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Monday, July 24, 2006

Overshooting in China?

Some comments by GaveKal Research this time on the recently released China Q2 GDP figures. They believe that GDP wasn't actually as high as the headline numbers, based on their proxy indicators, like electricity production and import growth. They believe no more rate hikes and reserve requirement hikes will happen for the meantime. Of course, we just got word that reserve requirement ratios have been hiked for the 2nd time in 5 weeks. Anyways, it is still useful commentary as it might also have bearing on our expected revaluation in the Rmb, which supports majority of our bullish stance on HK-listed Chinese equities.


China's growth continues to power ahead; but there is little evidence of a blow-out. The much-advertised "real" growth rate - 11.3% in Q2, a full point higher than in Q1 - is only as real as the deflator used to calculate it. And the latest deflator is decidedly dodgy. The National Bureau of Statistics (NBS) would have us believe that the GDP deflator slowed from 3.5% in Q1 to 2.9% in Q2, even though every other price index showed an accelerating trend during that period. This is most implausible.

Nominal GDP figures suggest that while growth has clearly accelerated over the past nine months, the acceleration is more modest than suggested by the "real" numbers. This interpretation is supported by growth in electricity production (one of our favored proxies) which, though somewhat volatile, is on a moving-average basis, still hovering around its 2005 average of just under 13%. Import growth (a significant indicator of domestic demand) has also clearly peaked and is now trending downwards.

Even at their current exalted levels, both nominal GDP and fixed asset investment growth remain well below their stratospheric highs of 2003-04. We suspect that the trend of headline GDP growth will be a bit hard to read for the remainder of the year, in part because there has been a change at the top of NBS. The old commissioner, Li Deshui, who appeared allergic to reporting GDP growth in excess of 10%, was axed over Chinese New Year. His successor, Qiu Xiaohua, appears more comfortable with reporting high growth rates, so the high numbers reported today and in April may in part reflect an effort by the new regime to bring physical and statistical reality into closer alignment. Nevertheless, the dodgy deflator also suggests another, more depressing interpretation: apparent growth is being maximized now, to make it easier to report a slowdown in H2, thereby vindicating government policy... Having said that, the big picture is that growth is very strong and likely to remain so for another 12 months, underpinned by strong fixed-asset investment growth, a swelling trade surplus, and a very impressive surge in industrial production.

Investment, we think, is being pumped up by local officials anxious to make a good impression before the next round of promotions in the middle of next year, leading up to the big Communist Party Congress in the fall of 2007. This type of investment is likely to begin tailing off in Q1 next year.

On this logic of a likely structural downturn next year, the government will want to be careful about the risk of overshooting on monetary tightening this year. Hence we anticipate no further hikes in interest rates or bank reserve ratios until the impact on credit growth of the most recent reserve-ratio increase - which only took effect in early July - is clear. There was some evidence of deceleration in loan growth in June and if this continues in July and August then there will be little case for additional tightening.

Aside from loan growth, the other numbers that bear watching are price indices. These all steadily declined from mid-2004 highs down to a trough in late 2005. Since then they have all picked up again, with the exception of the manufactured GDP deflator. The swiftness with which the previous trend was reversed suggests that the economy is running at very close to full capacity. If the policy stance is correct, then price indices (which are calculated on a year-on-year basis and so will continue to bulge on a low-base effect) should continue to rise moderately until about November and then crest. If, however, the authorities have underestimated the strength of demand, then we could see a severe inflationary spike in early fall which could prompt another interest rate rise.


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