Activity: economic growth will decelerate further in 2008 and 2009, partly as a result of a slower pace of exports to the G3 economies. The latter will also help to slow, albeit modestly, investment growth. Consumption may moderate as real earnings growth has peaked.

GDP growth has decelerated for three consecutive quarters (Q3’07 to Q1’08). Net exports was the only growth driver which saw a near continuous decline in its contribution over the period, followed closely by investment spending (however the latter still makes the single largest absolute contribution to GDP growth). The contribution of consumer spending to GDP growth rose during Q3’07-Q1’08. With the US, EU and Japan between them buying about 47% (2000-07 average) of China’s exports, their expected growth slowdown, especially during Q4’08-Q1’09, will impact total export growth and the trade balance. The impact will be cushioned, however, by the steady rise in importance of intraregional trade in Asia, not all of which is necessarily linked to G3 trade. The pace of real fixed asset investment (FAI) has stalled rather than fallen, with spending on property remaining strong. In the rest of 2008 and H1’09, the expected deceleration in export growth to the G3 economies should have only a limited impact on FAI. The fact that 25% of FAI is in property development, whose links to the export industry are likely to be weak or indirect, gives credence to estimates which put export-related FAI at a modest 10% of the total. It also explains the mild reaction of FAI to an export shock. We estimate that a one percent shock in exports generates about 0.16% of maximum shock on investment after about one year. Consumer spending has been growing at a modest pace, but there are signs that real earnings growth might be decelerating as inflation accelerates. The sell-off in the stock market and signs that the property boom has peaked could have some impact on urban consumer spending for the rest of 2008 and during 2009. The impact of the earthquake on the economy in 2008 is more likely to be on the profile of GDP growth rather than its overall speed and direction. Official estimates put the total damage at about 0.3% of GDP, while the expected additional investment and infrastructure expenditure by end-2008 is likely to be a very modest 0.24% of all FAI (based on 2007 FAI) with an equal amount likely to be spent in 2009.

Inflation: the worst of the acceleration in inflation is likely to be over by Q3’08 but the inflation rate is expected to stay at an average of 4.4% in 2009.

Price rises for food, in particular meat, are expected to decelerate after July, reflecting not only improved supplies but also the high base effect of the summer of 2007. However the earthquake may have a temporary impact on food prices. Oil price subsidies will continue to add to fiscal costs and could be adjusted in 2009 once food inflation has peaked.

Policy: monetary policy to stay restrictive in 2008 and possibly into 2009 and the RMB to strengthen. The stance of the authorities has not changed and is unlikely to do so even after the earthquake. Credit restrictions will stay and banks’ reserve requirements may increase further, as could interest rates, although hikes in the latter could be postponed to Q3’08, mainly for political reasons.

It can be contested that monetary conditions in the PRC are not tight. The recent acceleration in inflation has resulted in a deepening of negative real interest rates. As there are no signs of a marked slowdown in economic growth, and while monetary conditions remain broadly supportive, there is little reason to expect that the economy will slow ‘too fast’ or that the authorities will be forced into a policy U-turn. The apparent unwillingness of the authorities to let the RMB appreciate at the pace seen between January and March 2008, when it strengthened by 4%, has raised some concerns. Reasons given for the slowdown in the currency’s appreciation included the concern of the authorities over the impact on the growth of exports and the fact that building-up expectations of a stronger RMB made capital inflows to the PRC all the more attractive at a time when the authorities were keen to discourage them. We expect the appreciating trend of the RMB to resume, with a stronger RMB remaining an integral part of the overall tightening of monetary policy.