector

1Q10 2Q10 compared with the previous quarterNational 135.5 133.0 Lower

By sectorIndustry 133.7 131.0 Lower- Mining 148.5 –- Manufacturing 133.0 –- Electricity, gas & water 133.6 –Construction 142.2 142.8 Almost the sameTransportation, storage & post service 127.9 128.0 Almost the sameWholesale & retail 142.5 139.4 LowerProperty 133.1 109.3 LowerSocial services 132.9 136.4 HigherInformation transmission, computer service and software 152.8 149.0 LowerHotel & catering 127.8 131.8 Higher

By regionEastern region 133.6 133.1 Almost the sameCentral region 139.5 134.4 LowerWestern region 135.2 131.5 LowerSource: National Bureau of Statistics, PRC

10 China’s Entrepreneur Confidence Index (ECI) ranges from 0 to 200. A reading above 100 indicates an expectation of improving economic situation; A reading below 100 indicates an expectation of worsening economic situation.

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3. PMI softened to 51.2 in July

China’s manufacturing PMI came in at 51.2 in July, down from 52.1 in June. The PMI has declined for three consecutive months, indicating that growth momentum of China’s manufacturing sector has slowed. Nevertheless, the July reading was still above the critical level of 50, showing that the sector has continued to expand. We maintain our earlier view that we are not overly worried about an economic downturn in China. (See exhibit 16)

Except employment index, all sub-indices were lower than their respective levels in the previous month. As output index continued to moderate, we expect China’s industrial production growth to further soften in the next few months. New orders index and new export orders index fell by 1.2 and 0.5 respectively from the previous month to 50.9 and 51.2 in July, indicating slowing domestic and foreign demand.

On the other hand, cost pressure has continued to ease, as input prices index further dropped to 50.4 in July, down all the way from the recent high of 72.6 in April.

In July, 13 of the 20 industries recorded PMIs of 50 or above. Exceptions included Chemical fibres, rubber & plastics; Pharmaceuticals; Smelting of ferrous metals; Smelting of non-ferrous metals; Tobacco; Transport equipment; and Wood processing & furniture.

exhibit 16: china manufacturing PMI at a glance, Jul 2010

Index s. Adj Index Index compared with the Previous Month DirectionPMI 51.2 Lower ExpandingOutput 52.7 Lower ExpandingNew Orders 50.9 Lower ExpandingNew Export Orders 51.2 Lower ExpandingBacklogs of Orders 46.8 Lower ContractingStocks of Finished Goods 49.9 Lower ContractingPurchases of Inputs 52.2 Lower ExpandingImports 49.3 Lower ContractingInput Prices 50.4 Lower ExpandingStocks of Major Inputs 47.8 Lower ContractingEmployment 52.2 Higher ExpandingSuppliers’ Delivery Time 49.9 Lower Slackening

Source: Li & Fung Research Centre

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Part Two: Foreign Trade

I. Recent development

1. china’s export growth further accelerated, while import growth decelerated

After rebounding from 24.1% yoy in March to 30.4% yoy in April, China’s export growth accelerated quickly to 48.5% yoy in May and 43.9% yoy in June, and then moderated to 38.1% yoy in July. Note that China’s export hit record high in July (US$ 145.5 billion), as a result of strengthening demand from both advanced and emerging economies. Overall, China’s export surpassed the pre-crisis level and amounted to US$ 850.5 billion in the first seven months of 2010, up by 35.6% yoy. (See exhibit 17-19)

The abnormally high export growth in recent months was also attributable to the low comparison base11 in the same period last year, as well as the anticipation of both downward adjustments in export VAT rebate rates12 and RMB appreciation13.

It is worrisome that the deepening European debt crisis might worsen China’s export outlook, as the European Union (EU) is China’s top export destination. Nevertheless, in Jan - July 10, China’s export growth to the EU was very strong. The growth rate accelerated from 31.0% yoy in 1Q10 to 40.5% yoy in 2Q10 and 38.3% yoy in July, indicating that the negative impact of the debt crisis has so far been limited. One of the main reasons is that China’s exports to Greece, Spain, Italy, Portugal and Ireland, the European countries that face a serious sovereign debt crisis, take only a small share of China’s total export.14 On the other hand, the crisis has triggered the depreciation of the Euro against the RMB and other major currencies, as well as fiscal consolidation in the Eurozone. We expect the impact on China’s export to the region will start to unfold in 2H10 or early 2011.

On the other hand, China’s import increased from US$ 301.9 billion in 1Q10 to US$ 347.9 billion in 2Q10, reflecting the buoyant domestic demand. However, the import growth decelerated from 64.7% yoy in 1Q10 to 43.7% yoy in 2Q10 and 22.7% yoy in July, due to the higher comparison base in the same period last year.

Against the backdrop of faster export growth, China’s trade surplus rebounded all the way from US$ -7.4 billion in March 2010 to US$ 28.7 billion in July, the highest in eighteen months. Overall, the trade surplus totaled US$ 83.9 billion in the first seven months of 2010, down by 21.2% yoy.

11 China’s export growth declined to -26.5% yoy in May 2009, the lowest in 2009.12 On 22 June 2010, the Chinese government announced to scrap the export value-added-tax (VAT) rebates for 406 tariff items, effective

15 July 2010. The removal of the export VAT rebates would increase the unit cost of these products for export. Chinese exporters rushed to export their products before the effective date of the new measure. Detailed discussion can be found in the Highlight section.

13 The RMB has recently appreciated slightly against the US dollar, after staying relatively stable at around 6.80-6.85 throughout late August 2008 to mid June 2010. Detailed discussion can be found in the Highlight section.

14 China’s exports to the following countries, including Greece, Spain, Italy, Portugal, Ireland, accounted for 4.1% of China’s total export in 2008.

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exhibit 17: china’s quarterly foreign trade data, 3Q09 - 2Q10

USD billion (yoy growth) export Import Trade BalanceFY09 1,201.7 (-16.0%) 1,005.6 (-11.2%) 196.1 (-34.2%)

3Q09 325.0 (-20.3%) 286.2 (-11.9%) 38.8 (-53.4%)4Q09 355.1 (0.2%) 293.7 (22.3%) 61.4 (-46.3%)1Q10 316.1 (28.7%) 301.9 (64.7%) 14.2 (-77.3%)2Q10 389.0 (40.9%) 347.9 (43.7%) 41.1 (21.1%)Source: China Customs

exhibit 18: china’s monthly foreign trade data, Aug 2009 - Jul 2010

USD billion (yoy growth) export Import Trade BalanceAug-09 103.7 (-23.4%) 88.1 (-16.9%) 15.6 (-45.6%)Sep 115.9 (-15.3%) 103.1 (-3.5%) 12.8 (-56.3%)Oct 110.7 (-13.8%) 86.8 (-6.4%) 23.9 (-32.1%)Nov 113.7 (-1.2%) 94.6 (26.7%) 19.1 (-52.4%)Dec 130.7 (17.7%) 112.3 (55.9%) 18.4 (-52.8%)

Jan-10 109.5 (21.0%) 95.5 (85.9%) 14.0 (-64.2%)Feb 94.5 (45.7%) 87.0 (44.8%) 7.5 (57.0%)Mar 112.1 (24.1%) 119.4 (66.2%) -7.4 (-140.1%)Apr 119.9 (30.4%) 118.3 (49.8%) 1.6 (-88.0%)May 131.8 (48.5%) 112.2 (48.3%) 19.6 (49.7%)Jun 137.4 (43.9%) 117.4 (34.1%) 20.0 (151.7%)Jul 145.5 (38.1%) 116.8 (22.7%) 28.7 (180.6%)Source: China Customs

exhibit 19: growth rates of export and import, Aug 2008 - Jul 2010

Source: China Customs

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exhibit 20: export by category, 2009 & 1h10

yoy growth (%) of export value, calculated in US$ 2009 1h10Textile materials & products -8.4 32.3Garments & clothing accessories -11.0 16.0Footwear -5.7 20.8Toys -10.0 30.5Coal -54.7 -26.8Crude oil -28.2 -33.7Refined oil -8.5 112.1Steel -64.9 83.2Mechanical & electrical products -13.4 35.9


exhibit 21: Import by category, 2009 & 1h10

yoy growth (%) of import value, calculated in US$ 2009 1h10Cereal & cereal flour 22.7 51.8Soybean -13.9 25.4Iron ore -17.4 53.0Crude oil -31.0 113.1Refined oil -43.7 45.2Steel -16.9 7.6Synthetic yarn -4.1 26.2Vehicles and related parts 1.4 173.1


exhibit 22: Foreign trade of china (general & processing trade), 2009 - 2Q10

Yoy growth (%) share (%)Item FY09 1Q10 2Q10 FY09 1Q10 2Q10exports -16.0 28.7 40.9 100.0 100.0 100.0 Of which: General Trade -20.1 26.6 45.7 44.1 44.7 46.2 Processing Trade -13.1 29.8 35.6 48.8 48.0 46.5

Imports -11.2 64.7 43.7 100.0 100.0 100.0 Of which: General Trade -6.7 72.2 45.8 53.1 55.8 54.6 Processing Trade -14.8 56.1 42.3 32.1 29.4 30.6

Total of Imports and exports -13.9 44.1 42.4 100.0 100.0 100.0 Of which: General Trade -13.9 47.9 45.7 48.2 50.1 50.2 Processing Trade -13.7 38.4 38.0 41.2 38.9 39.0

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2. general trade grew faster than processing trade in 1h10

In 1H10, the growth rate of the trade value under general trade15 rose to 46.5% yoy, faster than that of processing trade (38.2% yoy). China’s import under general trade grew sharply by 56.6% yoy in 1H10, driven by the robust domestic demand for commodities. Besides, export under general trade expanded by 36.6% yoy in 1H10, improving greatly from the growth rate of 26.6% yoy in 1Q10. Consequently, the share of general trade in China’s total trade value increased to 50.2% in 1H10, compared to 46.8% in 4Q09. (See exhibit 22)

On the other hand, the share of processing trade16 in China’s total trade value decreased from 42.6% in 4Q09 to 39.0% in 1H10, indicating that processing trade has played a less important role in China’s foreign trade. Despite the falling share of processing trade in China’s total trade volume, processing trade accounted for 247.8% of China’s trade surplus in 1H10. (Note that processing trade recorded a trade surplus of US$ 137.3 billion, while general trade recorded a trade deficit of US$ 37.1 billion in 1H10.)

3. china’s trade with its major trading partners showed strong growth in 1h10; the negative impact of the european debt crisis on china’s export has so far been limited

China’s trade with its major trading partners showed strong growth in 1H10. Same as in FY09, the European Union (EU) was China’s biggest trading partner in 1H10, accounting for 16.2% of China’s total foreign trade. Sino-EU trade amounted to US$ 219.4 billion in 1H10, increasing by 37.2% yoy, compared to the negative growth of -14.5% yoy in FY09. (See exhibit 23 & 24)

Contrary to the case in FY09, China’s export to the EU rose more than its export to the US and Japan in 1H10, suggesting stronger rebound in demand from the EU. Export to the EU grew by 36.0% yoy, whilst export to the US and Japan gained 28.3% yoy and 25.2% yoy respectively in 1H10. It is worrisome that the deepening European debt crisis might worsen China’s export to the EU. Nevertheless, export growth to the EU even accelerated from 31.0% yoy in 1Q10 to 40.5% yoy in 2Q10 and 38.3% yoy in July, indicating that the negative impact of the debt crisis has so far been limited.

The US remained China’s second largest trading partner in 1H10. Sino-US trade rose by 30.2% yoy to US$ 172.0 billion in 1H10, compared to the negative growth of -10.6% yoy in FY09.

Japan was the third largest trading partner of China in 1H10. Sino-Japan trade grew by 37.0% yoy to US$ 136.6 billion in 1H10, accounting for 10.1% of China’s total foreign trade.

15 General trade refers to the import or export of goods by enterprises in China with import-export rights. According to the Chinese statistics, the scope of general trade covers: import and export using loans or aids; the import of materials by foreign invested enterprises (FIEs) for processing of goods for sale in the domestic market; the export of goods purchased by FIEs or manufactured by processing domestically-produced materials; the import of food and beverages by restaurants and hotels; the supply of domestically-produced fuel, materials, parts and components to foreign vessels or aircraft; the import of goods as payment in kind in lieu of wages in labour service cooperation projects with foreign countries; and the export of equipment and materials by enterprises in China for their investment abroad.

16 Processing trade refers to the business activity of importing all or part of the raw and auxiliary materials, parts and components, accessories, and packaging materials from abroad, and re-exporting the finished products after processing or assembling by enterprises within the Chinese Mainland.

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Boosted by the establishment of the ASEAN-China Free Trade Area (ACFTA)17 since 1 Jan 2010, China’s trade with the Association of South East Asian Nations (ASEAN) registered a stunning growth of 54.7% yoy in 1H10, compared to -7.9% yoy in FY09. As a result, Sino-ASEAN trade has gained weight – its share in China’s total foreign trade rose from 9.7% in FY09 to 10.1% in 1H10. Note that Sino-ASEAN trade hit US$ 136.5 billion in 1H10, only marginally lower than Sino-Japan trade. Looking forward, if this upward trend continues, the ASEAN will overtake Japan to become China’s third largest trading partner very soon.

4. The other BRIc members accounted for a bigger share of china’s total export

In 1H10, the other three members of the BRICs, namely, Brazil, Russia and India, accounted for 6.1% of China’s total trade, up from 5.6% in FY09. Driven by the strengthening demand from the BRIC economies, together they gained a bigger share in China’s export, increasing from 5.1% in FY09 to 5.8% in 1H10. On the other hand, together they accounted for 6.5% of China’s total import in 1H10, up from 6.3% in FY09. The yoy growth rates of China’s import from the BRIC economies were strong in 1H10. A major reason was the significantly higher international commodity prices compared with the same period last year. (See exhibit 23 & 24)

exhibit 23: china’s trading partners, 1h10

country Trade value share of total export value Import value yoy growth (%)/Region (usD billion) trade (%) (usD billion) (usD billion) Total trade export ImportEU 219.4 16.2 140.7 78.7 37.2 36.0 39.4 US 172.0 12.7 124.5 47.5 30.2 28.3 35.6 Japan 136.6 10.1 55.1 81.4 37.0 25.2 46.3 ASEAN 136.5 10.1 64.6 71.9 54.7 45.4 64.0 Brazil 26.4 1.9 10.3 16.1 60.3 103.7 41.1 Russia 25.8 1.9 11.8 14.0 51.6 59.2 45.6 India 30.4 2.2 18.5 11.9 54.9 41.8 80.7


exhibit 24: china’s trading partners, comparing the growth rates of 2009 & 1h10

Yoy growth (%)country/Region Total trade export Import 2009 1h10 2009 1h10 2009 1h10EU -14.5 37.2 -19.4 36.0 -3.6 39.4US -10.6 30.2 -12.5 28.3 -4.8 35.6Japan -14.2 37.0 -15.7 25.2 -13.1 46.3ASEAN -7.9 54.7 -7.0 45.4 -8.8 64.0Brazil -12.9 60.3 -24.9 103.7 -5.3 41.1Russia -31.8 51.6 -47.1 59.2 -10.7 45.6India -16.3 54.9 -6.1 41.8 -32.3 80.7


17 Detailed discussion can be found in Li & Fung Trade Quarterly, Issue 17.

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5. Jiangsu recorded impressive export growth in 1h10

The top three provinces/municipalities in terms of foreign trade values – Guangdong, Jiangsu and Shanghai – jointly accounted for 54.0% of China’s total foreign trade in 1H10. In 1H10, the total value of export and import of Guangdong was US$ 345.2 billion, up by 33.9% yoy; that of Jiangsu surged by 49.2% yoy to US$ 214.6 billion; and that of Shanghai increased strongly by 42.5% yoy to US$ 171.8 billion.

Guangdong remained the biggest contributor to China’s export in 1H10, as the total export value of the province amounted to US$ 195.6 billion. Nevertheless, its export growth of 27.5% yoy was much lower than the national growth rate of 35.2% yoy in 1H10. Meanwhile, Jiangsu, one of the major manufacturing bases in China, recorded impressive export growth of 44.4% yoy in 1H10.

6. FDI in china showed strong growth; FDI in the tertiary sector increased significantly by 38.2% yoy in 1H10

China’s utilized foreign direct investment (FDI) increased by 19.6% yoy to US$ 51.4 billion in 1H10, greatly improved from the negative growth of -2.6% yoy in FY09. (See exhibit 25)

Among industries, FDI in the tertiary sector increased significantly by 38.2% yoy in 1H10. The figure provides evidence that China’s domestic market has become promising enough to lure foreign companies to invest in the tertiary industry. By contrast, the growth rate of FDI in the manufacturing sector was much lower, which was only 1.9% yoy in 1H10.

Looking forward, we expect FDI in China to maintain strong growth in the foreseeable future, boosted by the optimism about China’s economy.

exhibit 25: china’s foreign direct investment (FDI), Jul 2009 - Jun 2010

Amount (us$ billion) yoy growthFY08 92.4 23.6%FY09 90.0 -2.6%

Jul-09 5.4 -35.7%Aug 7.5 7.0%Sep 7.9 18.9%Oct 7.1 5.7%Nov 7.0 32.0%Dec 12.1 103.1%

Jan-10 8.1 7.8%Feb 5.9 1.1%Mar 9.4 12.1%Apr 7.3 24.7%May 8.1 27.5%Jun 12.5 39.6%

Source: Ministry of Commerce, PRC

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7. The accumulation of the foreign exchange reserves declined to us$ 7.2 billion in 2Q10

As at 30 Jun 2010, China’s foreign exchange reserves totaled about US$ 2.45 trillion. The accumulation of the foreign exchange reserves declined all the way from US$ 177.9 billion in 2Q09 to US$ 7.2 billion in 2Q10. (See exhibit 26)

The sharp decrease in the foreign exchange accumulation in 2Q10 was attributable to the capital outflow, as well as the drop in value of euro-denominated assets held by the mainland government18 due largely to the depreciation of the Euro against the US dollar in 2Q10. The nominal USD/Euro exchange rate was 1.22 on 30 June, compared to 1.35 on 31 March.

Looking forward, China’s foreign exchange reserves are expected to post bigger gains in the coming months, boosted by larger hot money inflows due to the renewed anticipation of RMB appreciation. The RMB has recently appreciated slightly against the US dollar, after China’s central bank announced to “proceed further” with the reform of the RMB exchange rate regime on 19 June 2010. (Detailed discussion can be found in the Highlight section.)

exhibit 26: Foreign exchange reserves by quarter, 3Q09 - 2Q10

USD billion Accumulation end of the quarterFY09 453.1 2,399.2

3Q09 141.0 2,272.64Q09 126.6 2,399.21Q10 47.9 2,447.12Q10 7.2 2,454.3

Source: State Administration of Foreign Exchange, PRC

II. highlights

1. The RMB has appreciated slightly against the us dollar since 19 June 2010

The nominal RMB/USD exchange rate stayed relatively stable at around 6.80-6.85 throughout late August 2008 to mid-June 2010. On 19 June 2010, the People’s Bank of China (PBOC), China’s central bank, announced to “proceed further” with the reform of the RMB exchange rate regime and to increase the flexibility of the RMB exchange rate.19 The central bank reiterated that the RMB exchange rate would be determined with reference to a basket of currencies, instead of pegging to the US dollar solely. Such an important announcement signaled a big change in the Chinese government’s exchange rate policy. Afterwards, the RMB has appreciated slightly against the US dollar, with the nominal RMB/USD exchange rate edging up from 6.83 on 21 June to 6.77 on 9 August. (See exhibit 27 and 28)

18 According to an expert at the Chinese Academy of Social Sciences, more than 20% of China’s foreign exchange reserves are held in the form of euro-denominated assets.

19 http://www.pbc.gov.cn/detail.asp?col=100&ID=3664

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On the other hand, the RMB has appreciated strongly against the Euro since late November 2009: The nominal RMB/Euro exchange rate strengthened from the recent low of 10.32 on 26 November 2009 to 8.13 on 7 June 2010, before depreciating a bit to 8.99 on 9 August. (See exhibit 27)

Against its trading partners, the RMB appreciated by 2.7% in real terms in 2Q10, as indicated by the real effective exchange rate (REER) compiled by the Bank for International Settlements.20 The RMB REER rose from 116.06 in April 2010 to 119.97 in May, due largely to the rebound of the US dollar against the currencies of a number of countries, and then softened a bit to 118.80 in June. Overall, the RMB appreciated by 3.2% in real terms in the first six months of 2010. (See exhibit 29)

Since the introduction of the reform of the RMB exchange rate regime in late July 2005, the RMB has been depegged from the US dollar, and the RMB exchange rate has been determined with reference to a basket of currencies. During July 2005 - late August 2008, the RMB gained by more than 20% against the US dollar. The global financial crisis broke out afterward, leading to sharp contraction in export and in turn, serious job losses and factory closures in China. Therefore, the RMB appreciation against the US dollar stopped from late August 2008 to mid-June 2010. (See exhibit 28)

In recent months, China’s export in current US dollar terms has returned to the pre-crisis level and started to record strong yoy growth. At the same time, international pressure for RMB appreciation has been building up. Many global leaders, including the US president Obama, the International Monetary Fund’s Managing Director Dominique Strauss-Kahn and the Asian Development Bank’s President Haruhiko Kuroda have called for RMB appreciation. Indeed, many of China’s key trading partners have blamed the weak RMB for harming their domestic industries seriously. Particularly noteworthy is that, in mid-March, a group of 130 members of the US Congress called on the US Treasury Secretary Timothy Geithner to impose countervailing duties on Chinese imports, in a bid to pressure China into appreciating the RMB.

Looking ahead, we expect a gradual appreciation of the RMB against the US dollar to take place in the near term, thereby easing international pressure, as well as bringing down the prices of imported commodities in RMB terms. It is forecast that the RMB will gain about 2% against the US dollar in 2010. It is unlikely that there will be a substantial RMB appreciation against the US dollar. Otherwise, the competitiveness of China’s exports will be weakened seriously, and it will cause a big loss in value (in RMB terms) of China’s foreign exchange reserves.21

20 The Bank for International Settlements (BIS) calculates effective exchange rate (EER) indices for a total of 58 economies (including individual euro area countries and, separately, the euro area as an entity). Nominal EERs are calculated as geometric weighted averages of bilateral exchange rates. Real EERs are the same weighted averages of bilateral exchange rates adjusted by relative consumer prices. The weighting pattern is time-varying, and the most recent weights are based on trade in 2005-07.

21 According to the local media, more than 60% of China’s foreign exchange reserves are held in US dollar-denominated assets. http://www.cs.com.cn/xwzx/03/201007/t20100706_2499504.htm

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exhibit 27: RMB/usD and RMB/euro, Aug 2009 - Aug 2010

Source: State Administration of Foreign Exchange

exhibit 28: RMB/usD, May 2005 - Aug 2010

Source: State Administration of Foreign Exchange

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exhibit 29: RMB ReeR, Jul 2009 - Jun 2010

Source: Bank for International Settlements

2. The pilot program for using RMB for cross-border trade transactions has been expanded to cover all foreign countries and designated enterprises in twenty provinces/municipalities in china

On 22 June 2010, the Chinese government announced that the pilot program for using RMB for cross-border trade transactions would be expanded to cover all foreign countries, as well as designated enterprises in twenty provinces/municipalities in China.22 These twenty provinces/municipalities include Guangdong, Shanghai, Jiangsu, Zhejiang, Beijing, Tianjin, Chongqing, Shandong, Inner Mongolia, Liaoning, Jilin, Fujian, Sichuan, Xinjiang, Yunnan, Hubei, Hainan, Heilongjiang, Guangxi and Tibet. The effective date of the new measure is not mentioned in the announcement. Nevertheless, the local media reports that the program has kicked off in a number of provinces/municipalities such as Beijing, Zhejiang, Shangdong, Jiangsu, Sichuan ,etc. in recent weeks.

In early July 2009, the Chinese government first launched the pilot program, which enables companies in Hong Kong, Macau and ASEAN to settle trades in RMB with designated enterprises in Shanghai, Guangzhou, Shenzhen, Zhuhai and Dongguan. The volume of trades settled in RMB increased significantly in 2Q10, amounting to 48.7 billion yuan, up 165% from the previous quarter. The recent expansion of this program is expected to further boost the volume of trades settled in RMB.

Currently, most Mainland enterprises face currency risk, as they are only permitted to use foreign currencies to settle trades with its foreign trading partners – and the US dollar is the mostly used currency. In fact, the RMB has appreciated slightly against the US dollar since late June 2010, after staying stable against the US dollar throughout late August 2008 to mid-June 2010. If the RMB continues to appreciate against the US dollar, Mainland exporters who need to convert their USD receipts into RMB will find their profit margins eroded. To reduce exporters’ currency risk, we believe the government will expand the program to cover all enterprises in the whole country soon.

22 http://big5.china.com.cn/finance/txt/2010-06/22/content_20318718.htm

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3. The economic cooperation Framework Agreement (ecFA) between the chinese Mainland and Taiwan was signed on 29 June 2010

Taiwan signed the Economic Cooperation Framework Agreement (ECFA) with the Chinese Mainland on 29 June 2010, which is a milestone in cross-strait ties. The ECFA aims to set out the framework and targets; and is not a one-off agreement. The content will be expanded step-by-step in future negotiations. More deregulations are in the pipelines.

To satisfy the demand for urgent actions in certain sectors, the ECFA includes an “early harvest” plan, which will hopefully take effect in January 2011 after Taiwan’s Legislative Yuan’s approval. Good and services not included in the early harvest list will be dealt with in future ongoing negotiations. Apart from the trade pact, the two sides have also signed an agreement on intellectual property rights protection.

The early harvest list includes tariff reduction/ removal and liberalization of trade in services, as summarized below:

(1) Tariff concessions

Import duties on 539 tariff items of Taiwanese exports will be eliminated gradually. Taiwan will follow a similar time frame to eliminate the tariffs it presently imposes on 267 goods from the Chinese mainland.

Included in the agreement is a set of provisional rules governing certificate of product origins. The provisional rules prescribe more stringent regulations in defining product origins. According to the head of Taiwan’s Department of Customs Administration, the required percentage of content provided at product origins should be between 40% and 50%.

(2) Open up service industries

The Chinese Mainland will open up 11 service industries to Taiwan: accounting and audit; computer services (software & data processing); research & development (natural science & engineering); convention; professional design; film import; hospital; civil aircraft maintenance; banking; securities; insurance.

Taiwan will liberalize 9 service sectors to the Chinese Mainland: research and development; convention; exhibition; product design; film import; agency services; sports and entertainment; air ticketing; banking and financial services (excluding securities, futures and insurance).

The ECFA is set to further advance cross-strait relations and give a major boost to two-way trade. According to a prediction by the Taipei-based Chung-Hua Institution for Economic Research, the signing of the ECFA will help to raise Taiwan’s GDP by 1.65-1.72%, and Taiwan’s exports and imports by 4.87-4.99% and 6.95-7.07%. respectively. In addition to gradual tariff reductions in goods and open-ups in services after signing the ECFA, one of the possible supplements is to deepen development in the Strait-West Coast Economic Zone, particularly for the financial sector.

Signing the ECFA will help Taiwan avoid being marginalized in the face of increasing trade blocs in the region and opening the door for similar treaties between Taiwan and other countries. The inking of the ECFA will hopefully reduce the obstruction to Taiwan’s effort to sign FTAs with other trading partners with improved cross-strait ties.

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The ECFA, coupled with the progress in Three Linkages and other measures offered by the Taiwan government to attract foreign investment and to encourage the return of Taiwan businesses to the domestic markets (such as the reduction of corporate income tax and offering incentives for building R&D centers), will enhance the incentive for multinationals/ Taiwan companies to invest in Taiwan.

Looking ahead, the two sides will continue discussing agreements for commodity trade, service trade and investment six months after the ECFA takes effect. Further discussion will include tariff reduction and removal; rules of origin; customs procedures; trade remedies. Discussions on service trade agreement will focus on cutting and removing restrictive measures gradually, enlarging the service sectors covered, and enhancing cross-strait cooperation. In addition, the two sides agree to enhance cooperation in medical and health, intellectual property protection, investment protection, finance, trade facilitation, customs, and E-business at the new round of talks.

4. The chinese government announced to scrap export VAT rebates for 406 tariff items

On 22 June 2010, the Chinese government announced to scrap the export value-added-tax (VAT) rebates for 406 tariff items, effective 15 July 2010.23 These 406 tariff items include various types of products such as steel and non-ferrous metal products, silver powder, ethanol, corn starch, glass products, pesticides, pharmaceuticals, chemicals, plastics and rubber. The removal of the export VAT rebates would increase the unit cost of these products for export.

In fact, during 2006 - early 2008, the Chinese government eliminated or slashed export VAT rebate on a large number of products, and expanded the prohibited and restricted lists for processing trade, with an aim to discourage the export of products that were energy- and resource-intensive, highly polluting, labour-intensive and low value-added, as well as to promote industrial upgrading. However, the global financial crisis and economic slowdown dealt a hard blow to the export sector in China. The government reversed its earlier policy and raised the export VAT rebate rates for selected products for seven times during late 2008 - June 2009.

Currently, China’s exports in US dollar terms have already returned to the pre-crisis level and are showing strong growth again. The latest policy to scrap export VAT rebates indicates that the Chinese government is renewing its efforts to discourage undesirable industries.

5. Total value of deals signed at the 107th canton Fair increased by 12.6% from the previous session

Total value of deals signed at the 107th China Import and Export Fair24 (famously known as the Canton Fair), held in Apr-May 2010, increased by 12.6% from the previous session held in Oct-Nov 2009. These figures reflected the continuous improvement of China’s export sector. Total value of deals signed at the Canton Fair amounted to US$ 34.3 billion in this session, which was still lower than the pre-crisis level of US$ 38.2 billion in the Apr-May 2008 session.

23 http://szs.mof.gov.cn/zhengwuxinxi/zhengcefabu/201006/t20100622_323730.html24 The China Import and Export Fair is China’s largest and oldest trade exhibition, which is regarded as the barometer of China’s trade.

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It is noteworthy that the Chinese exporters, in general, were cautious about taking orders, and tended to sign short-term contracts with their foreign counterparts. 53% of orders were scheduled to be fulfilled within three months. One of the main reasons was that they were uncertain about the rate at which production costs increase.

The number of overseas buyers totaled 203,996 in this session, up by 8.4% from the previous session. Looking closer at the country breakdown, the number of overseas buyers from the EU and Japan, two major trading partners of China, declined by 15.2% and 4.6% respectively from the previous session. On the other hand, the number of overseas buyers from non-traditional markets recorded rapid growth. For example, buyers from Oceania, Africa and Asia grew by 23.6%, 17.7% and 10.5% respectively from the previous session.

6. The number of new import-restricting measures imposed by the WTO members decreased sharply in 1Q10, but chinese exporters were still adversely affected by trade protectionism

According to a report published by the World Bank, the number of new product-level definitive import restrictions imposed by the WTO members decreased sharply from 31 in 4Q09 to 12 in 1Q10, the lowest since 2Q08.25

However, Chinese exporters were still adversely affected by trade protectionism. Among different countries, China faced the greatest number of new import-restricting measures in 1Q10. Of the total new product-level import restrictions targeted at specific countries, around 82% were imposed on China in 1Q10. For example, Argentina and Brazil announced to impose anti-dumping measures on footwear products imported from China in March. China also faced 47.4% (9 of the 19) of all newly launched import-restricting trade remedy investigations in 1Q10.

III. Outlook

1. The world economy grew faster than expected in 1Q10, but facing higher downside risks

According to a report published by the International Monetary Fund (IMF) in early July26, the world economic growth was faster than expected in 1Q10, boosted by the robust Asian economy. The institution, thus, revised upward its earlier forecast for the world economic growth in FY10 from 4.2% to 4.6%. Of which, the advanced economies, and the emerging and developing economies will increase by 2.6% and 6.8% respectively in FY10. (See exhibit 30) It is forecast that the world economy growth will moderate a bit to 4.3% in FY11.

Nevertheless, the institution warned that the recent financial turbulence triggered by the European sovereign debt crisis could eventually lead to the reduction of the supply of bank credit and government spending, as well as undermining business and consumer confidence, thereby worsening the growth outlook.

25 World Bank, A Monitoring Update to the Temporary Trade Barriers Database, 25 May 2010 http://siteresources.worldbank.org/INTTRADERESEARCH/Resources/544824-1272916036631/Bown-TTBD-Monitoring-

Report-05-2010.pdf26 IMF, World Economic Outlook Update, 7 July 2010

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exhibit 30: Latest global economic forecasts by the IMF

yoy growth (%) 2009 2010 (forecast) 2011 (forecast)World economy -0.6 4.6 4.3Advanced economies -3.2 2.6 2.4Emerging and developing economies 2.5 6.8 6.4

Source: IMF

2. The us economic growth continued to moderate in 2Q10

Of particular concern to China’s foreign trade outlook is the US economy. The US real GDP rose at an annual rate of 2.4% in 2Q10, compared to 3.7% in 1Q10. The economic growth has moderated for two consecutive quarters, heightening the concerns over the sustainability of the US recovery. (See exhibit 31)

The US consumer spending, which accounts for around 70% of the US economy, registered an annual growth rate of 1.6% in 2Q10, down from 1.9% in 1Q10. The US retail sales registered negative mom growth rate of -1.1% and -0.5% in May and June respectively, after showing positive mom growth for seven consecutive months. (See exhibit 33)

The decline in US retail sales could be attributed to the weak labor market. The US unemployment rate edged down from 9.7% in May to 9.5% in June, due largely to the decline in labour force, and then stayed high at 9.5% in July. (See exhibit 34) Compared to the previous month, the non-farm payroll employment decreased by 131,000 in July. Of which, the private-sector payroll employment in July rose by 71,000 from the previous month, pales in comparison with the job gains of 241,000 in April, reflecting the slower private job growth.

Looking forward, we expect the demand from US consumers to further moderate in the near term, especially as US consumer confidence has weakened. The Reuters/University of Michigan index of consumer sentiment dropped sharply from 76.0 in June to 67.8 in July, the lowest since Nov 2009. (See exhibit 33)

On the production side, US manufacturers reduced industrial output of consumer goods by 0.6% mom in June. Overall, the industrial production growth in the US slowed from 1.3% mom in May to 0.1% mom in June. (See exhibit 32) Besides, according to the US Department of Commerce, new orders for manufactured durable goods have declined for two consecutive months, down by 0.7% mom and 1.2% mom in May and June respectively on a seasonally-adjusted basis, indicating reduced market demand.

Nevertheless, some positive signs remain. According to the Institute for Supply Management, the manufacturing PMI has already stayed above the critical level of 50 for twelve consecutive months, suggesting a sustained recovery of the US manufacturing sector; the non-manufacturing index (NMI) remained high at 54.3 in July, indicating relatively fast expansion of the non-manufacturing sector.

Looking ahead, we believe that the US recovery will continue, albeit with some moderation. Various institutions predicted that US economic growth in FY11 will be lower than in FY10. For example, in early July, the IMF projected that the US GDP will grow by 3.3% and 2.9% in real terms in FY10 and FY11 respectively.27 In early June, the World Bank also forecasted that the US real GDP will grow by 3.3% and 2.9% in FY10 and FY11 respectively.28

Against the backdrop of slowing US recovery, it will be hard for China to maintain the currently strong export growth to the US in FY11.27 IMF, World Economic Outlook Update, 7 July 201028 World Bank, Global Economic Prospects Summer 2010, 10 June 2010

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exhibit 31: us national accounts, 2008 - 2Q10

annual growth (%) 2008 2009 3Q09 4Q09 1Q10 2Q10GDP 0.0 -2.6 1.6 5.0 3.7 2.4

exhibit 32: us industrial output growth, Jan - Jun 2010

mom growth(%), seasonally adjusted Jan-10 Feb Mar Apr May JunIndustrial production 1.0 0.0 0.6 0.3 1.3 0.1

Source: US Federal Reserves

exhibit 33: us consumer market, Feb - Jul 2010

Feb Mar Apr May Jun JulRetail and food services sales 0.6 2.1 0.3 -1.1 -0.5 –(mom growth %, seasonally adjusted)Reuters/University of Michigan index of 73.6 73.6 72.2 73.6 76.0 67.8consumer sentimentCPI (yoy growth %) 2.1 2.3 2.2 2.0 1.1 –

Source: US Department of Commerce, Reuters/University of Michigan Surveys of Consumers, US Department of Labor

exhibit 34: us employment situation

unemployment nonfarm payroll employment, Aug 2009 - Jul 2010 rate (%) In thousands, seasonally adjusteded2008 5.82009 9.3

Aug-09 9.7Sep 9.8Oct 10.1Nov 10.0Dec 10.0Jan-10 9.7Feb 9.7Mar 9.7Apr 9.9May 9.7Jun 9.5Jul 9.5yearly figures: annual average Source: US Department of Labormonthly figures: seasonally adjusted

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3. The eurozone gDP growth remained slow in 1Q10

Supported by the improvement in government expenditure and export, real GDP growth in the Eurozone29 increased slightly from 0.1% qoq in 4Q09 to 0.2% qoq in 1Q10, but still lower than the recent high of 0.4% qoq in 3Q09. (See exhibit 35) In 1Q10, investments fell by 1.2% qoq; government final consumption expenditure grew by 0.2% qoq; household final consumption expenditure edged down by 0.1% qoq; exports and imports increased by 2.1% qoq and 3.8% qoq respectively, compared with the previous quarter. The retail sales in the Eurozone have remained weak. The volume of retail trade in the region in June stayed unchanged from the previous month. (See exhibit 36) Particularly noteworthy is that the volume of retail trade in Germany and France recorded negative growth of -0.9% mom and -1.3% mom respectively in the month, indicating that consumers in the two largest economies in the Eurozone reduced spending. One of the major causes of the sluggish demand was the poor employment market in the Eurozone: The unemployment rate in the region hit 10.0% in June, the highest in twelve years. (See exhibit 37)

The above figures pointed to a still weak Eurozone economy. Concerns over the European debt crisis have been deepening since May. The high sovereign risk in the region is set to pose greater downside risks to the economy. To reduce budget deficits, many member countries of the Eurozone have intensified their efforts to lower fiscal expenditures as well as to raise taxes. Taking into account the additional fiscal consolidation after the financial turbulence, the IMF in July reduced its forecast for the Eurozone GDP growth in FY11 to 1.3% in real terms, down 0.2 ppt. from its previous forecast made in April 2010.

Since November 2009, the Euro has depreciated sharply against other major currencies. For example, the nominal RMB/Euro exchange rate went down from 10.32 on 26 November 2009 to 8.13 on 7 June 2010, before rebounding a bit to 8.99 on 9 August. The Euro depreciation against the RMB has weakened the competitiveness of Chinese exports. China’s export growth to the EU, China’s biggest trading partner, was robust in Jan - Jul 10, reaching 36.4% yoy. However, we expect the impact of modest economic growth in the Eurozone and the weak Euro on China’s export to the region will start to unfold in 2H10 or early 2011. (Currently, the Eurozone comprises 16 of the 27 member countries of the EU.)

exhibit 35: eurozone gDP growth, 2008 - 1Q10

2008 2009 2Q09 3Q09 4Q09 1Q10GDP (qoq growth %) -0.1 0.4 0.1 0.2GDP (yoy growth %) 0.5* -4.1 -4.9 -4.1 -2.1 0.6

* The figure in 2008 does not reflect Slovakia’s membership of the Eurozone, which has begun on 1 January 2009.Source: Eurostat

29 The member countries of the Eurozone include Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, Netherlands, Portugal, Slovenia, Spain and Slovakia.

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exhibit 36: eurozone consumer market, Jan - Jun 2010

Jan-10 Feb Mar Apr May JunVolume of retail trade -0.3 0.0 0.7 -1.0 0.4 0.0(mom growth %, seasonally adjusted)Annual inflation (%) 1.0 0.9 1.4 1.5 1.6 1.4

Source: Eurostat

exhibit 37: eurozone labor market, Jan - Jun 2010

Jan-10 Feb Mar Apr May JunUnemployment rate (%) 9.9 9.9 10.0 10.0 10.0 10.0

Source: Eurostat

exhibit 38: eurozone economic sentiment indicator, Feb - Jul 2010

seasonally adjusted Feb-10 Mar Apr May Jun JulEconomic sentiment indicator 95.9 97.9 100.6 98.4 99.0 101.3

Source: Eurostat

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Li & Fung Research centre Member of the Li & Fung group 利豐研究中心Founded in Guangzhou in 1906, the Li & Fung group is a multinational group of companies headquartered in Hong Kong, operating in three distinct core businesses - export sourcing, integrated distribution and retailing. The Li & Fung Group has a total staff of over 35,000 across more than 40 countries worldwide, with an annual turnover exceeding US$15.8 billion in 2009. One of its core competency is Supply Chain Management (SCM).

Li & Fung Research centre (“the Centre”) researches and publishes reports on wide-ranging topics: Chinese economy, consumer market, retail sector, trade-related issues, and consumer goods industries, etc. Apart from providing internal consultancy for the Group and its clients, the Centre also participates in formulating business strategies in the Mainland market.

The Centre has been actively promoting the application of SCM. In 2003, the Centre published the book “The Orchestrator of Global Supply Chain Management”, which is regarded as a very useful reference among businessmen and academics in the Chinese mainland, Taiwan and Hong Kong. The revised and expanded edition was published in August 2009.

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