ms report on China Economy

[Tony_onrock]

MORGAN STANLEY RESEARCH

 

CHINA ECONOMICS: DEJA VU: DISSECTING HEIGHTENED UNCERTAINTY - February 08, 2010 GMT (6 pgs/ 63 kb)

 

Qing Wang +852 2848 5220 Morgan Stanley Asia Limited

Steven Zhang +86 21 2326 0029

 

Deja vu: There has been tremendous uncertainty about economic and policy outlook of late. At such times we tend to look to recent history for guidance. Is this going to be like 2003-04 where the authorities responded to an overheating economy with campaign-style macro-controls in Apr 04 that lasted about 6 months, and both the economy and stock market demonstrated remarkable resilience? Or is this going to be like 2006-2007 when aggressive credit controls were imposed in Oct 07-especially vis-a-vis the property sector-lasting for about 9 months and contributed to-albeit not directly causing-a hard landing of the economy upon the onset of the Great Recession.

 

Dissecting heightened uncertainty: First, a repeat of 2003-04 is possible IF external demand were to turn out to be extraordinarily strong ('the Summer: Overheating' scenario under our four-season framework). Second, a repeat of 2007-08 is possible IF Chinese authorities were to fail to learn the lesson from their management of the property sector in 2008 and go down the same policy route in 2010 and the major industrial economies were to suffer a 'double-dip' in growth ("the Winter: Policy-induced Double Dip' scenario). Last but not the least, entering 2010 the Chinese economy is facing a weak (instead of strong, as in 2003-04) but improving (instead of deteriorating, as in 2007-08) external environment. This, together with less political-cycle influence, will make Chinese authorities more likely to get macro policy right this time, in our view.

 

Conclusions: ''The Autumn: Goldilocks' under our four-season framework remains our base case scenario. While the heightened uncertainty of late has already taken its toll on the stock market, the rather violent market reaction since the beginning of the year is unwarranted, in our view. We endorse the investment theses recently put forward by our equity strategy team.

 

 

 

Introduction: Deja vu

 

There has been tremendous uncertainty about economic and policy outlook of late. In such times we tend to look to recent history for guidance. Is this going to be like 2003-04 where the authorities responded to an overheating economy with campaign-style macro-controls in Apr 04 that lasted about 6 months and both the economy and stock market demonstrated remarkable resilience? Or is this going to be like 2006-2007 where aggressive credit controls were imposed in Oct 07¡ªespecially vis-a-vis the property sector¡ªlasting about 9 months and contributed to¡ªalbeit not directly causing¡ªa hard landing of the economy.

 

It may be like ¡®2003-04¡¯ IF¡­

 

The situation in the run up to tightening that began in April 2004 was quite different from the current one, making the tightening back then completely justified. The average YoY growth rates of key variables during the six months leading to the onset of tightening in April 2004 clearly pointed to an overheating economy: FAI 37%, Exports 37%, IP 18%, Loan 27%, and CPI 2.7% (Exhibit 1).

 

The aggressive tightening launched in April 2004 featured strict investment project approval, tight controls over bank lending, and a moratorium on developing agricultural land for industrial/commercial use, as well as a RRR hike. There was only one interest rate hike six months after the tightening began, as the headline CPI inflation peaked and stared to moderate while PPI was about to peak (Exhibit 6 and 7).

 

Despite the aggressive tightening, the economy demonstrated remarkable resilience: while FAI growth decelerated sharply from the pre-tightening levels of 40-50%YoY to about 20%YoY in the months immediately after the launch of tightening before stabilizing around 25%YoY thereafter (Exhibit 3). In the meanwhile, IP growth only registered a modest slowdown, helped by extraordinarily strong export growth throughout the entire tightening cycle (Exhibit 2 and 4).

 

Obviously, the current cyclical conditions of the economy are far too weak to justify an aggressive tightening of the same magnitude that launched in April 2004. Moreover, it should be highlighted that the overheating in 2003-04 reflected remarkable strength in both domestic (i.e., FAI) and external (i.e., exports) demand.

 

The only explanation for the current round of tightening¡ª although we prefer calling it ¡®policy normalization¡¯¡ªwith its beginning dated January 2010 appears to be early policy action to preempt an economic overheating like the one in 2003-04. Further policy action in this regard will likely be measured, hinging on the pace of improvement on the external demand front, in our view.

 

In this context, a repeat of 2003-04 is possible IF external demand were to turn out to be much stronger than expected (¡®the Summer: Overheating¡¯ scenario under our four-season framework materializing). This may therefore trigger aggressive policy tightening, in which case some components of the economy (e.g., FAI) may slow substantially in the short run, but the overall economy will likely be able to weather the policy shift reasonably well beyond the near term.

 

It may be like ¡®2006-07¡¯ IF¡­

 

An increasing number of market observers have started to wonder whether China may repeat the aftermath of the tightening that started in October 2007. In fact, the situation in late 2007 was also quite different from the current one. Although the economy in late 2007 appeared less overheated compared to early 2004, the activity was no doubt very strong and, in particular, inflation was stubbornly high, with the average YoY growth rates of key variables being: FAI 27%, Exports 27%, IP18%, Loan 17%, and CPI 4.9% (Exhibit 1).

 

The tightening launched in October 2007 mainly featured very tight controls over bank credit, especially vis-a-vis the property sector, such that a number of property developers were cut off their access to bank lending. As a result, investment growth declined after the tightening was launched, although the slowdown was not as sharp as in 2004. Industrial production growth also moderated accordingly. Against this backdrop of a policy-induced weakening in domestic economy, especially the property sector, the onset of the Great Recession in September 2008 brought about a collapse in China¡¯s exports, a hard landing of the economy and attendant deflation.

 

Could we see a repeat of 2007-2008 tightening experience this time? It is possible IF: first, Chinese authorities were to fail to learn the lesson from their management of the property sector in 2008 and go down the same policy route in 2010 such that both property sales and property construction activity would slow sharply; and second, if the major industrial economies were to suffer a ¡®double-dip¡¯ in growth. (This would be ¡°the Winter: Policy-induced Double Dip¡¯ scenario under our four-season framework.)

 

We, however, have reason to believe neither condition is likely to be met. First, the recent policy initiatives targeting at the property sector are mainly to discourage speculation and, at the same time, encourage supply, with the objective of preventing a too rapid rise in property prices. While similar policy measures were implemented back in 2007-2008, they were not the main causes for a major slowdown in property sector, in our view. The sharp slowdown in property sector in 2008 was mainly due to a ¡®buyer strike¡¯ based on expectations of a broad-based property price decline. Since property developers were cut off from their access to bank lending, it was widely expected that the credit crunch would force developers to cut property sale prices in order to promote sales and thus cash flows. Chinese authorities appear to have no intention to intervene in such a heavy-handed way this time.

 

Second, while the recent fiscal crisis in some European countries may have cast some dark clouds over prospects for global economic recovery, this is consistent with a tepid recovery in G3 economies in 2010 as envisaged by Morgan Stanley global economics team. Our team attaches a low probability to a double-dip in growth.

 

The authorities more likely get it right this time

 

Given the memories of previous tightening cycles (i.e., April 2004, October 2007), there are rising concerns that the earlier-than-expected policy shift in China might suggest the onset of another round of aggressive tightening. However, as we have discussed, the current cyclical conditions of the economy are much weaker than the initial conditions that have led to the previous two rounds of aggressive tightening and thus do not justify similar policy action, in our view.

 

With the benefit of hindsight, the tightening launched in April 2004 was more appropriate than that launched in October 2007. Both previous rounds of tightening provide useful guidance to help understand the possible future course of policy action, in our view.

 

First, getting external demand right is key. The political campaign tightening in April 2004 did not do much damage to the real economy, because extraordinarily strong external demand helped cushion the impact of blunt policy measures. On the contrary, the tightening launched in October 2007 turned out to be ill-timed even though it was less heavy-handed than the 2004 tightening, because the external environment deteriorated drastically.

Second, early and moderate tightening should always be preferred to late and drastic tightening. Both April 2004 and October 2007 tightening should have been implemented earlier, in our view. Specifically, the Chinese economy already showed signs of overheating in 2Q03 after the change of government took place. However, the policy tightening planned for 2H03 was delayed by the breakout of SARS such that aggressive tightening was not carried out until early 2Q04, when SARS was finally brought under control. The timing of the late 2007 tightening was also influenced by China¡¯s political cycle. While the economy had already shown clear evidence of overheating in the run up to change of senior leadership in October 2007, tightening policy was not implemented until immediately after the completion of election/re-election of senior headship that takes place every five years.

 

Third, in the wake of the Great Recession, the Chinese authorities¡¯ awareness of the uncertainty over external demand could not be higher. This makes any important policy shift likely be measured and hinge on the pace of improvement in external demand. At the same time, since it is still the beginning of the third year of the current government¡¯s five year term, there is no obvious political consideration in this regard that is likely to delay any necessary policy adjustment unduly. These two factors, as well as the lessons from the previous two rounds of tightening, make us believe that recent policy action taken by the Chinese authorities should be viewed as precautionary measures to prevent a full-blown overheating and a typical boom-bust cycle. The Chinese authorities are more likely to get it right this time, in our view.

 

Implications

 

¡®The Autumn: Goldilocks¡¯ under our four-season framework remains our base case scenario, although recent better-than-expected developments on the external demand front point to somewhat higher probability of the Summer scenario (see ¡°China Economics: Upgrade 2010 Forecasts on Improved External Outlook, ¡° Feb 3, 2010). While the heightened uncertainty of late has already taken its toll on the stock market, the rather violent market reaction since beginning of the year is unwarranted from the perspective of economic fundamentals, in our view. We endorse the investment theses recently put forward by our equity strategy team (see Jonathan Garner: Quantifying the Inflation Risk in APxJ ¨CMarket Impact & Winners / Losers; and Jerry Lou: Our inflation Play Book, February 3, 2010).

[b.c]

Thanks again Tony. I appreciate these reports.