November 22, 2010

China Economics 2011: A Year of Reflation

Chinese economy in 2010 has featured a Goldilocks scenario, as a mix of normalized policy environment and a tepid G3 recovery has helped deliver relatively strong growth and modest inflation so far this year. However, the recent flaring in inflation suggests the Goldilocks scenario is close to running its course.

It will be a Year of Reflation for Chinese economy in 2011, as the post-crisis economic normalization and rebalancing carry on. Specifically, the lagged effect of massive monetary expansion in 2009-10 is expected to continue to provide strong tailwinds for inflation in the near term, while the headwinds stemming from weak external demand are letting up. Beyond the near term, China’s economic rebalancing that features a shift in growth drivers from tradable to non-tradable sectors also points to a higher future secular inflation rate.

We forecast 9.0% GDP growth and 4.5% CPI inflation for 2011, with consumption and investment envisaged to be equally important in terms of contribution to growth. CPI inflation is expected to rise in 1H11 and peak at 5.5% YoY by mid year and then start to decelerate to the tune of 4.0% YoY by year end.

Tackling inflation will be an overarching policy priority, especially in 1H11. The M2 growth target and quota for new bank lending for 2011 will likely be set at 15% and Rmb7tn, respectively. And the monetary tightening will be frontloaded. We expect three 25bps interest rate hikes through mid year and maintain the target for US$/CNY rate at 6.20 by end-2011.

The primary risk to this outlook stems from potential policy missteps. If Chinese authorities were to mainly rely on administrative controls over monetary aggregates instead of allowing price-based policy instruments such as rate hikes and appreciation of the Renminbi to control inflation, the risk of policy-induced boom (in 2010) and bust (2011) cycle would be on the rise. Continued tepid recovery in G3 economies would make it easier to manage inflation pressures and reduces the policy risk.

China’s Super Cycle in A Globalized Economy

2008:“Imported Soft

Landing”

2009:“Policy-driven Decoupling”2010:

“Goldilocks Scenario”

20011:“A Year of Reflation”

2008:“Imported Soft

Landing”

2009:“Policy-driven Decoupling”2010:

“Goldilocks Scenario”

20011:“A Year of Reflation”

Great Recession in

2008-09

China: A Year of Reflation

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For important disclosures, refer to the Disclosures Section, located at the end of this report.

M O R G A N S T A N L E Y R E S E A R C H A S I A / P A C I F I C

Morgan Stanley Asia Limited Qing Wang

Qing.Wang@morganstanley.com +852 2848 5220

Steven Zhang Steven.Zhang@morganstanley.com

Ernest Ho Ernest.Ho@morganstanley.com

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M O R G A N S T A N L E Y R E S E A R C H

November 22, 2010 China Economics

2011: A Year of Reflation It has been a Goldilocks Scenario… A key thesis of our outlook for Chinese economy in 2010 is that the macro economy will demonstrate a Goldilocks scenario featuring relatively strong growth and modest inflation. We made the call on November 22, 2009, exactly one year from publication of this report (see China Economics: A Goldilocks Scenario in '10, November 22, 2009). This call hinges on two key assumptions: a) a tepid G3 recovery; which provides headwinds for inflation; and b) normalization of macroeconomic policy stance, which underpins robust domestic demand.

With the benefit of hindsight, we think that Chinese economy has indeed demonstrated a Goldilocks scenario, with the average year-to-date GDP growth of 10.6%yoy and CPI inflation of 3%yoy. Specifically, the rather benign inflation print squarely contradicts the prediction by some market commentators of an overheating economy in general and a surge in inflation in particular in 2010, a concern that escalated to its highest level upon release of the data pack for 1Q10. Moreover, the robust growth has also suggested that the fear of a potential hard landing of the economy, which intensified greatly in early 2Q10 when Chinese authorities launched austere measures against property speculation, has been indeed unwarranted.

…Which Is Close to Running Its Course The recent flaring in inflation suggests the Goldilocks scenario is close to running its course, in our view.

To be sure, we do no think that Goldilocks is a new norm for the Chinese economy in the first place, but rather a special macro scenario under a particular circumstance: the immediate aftermath of the great recession in 2008-09. Goldilocks is therefore best suited to describe a transitional instead of permanent state of the economy.

To be sure, we do not think that Goldilocks is a new norm for Chinese economy…but rather a special macro scenario under a particular circumstance: theimmediate aftermath of great recession in 2008-09

We therefore are vigilant on any signs of developments that can help to determine whether the Goldilocks scenario is on track or close to running its course.

The global financial and economic crisis in 2008-09 should be treated as part of the correction of global imbalances forced upon the global economy by market forces. The crisis also serves a catalyst for a more profound global rebalancing for years to come, in our view.

Exchange rate adjustment is bound to be part of the solution to addressing global imbalances. Chinese Renminbi exchange rate must appreciate in real terms. Barring adequate nominal appreciation of the Renminbi, inflation will sooner or later emerge in a meaningful way in China, in our view.

In this context, we take any signs of meaningful inflation seriously. The latest developments on this front lead us to believe the Goldilocks scenario is close to running its course and, going forward, the economy will likely start embarking on a more profound rebalancing, with structurally higher inflation featured prominently in this process.

A Year of Reflation in 2011: The Cyclical Conditions The cyclical conditions of the economy suggest that it will likely be a year of reflation in 2011.

The tailwinds for inflation stemming from the extraordinarily strong monetary expansion in 2009, as shown in the surge in M1 growth from 9%YoY in Dec 2008 to 32%YoY in Dec 2009, which, however, did not result in significant inflation (Exhibit 1).

This is in part because the post-crisis tepid recovery in G3 economies has indeed constituted strong headwinds for China’s inflation, despite the tail winds from the strong monetary expansion in 2009. This is highlighted in the huge swing in China’s export growth rates from +23%YoY in 3Q08 to -23%YoY in 2Q09 (Exhibit 1).

The development in 2010 was that the M1 growth slowed on the back of strong growth in 2009, while export growth rebounded sharply (Exhibit 1). However, the former did not appear to have any dampening impact on headline CPI, the latter did not appear to have any boosting impact on headline CPI either.

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M O R G A N S T A N L E Y R E S E A R C H

November 22, 2010 China Economics

This is because despite the deceleration in M1 growth in 2010, M1 is still well above its long-term trend growth (Exhibit 2). In the same vein but opposite situation, despite strong rebound in export growth in 2010, exports are only about to close the negative gap with its long-term trend.

Exhibit 1 China: Benign Inflation in 2010

Inflation has been benign, despite tailwinds from extraordinarily strong monetary expansion…

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In year 2011 that features normalization, a more suitable

approach to gauge inflationary pressures is to examine how monetary aggregates and exports deviate from and converge to their long-term trends. This is because the wild and large swings of key macro variables during the crisis (i.e., 2H08-09) and in its immediate aftermath (i.e., 2010) have rendered the original functional

relationships—which are based on the YoY changes of key variables—unstable. In this light and looking ahead, both monetary and export factors continue to work toward adding to inflationary pressures (Exhibit 2).

In 2011, the lag effect of expansionary monetary expansion in 2009-10 is expected to continue to constitute strong tailwinds for inflation, while headwinds stemming from external demand are receding (Exhibit 2).

Exhibit 2 China: Inflation to Accelerate in 2011

Until monetary growth starts to return to its long-term trend, inflationary pressures are likely to persist…

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M O R G A N S T A N L E Y R E S E A R C H

November 22, 2010 China Economics

A Year of Reflation in 2011: The Secular Forces The potential reflation in 2011 reflects not only post crisis normalization in terms of cyclical conditions but also medium- and long-term structural rebalancing of Chinese economy.

China’s economic rebalancing that features a shift in growth drivers from tradable to non-tradable sectors would lead to slower overall productivity growth and thus a higher future secular inflation, in our view.

First, in general, productivity growth in non-tradable sectors (e.g., lodging, dining) tends to be slower than tradable sectors (e.g., IT). Second, it takes time and great effort to adapt production factors (e.g., labor) that are suitable for tradable sector activity to the need of non-tradable sectors. In this transition, productivity growth tends to slow, creating upward pressures on inflation.

Exhibit 3 Chinese Economy at an Inflection Point

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Source: CEIC, Morgan Stanley Research.

In terms of secular trend, the Chinese economy is now at an inflection point similar to that of the Japanese economy 40 years ago and the Korean economy 20 years ago, in our view (Exhibit 3). After this inflection point is crossed and if history is a guide, the overall GDP growth tends to decelerate and inflation to accelerate (see China Economics: Chinese Economy through 2020: Not Whether but How Growth Will Decelerate, September 20, 2010).

From the historical perspective, the reflation that we envisage to happen in 2011 should be viewed as part of secular trend of rising inflation that started as early as 2007. And with the benefit of hindsight, this secular trend appears to have been temporarily disrupted by the Great Recession in 2008-09 but will likely be reasserting itself in 2011 and beyond.

… the reflation that we envisage to happen in 2011 should be viewed as part of secular trend of rising inflation that started as early as 2007

A Year of Reflation in 2011: The Political Economy Factor In gauging China’s economic outlook for 2011, one must not lose sight of the big picture of political economy in China, in our view. The political cycle in China points to, ceteris paribus, upside risk to fixed asset investment (FAI) growth over the next couple of years, adding to reflationary pressures. And China’s economic growth cycle has been largely dictated by the FAI cycle.

China’s FAI cycle tends to be influenced by China’s political cycle, as FAI tends to accelerate in the run to change of government (Exhibit 4). Experiences since early 1990s suggest that China’s investment cycle tends to coincide with the cycle of change of governments – at both central and local levels – which takes place very five years. If this pattern persists, FAI growth in China appears poised to enter an upturn phase in the next two years through early 2013, when the next change of government is due to take place.

Another pattern in this regard is that FAI growth tends not show meaningful slowdown in the first year of a new five-year plan, because many new projects that are planned and approved by the relevant authorities are expected to kick off in the first year of the implementation of the 5-year plan. Year 2011 would be the first year of the 12th 5-year plan.

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M O R G A N S T A N L E Y R E S E A R C H

November 22, 2010 China Economics

Exhibit 4 China: Political Cycle-driven FAI Cycle

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Source: CEIC, Morgan Stanley.

The political cycle in China points to, ceteris paribus, upside risk to fixed asset investment (FAI) growth over the next couple of years, adding to reflationary pressures.

Forecasts: Growth Outlook We forecast 9.0% GDP growth and 4.5% CPI inflation for 2011, with consumption and investment envisaged to be equally important in terms of contribution to growth. Forecasts of a full set of macro indicators including FAI, retail sales, IP and so on can be found in Exhibit 13.

First, consumption is expected to register modest acceleration:

We forecast consumption growth to accelerate from 9.8% in 2010 to 10% in 2011, reflecting sustained strong income growth as a result of a tight labor market (Exhibit 5).

Consumer confidence will likely remain buoyant, aided in part by a favorable policy environment that features an ambitious social housing program (see below for Special Topic I: Even Stronger Push for Social Housing Program).

By helping stabilize expectations of property price inflation and improve housing affordability, the ambitious social housing program represents a large scale transfer of wealth from the public to house sector, greatly helping boost the latter’s purchasing power, in our view.

The sustained strong consumption growth in 2011 will prove to be part of a secular consumption boom over the medium- and long-run in China, in our view (see China Economics: Chinese Economy through 2020 (Part 3): A Golden Age for Consumption, October 31, 2010)

Exhibit 5 China: Forecasts of Key Macroeconomic Indicators

2008 2009 2010E 2011EGrowth Rate (YoY, %)

GDP 9.6 9.1 10.2 9.0Consumption 8.6 8.4 9.8 10.0GCF 11.0 20.5 12.0 10.0

Mining 15.4 7.7 7.3 6.0Manufacturing 14.8 16.7 13.1 15.0Real estate 8.3 13.2 21.0 16.0Infrastructure 8.6 30.5 7.3 2.7Other 11.6 26.5 5.0 3.6

Net exports (Cont, ppt) 0.8 -3.7 -0.2 -0.6Contribution to growth (ppt)

GDP 9.6 9.1 10.2 9.0Consumption 4.2 4.1 4.7 4.8GCF 4.6 8.7 5.6 4.7

Mining 0.3 0.2 0.1 0.1Manufacturing 1.9 2.2 1.9 2.2Real estate 0.9 1.4 2.3 1.9Infrastructure 1.1 4.0 1.1 0.4Other 0.4 1.0 0.2 0.1

Net exports 0.8 -3.7 -0.2 -0.6

Exports (%, US$) 17.3 -15.9 29.5 15.0Imports (%, US$) 18.4 -11.3 36.0 18.0Trade balance (in US$bn) 297 198 191 179

% of GDP 6.5 3.9 3.2 2.4CPI (%) 5.9 -0.7 3.2 4.5

Source: CEIC, Morgan Stanley Research.

Second, investment growth is expected to register only modest deceleration in 2011, in part reflecting the political economy factor (Exhibit 4). More specifically,

We forecast a moderation in investment growth from 12% in 2010 to 10% in 2011. The deceleration primarily reflects slowdown in infrastructure investment, as the massive spending program launched as anti-crisis policy package in 2009-10 runs its course in 2011.

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M O R G A N S T A N L E Y R E S E A R C H

November 22, 2010 China Economics

While real estate investment is also expected to decelerate from 21% in 2010 to 16% in 2011, the slowdown will unlikely be as deep as the heavy-handed austere policy measures against property speculation would suggest, in our view. This is because a substantial acceleration of construction of social housing should be able to provide an adequate cushion for the downside, in our view (see below for Special Topic I: Even Stronger Push for Social Housing Program).

The impact of slowdown in real estate investment can be largely offset by acceleration in manufacturing investment in 2011, in our view. Indeed, potential pickup in investment in manufacturing sector will likely be one of the most interesting developments in 2011, in our view. Three considerations underpin this rather optimistic outlook for manufacturing investment: a) the industrial capacity utilization has already recovered back to pre-crisis peak level; b) a key finding of a proprietary survey conducted recently by Morgan Stanley China AlphaWise Evidence team is that ‘private capex growth is likely to halt its deceleration and approach an inflection point’ (see AlphaWise Evidence Series: China Macro: Private Capex Is Likely to Accelerate, November 8, 2010); and c) the financing conditions facing investors in manufacturing sector will likely improve in 2011, as the crowding-out effect stemming from massive public investment in 2009-10 is expected to diminish.

Potential pickup in investment in manufacturing sector

will likely be one of the most interesting developments in

2011

Third, both export and import growth is expected to decline significantly to a more sustainable level in 2011 after a sharp rebound in 2010:

The performance of G3 economies in 2010 will likely continue to be best characterized as a ‘BBB recovery’, a long-standing made call by Morgan Stanley global economics team co-headed by Richard Berner and Fels Joachim, namely ‘recovery in domestic demand remains bumpy, the rate of expansion below par, and the domestic demand recovery brittle (see Global Forecast Snapshots 2010 Outlook: from Exit to Exit, December 9, 2009).

China’s export growth in 2011 will continue to outperform global trade, as China’s external competitiveness remains strong, which allows Chinese exporters to continue to gain their market shares in both DM and EM economies.

A mid-teen export growth for China is sustainable over the next 2-3 years, unless there is a substantial appreciation of the Renminbi exchange rate in a short period of time or a sudden jump in labor costs.

Import growth will likely continue to outpace export growth, a pattern established since 2008, given still resilience domestic demand. However, since the import component of exports is large, the gap in the growth between exports and imports will likely remain modest such that trade surplus will be broadly stable in absolute terms and narrow gradually in percent of GDP.

Fourth, the quarterly growth trajectory will be characterized by moderation in 1H, stabilization in 3Q11, and acceleration in 4Q11 (Exhibit 6). We envisage that the seasonally-adjusted QoQ

annualized sequential GDP growth will accelerate further to 10.4% in 4Q10 (from 9.8% in 3Q10) but start to moderate in 1Q11 and reach a trough rate of around 8.0% in 2Q11, as the effect of anti-inflation policy tightening kicks in (to be discussed below).

Exhibit 6 China: Quarterly Trajectory of GDP Growth

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We envisage that the sequential growth rate will bottom

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M O R G A N S T A N L E Y R E S E A R C H

November 22, 2010 China Economics

inflation peaks by mid year, when a shift toward a neutral policy stance would be warranted, in our view.

This will translate into a sustained moderation in the YoY

GDP growth through 2011 from 9.6% in 3Q10 to 8.7% in 4Q11 such that the average GDP growth for the year will be 9.0%.

Forecasts: Inflation Outlook Inflation is ultimately a monetary phenomenon. Inflation in China is no exception, in our view. Even when inflation pressures tend to initially stem from and concentrate in food price increase as is often the case in China, food price increase is more likely symptomatic of demand pressures than due to supply shocks, in our view (see below for Special Topic II: Why Food Price-driven Inflation May Not Be Due To Supply Shock).

…food price increase is more likely symptomatic of demand pressures than due to supply shocks

We expect that the recent policy shift toward tackling inflationary pressures will bring about a further deceleration in M1 growth to high teens such that the positive gap between M1 growth and its long-term trend start to narrow in 2011 (Exhibit 1 & 2). This would suggest that the tailwinds for inflation would start to let up by mid-year 2011, as there is roughly two-quarter lag between the change in M1 and its impact on CPI inflation.

We forecast that CPI inflation will rise in 1H11 and peak at 5.5%YoY by mid year and then start to decelerate to the tune of 4.0%YoY by year end (Exhibit 7). Besides the evolution of carry-over effect (Exhibit 8), forecast of such a trajectory of inflation also hinges on three key assumptions:

1) Monetary tightening that is being initiated at the current juncture will effectively moderate the sequential growth momentum for CPI in 2H11, a situation similar to the inflation episode during 2006-08 (Exhibit 9).

2) Average 15% increase of pork prices in 2011 according to the forecast made by our colleague Lillian Lou, Morgan Stanley Agriculture and Food Industries analyst.

3) Average $100 per barrel crude oil prices in 2011, or some over 20% increase from the level in 2010, according to the forecasts made by our colleague Hussein Allidina, Morgan Stanley Lead Commodity Analyst (see The Commodity Call: Crude Oil To $90/bbl and Higher, November 5, 2010).

Exhibit 7 China: CPI Inflation Forecasts

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Exhibit 8 China’s Inflation: The Carry-over Effect in 2011

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M O R G A N S T A N L E Y R E S E A R C H

November 22, 2010 China Economics

Exhibit 9 China: A Tale of Two Episodes of Inflation

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Policy Outlook: Front-loaded Policy Tightening Tackling inflation has become Chinese authorities’ overarching policy priority. Of note, the current inflation situation is broadly similar to late 2007/1H08, in our view. However, compared to late 2007/1H08, there are several key differences in terms of initial conditions:

While in late 2007/1H08 there was a surge in global soft and hard commodity prices, this is not yet the case at present.

While in late 2007/1H08 there was considerable concern about economic overheating and asset price bubble, this is not the case at present, especially in view of the muted property transactions after austerity measures were imposed.

While in late 2007/1H08, there was a major supply shock (i.e., blue ear disease that killed a large portion of the hog population); the supply shock, if any, is mainly related to vegetables this time around.

However, there is currently a large overhang of money in the system as a result of massive cumulative monetary expansion over 2009-10. It was not the case back in late 2007 and 1H08.

It is the last point that makes Chinese authorities uncomfortable with the current situation and explains why they have taken action rather decisively, as soon as the downside risk to growth outlook diminishes, as indicated by the 3Q10

data pack, in our view (Exhibit 6). At the same time, we believe that the authorities also recognize the implications of structural rebalancing of the economy to secular inflation, which would call for tolerance of relatively high inflation going forward.

We therefore believe the policy objective at the current juncture is to prevent an overshoot of inflation beyond a reasonable level that is consistent with the need to accommodate for structural rebalancing. To this end, we expect: a) a change in characterization of monetary policy stance from “appropriately loose’ in 2010 to “prudent” in 2011; and b) the target average CPI inflation rate will be at 4% for 2011, higher than the target of 3% for 2010.

We expect monetary policy tightening will be front-loaded. Inflation is a monetary phenomenon, and in some sense, tackling inflation is all about managing expectations. Of note, inflation expectations could become self-fulfilling more easily in China, because there has been an overhang of money in the system, due in part to massive cumulative monetary expansion in 2009-10. Inflation expectations tend to lead to increase in velocity of money and therefore effective money supply.

…it is possible that the authorities would deliberately announce a rather low quota for new bank lending…and/or a low M2 growth target…with a view to crushing inflation expectations…

We therefore expect China’s anti-inflation monetary policy would be front-loaded. Specifically, we make the following calls on monetary policy:

The M2 growth target and quota for new bank lending for 2011 will likely be15% and Rmb7tn, respectively.

Three 25bps base interest rate hikes through mid year. The possibility of asymmetric rate hikes will increase after the first 1-2 hikes, in our view.

Multiple RRR hikes to help liquidity management and achieve the target for new bank lending. The exact number of RRR hikes hinges on the excess liquidity conditions which are influenced by China’s balance of payment situation (e.g., trade surpluses, .capital inflows).

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M O R G A N S T A N L E Y R E S E A R C H

November 22, 2010 China Economics

We maintain the target for US$/CNY rate at 6.20 by end 2011, but consider the risk to this forecast is tilted to the downside (more discussion below).

To achieve the effect of front-loading policy, it is possible that the authorities would deliberately announce a rather low quota for new bank lending (e.g., around Rmb6tn or below) and/or a low M2 growth target (e.g. 14% or below) with a view to crushing inflation expectations early on, despite that these targets may sound too low to be realistic/credible from the perspective of maintaining a “sound and fast” growth, which is the official party line objective.

Alternatively, authorities may choose not to announce a concrete target for new bank lending at all but instead talk hawkish to generate fear of aggressive tightening. The purpose is to scare the market so that the excess liquidity will return back to the banking system. Put differently, to force the "tiger back into its cage", because the overhang of money has been traditionally treated as "a tiger in the cage" which is dangerous but under control.

Besides monetary policy measures, the authorities will take some additional actions to manage inflation expectations, some of which have already been announced, including:

Direct control over the prices of items that have direct impact on the headline CPI, which was announced last week and similar to the practice in late 2007/1H08.

Further tightening controls over FX inflows, including the introduction of a special tax on short-term capital inflows, also known as a "Tobin tax," as Brazil did. This should help ease the liquidity pressures.

Deregulation of controls overseas direct investment (ODI) by Chinese companies, as a means to induce capital outflows, which also help ease domestic liquidity pressures.

On fiscal policy front, the official characterization of fiscal stance will likely remain unchanged as “proactive fiscal policy”. And we expect the following potential policy moves:

The absolute amount of fiscal deficit will likely be broadly stable at the same level in 2010, but some modest cut likely related to central governments-sponsored infrastructure projects. The overall fiscal deficit in terms of GDP will likely be 2.5-2.8% for 2011.

Natural resource tax is expected to be implemented, but the exact timing appears to be complicated once again by the current policy priority of controlling inflation.

Value-added tax will likely be implemented in the service sector to replace the current transaction-based tax categories, which is the usual practice in this sector. This change should have the effect of boosting investment in service sector. The initial implementation will likely start with services that have more direct link to manufacturing production (e.g., transportation).

The absolute amount of fiscal deficit will likely be broadly stable at the same level in 2010, but some modest cut likely related to central governments- sponsored infrastructure projects.

The minimum threshold of personal income tax will likely

be raised, while the margin tax rate for high-income brackets will likely be raised. These potential policy measures are believed to help address income inequality.

Special real estate tax will be implemented in a small number of cities on residential property that meet certain criteria, as a means to curb property speculation.

With regards to Renminbi exchange rate policy, we expect the following to take place over the course of 2011:

At some point and likely in the early part of the year, Chinese authorities may start to publish the nominal effective exchange rate (NEER) index for Renminbi, which will likely represent the beginning of adopting Renminbi NEER as the operating target instead of the current practice of using US$/CNY as the operating target for exchange rate policy. The authorities may start to target an appreciation path of the NEER instead of US$/CNY rate.

While Renminbi appreciation against US$ will remain broadly gradual, we expect its pace will accelerate— especially during 1H11—compared to that in 2H10, as warranted by the need to contain inflationary pressures stemming from rising international prices of key commodities.

In the months immediately ahead, there could be another round of relatively fast Renminbi appreciation against the

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US$ in the run-up to the state visit by Chinese President Hu Jintao to the USA that is reportedly scheduled to take place in mid January 2011.

Risks: Potential Policy Missteps The primary risk to this outlook stems primarily from potential policy missteps. If Chinese authorities were to mainly rely on administrative controls over monetary aggregates instead of allowing price-based policy instruments such as rate hikes and appreciation of the Renminbi to control inflation, the risk of policy-induced boom (in 2010) and bust (2011) cycle would be on the rise. Although direct credit controls has been seemingly quite effective in controlling inflation in the short run, they are also very blunt and tend to inflict substantial damage to the real economy and market sentiment.

We construct two illustrative alternative scenarios to highlight only the policy risks, both downside and upside, to our base case scenario.

Exhibit 10 China: Illustrative Alternative Scenarios

2010E 2011EBase Bull Bear

Subjective probability (%) 70 10 20

Real GDP growth (%) 10.2 9.0 10.5 7.5Consumption 9.9 10.0 11.4 8.3GCF 12.0 10.0 12.6 7.3Net Exports -0.2 -0.6 -1.0 0

Contribution to Grwoth (ppt)Consumption 4.8 4.8 5.5 4.0GCF 5.6 4.7 6.0 3.5Net Exports -0.2 -0.6 -1.0 0.0

CPI (%) 3.2 4.5 5.5 3.5

Trade balance (in US$bn) 191 179 152 220Exports (%, US$) 30 15 15 15Imports (%, US$) 36 18 20 15

Source: Morgan Stanley Research

Under the bear case to which we assign 20% probability, we envisage that the policy tightening will be rather draconian in that the new bank lending quota is assumed to be set at Rmb6tn in 2011, down substantially from Rmb7.5tn in 2010. This implies less than 13% growth of the outstanding amount of loan in 2011, down markedly from 18-19% in 2010. If this target amount of new loan were to be executed, it would indicate a very tight credit

condition for the economy, even tighter than that in the 1H08 during which period the overall credit expanded by 14%YoY. Under this scenario, we expect a sharp slowdown in FAI growth that would result in 7.5% GDP growth and 3.5% CPI inflation, or an effective hard landing of the economy.

Under the bull case, to which we assign 10% probability, we envisage no meaningful policy tightening in that the new bank lending quota is assumed to be set at Rmb8tn in 2011, higher than the Rmb7.5tn target in 2010. This implies about 17% growth of the outstanding amount of loan in 2011, down only slightly from 18-19% in 2010. Under this scenario, the economy will likely demonstrate high growth (10.5%) and high inflation (5.5%), or an effective overheating scenario.

Besides policy risks, potential developments in G3 economies also represent important risks.

If the recovery in G3 economies were to be even weaker than expected, it would provide sufficiently strong headwinds for China’s inflation and thus make it easier for Chinese authorities to manage inflation pressures, reducing the risk of policy missteps that could result in a hard landing of the economy.

If the recovery in G3 economies were to be much stronger than expected, it would definitely add to inflationary pressures in China. Under this scenario, while China’s policy tightening may be appropriately aggressive and contribute to a substantial slowdown of FAI, the overall economic activity may prove to be resilient, as strong exports would provide an important offset to the policy tightening effect.

While there are of course other idiosyncratic risks that could destabilize the economy, we choose not to address them in this note but instead delegate the relevant discussion to our regular publication China Macro Risk Radar (see China Economics: China Macro Risk Radar, October 18, 2010)

Investment Implications: Do Not Fight the State Council The experiences since 2008 teach many of us one useful lesson: do not fight the State Council! It is by now clear that the State Council has made controlling inflation a top policy priority, in which case there typically is a concerted effort by all relevant government agencies to address the same problem simultaneously. The risk of compound policy effects and thus overreaction is not trivial, in our view.

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While we are of the view that macroeconomic and policy uncertainties will eventually diminish especially in 2H11, the potential macroeconomic policy environment calls for exercising great caution for market participants over the next 3-6 months, in our view. That said, we believe China’s inflation risk is still quite manageable, and the early and resolute policy responses by the authorities so far suggest that the situation will be more likely than not turn out to be rather benign beyond the next 3-6 months, in our view.

Special Topic I: Strong Push for Social Housing Program in 2011 Review: Sticking with Our (Once) Out-of-Consensus Call We had been optimistic about the social housing program ever since it began in earnest in April earlier this year. It certainly was an out-of-consensus call at the time. In particular, we dismiss simplistic comparison with its lackluster track record, but instead resort to robust analyses of construction activities, political will and financing incentives which helped us reach the conclusion that the aggressive social housing program would not only help offset a potential slowdown in market-based residential property construction, but also contribute to a soft landing in overall fixed asset investment (FAI) growth. (see China Economics: Social Housing: Lackluster Growth or Quantum Jump? dated August 12, 2010 and China Economics: Can Social Housing Program Help Secure a Soft Landing? dated June 17, 2010). With Urban FAI growing at an astonishing rate of 24.5% YoY YTD, we can rest assured that the fear of a hard landing in FAI was indeed unwarranted. Robust Progress: It Is For Real This Time Around By end of September 2010, 5.2 million units, or 90% of the annual target of 5.8 million units of social housing construction had been started, with at least 60% to be basically completed by the end of this year. On the funding side, the Rmb79.2 billion central government subsidies had all been disbursed. More than Rmb470 billion (vs. our estimate of Rmb370 billion) had already been invested. In addition, more supportive measures are in the pipeline, including tax breaks and exemption of social housing construction projects from Local Government Financing Platform (LGFP) “clean-up” campaign.

More importantly, the social housing program is imperative to the pressing needs for economic rebalancing: In the 12th Five Year Plan, the Chinese government is committed to rebalance the economy by establishing a “sustainable mechanism” to boost consumption in order to achieve balanced growth drivers between consumption, investment and exports. In this context, as we argue in one of our recent report (see Chinese Economy

through 2020 (Part 3): A Golden Age for Consumption, dated October 31, 2010), the aggressive social housing program is one of the integral parts of this “mechanism” that help reduce precautionary savings, especially for low-income households. A declining household saving ratio would in turn boost consumption growth.

The successful implementation of the social housing program, in particular, the focus on public rental housing, would not only break this cycle of inter-generational precautionary savings for property acquisitions, but also indirectly facilitate wealth redistribution – the high land premium, which originally would have ended up as government revenue and would flow through to high property prices borne by the household sector, is now retained in the household’s pocket.

The implication is immense, as it helps lower precautionary savings, unleash the consumption power of the low- to middle-income household and in turn contribute positively to the transition from the investment- and export-led to consumption-driven growth model.

Looking Ahead: Building 15 million units in the next 2 years We had originally expected social housing construction to be 5 to 6 million units for the next two years, allowing MoHURD to deliver its pledge to “solve the housing problem for 15.4 million low-income households by end of 2012”. However, the latest information we managed to collect suggest that the strong momentum in construction activities will very likely continue and strengthen heading into year 2011. Specifically, the potential plan is to build 6.8 million and 6.2 million units for year 2011 and 2012, respectively. Taking into account the 2.3 million units brought forward from year 2010 (given 60% completion of the 5.8 million units construction target as guided by government officials), for year 2011 alone the construction volume could add up to 9.1 million units, equivalent to about 491 million sqm, compared to the total residential floor space completed of 821 million in year 2009 (Exhibit 11).

Exhibit 11 Aggressive Construction Targets

avg. sqm

# of units (mn)

Floor Space

(sqm, mn)# of units

(mn)

Floor Space

(sqm, mn)

Non-Commodity 7.3 365 5.0 250Public Rental 50 5.5 275 3.8 190Low-Rent Housing 50 1.8 90 1.2 60

Commodity - Economic Housing 70 1.8 126 1.2 84

TOTAL 9.1 491 6.2 334

2011 2012

Source: Morgan Stanley Research

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It is worth noting that this is an upward revision to the original plan to “solve the housing problem for 15.4 million low-income households by end of 2012”, with the new target is to build a total of 18.8 million units (5.8 + 6.8 + 6.2 million units) by end of 2012. We believe that it will be instrumental in cushioning the potential slowdown in the commodity residential building construction activities.

Special Topic II: Why Food Price-driven Inflation May Not Be Due To Supply Shock? The headline CPI inflation jumped to 4.4% on the back of escalated food inflation (10.1% YoY) in October 2010. The heightened food inflation is symptomatic of general demand-side pressure instead of being due to supply-side shocks, in our view. This argument can be illustrated with a simple example.

Assume that Country A only consumes two kinds of goods, food and clothing, each accounting for a 50% weight in the consumption basket.

Moreover, Country A has a large pool of surplus labor and tends to overinvest in the clothing-producing industry, so that it always produces more clothing than it can consume and thus exports the rest. In this context, firms in the clothing-producing industry have little pricing power.

If Country A’s policy authorities run a loose monetary policy to stimulate domestic demand, the resulting inflationary pressures will manifest first and foremost in the increase in food prices rather than in clothing prices. In a demand-supply framework, because the supply curve for clothing shifts to the right (driven by overinvestment) much more readily than that for clothing, the price increase in response to a positive demand shock would be much more pronounced in food than in clothing.

Exhibit 12 Pricing of Clothing vs. Pricing of Food

Source: Morgan Stanley Research Based on the above analysis, food items are the most sensitive to change in underlying monetary conditions among the CPI basket components, in our view. In other words, inflationary pressure stemming from loose monetary conditions tends to be reflected in food price inflation first. In China’s context, attributing food inflation merely to supply-side factors – as is the usual case in many other countries – tends to underestimate the inflationary consequences of loose monetary policy.

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Exhibit 13 China: Summery of Key Macroeconomic Indicators

2005 2006 2007 2008 2009 2010(F) 2011(F)GDP (Normial, RMB, bn) 18,713 22,224 26,583 31,490 34,502 39,988 46,115

Real GDP Growth (%) 11.3 12.7 14.2 9.6 9.1 10.2 9.0Consumption 8.1 9.8 11.1 8.6 8.4 9.8 10.0GCF 10.6 13.5 14.6 11.0 20.5 12.0 10.0

Contribution to Growth (ppt)Consumption 4.3 5.1 5.6 4.2 4.1 4.7 4.8GCF 4.4 5.6 6.1 4.6 8.7 5.6 4.7Net Exports 2.6 2.0 2.5 0.8 -3.7 -0.2 -0.6

Nominal GDP Growth (%)GDP 16.4 18.8 19.6 18.5 9.6 15.9 15.3

Consumption 13.1 13.7 16.8 15.8 8.7 14.8 15.6GCF 12.6 19.4 19.4 24.7 18.9 18.7 16.7

Contribution to Growth (ppt)GDP 16.4 18.8 19.6 18.5 9.6 15.9 15.3

Consumption 7.2 7.3 8.5 7.8 4.2 7.1 7.4GCF 5.4 8.1 8.1 10.3 8.3 8.9 8.2Net Exports 3.8 3.4 3.0 0.3 -2.9 -0.1 -0.3

Structure of Economy (%)GDP 100 100 100 100 100 100 100

Consumption 52.9 50.7 49.5 48.4 48.0 47.5 47.6GCF 41.6 41.8 41.7 43.9 47.7 48.8 49.4Net Exports 5.5 7.5 8.8 7.7 4.4 3.7 2.9

Current Account as % of GDP 7.0 9.1 10.6 9.6 5.9 4.6 3.6

Key Pricing Data (YoY, %)CPI 1.8 1.5 4.8 5.9 -0.7 3.2 4.5PPI 4.9 3.0 3.1 6.9 -5.4 5.5 6.0GDP Deflator 4.6 5.4 4.7 8.1 0.4 5.2 5.8

Key Economic Activity Data (%)Industrial Production 16.4 16.6 18.0 12.6 11.6 15.5 13.0Fixed Asset Investments 28.1 24.5 25.6 26.2 31.0 24.0 20.0Retail Sales 12.9 13.7 16.8 21.6 15.5 18.2 19.0Exports 28.4 27.2 25.7 17.3 -15.9 29.5 15.0Imports 17.7 19.9 20.8 18.4 -11.3 36.0 18.0Trade Balance (USD bn) 102 178 262 297 198 191 179

Key Policy Variables %)Policy Interest Rate 5.58 6.12 7.47 5.31 5.31 5.56 6.31USD/CNY Exchange Rate (eop) 8.19 7.97 7.60 6.95 6.83 6.60 6.20

Source: Morgan Stanley Research

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