2Q2007 China Economics Quarterly Final - ghsl.cn...Goldman Sachs Economic Research China Economics Quarterly Issue No: 07/02 2 2Q2007 2Q2007 data summary: % change, unless otherwise

Growth momentum accelerated significantly in 2Q

Growth of broad money supply as measured by M3 continued to stay at elevated levels

Inflation accelerated

We believe the economy is already overheated and further tightening measures are needed

China Economics Quarterly 中国经济研究季刊 2nd Quarter 2007

Asia Economics Research

Goldman Sachs Economic Research China Economics Quarterly

Issue No: 07/02 2Q2007

Authors Hong Liang Helen (Hong) Qiao Yu Song Eva Yi [email protected] [email protected] [email protected] [email protected] 852-2978-0036 852-2978-1630 852-2978-1260 852-2978-1870

Table of Contents

Themes of the quarter:

• Is China overheating? page 3

Real GDP growth came in at 11.9% and CPI inflation 4.4% for June—readings of the 2Q2007 data page 6

Raising our growth and inflation forecasts for 2007 and 2008 page 9

How significant is the exchange rate pass-through effect on CPI inflation? page 11

Special treasury bonds to be issued for the new state foreign exchange investment agency— How will they affect monetary operations? page 15

• M2 growth may have understated the speed of monetary expansion page 18

Why should we care about M3 growth? page 22

• China’s 17th Party Congress: Implications and complications page 24

• Time to anchor asset inflation expectations in the A-share market page 27

Will the wealth effect of equity prices be significant in China? page 31

China’s financial market: Time to overcome its fear of opening page 34

Policy issues:

The PBOC raised the 1-yr deposit and lending rates to 3.33% p.a. and 6.84% p.a. respectively as well as the RRR to 11.5% page 36

Initial thoughts on the CBRC’s permission of overseas equity investment for high-net-worth bank clients page 37

The PBOC widened the USD/CNY trading band page 38

China raised the stamp duty overnight page 39

China should cut the import tax more page 40

China announced adjustments to export tax rebates page 42

China cut the tax on interest income to 5% from 20% page 43

Charting China page 44


Issue No: 07/02 1 2Q2007

China impression – 2Q2007:

• Growth and inflation accelerated significantly in 2Q... (see Real GDP growth came in at 11.9% and CPI inflation 4.4% for June—readings of the 2Q2007 data, and Raising our growth and inflation forecasts for 2007 and 2008).

• ...on the back of strong monetary expansion (see M2 growth may have understated the speed of monetary expansion and Why should we care about M3 growth?).

• We think the Chinese economy is already overheated, evident by rising inflationary pressures in the overall economy. However, necessary tightening measures might be delayed (see Is China overheating? and China’s 17th Party Congress: Implications and complications).

• We believe currency appreciation will be helpful in containing inflationary pressures (see How significant is the exchange rate pass-through effect on CPI inflation?).

• Asset inflation, as evident by the surge in the A-share market, are better dealt with by market-based measures as well as by further opening (see Time to anchor asset inflation expectations in the A-share market and China’s financial market: Time to overcome its fear of opening).

What else is in this issue:

• We reviewed the policy changes implemented so far (see the collection of comments in the Policy issues section).

• The government adjusted export and import taxes to reduce the external imbalances. We argue that these measures are both inefficient and ineffective in achieving that goal (see China should cut the import tax more).

• We reviewed the impacts of the issuance of the special treasury bonds on monetary policy (see Special treasury bonds to be issued for the new state foreign exchange investment agency—How will they affect monetary operations?).

Key charts of the quarter:

Exhibit 1: Inflationary pressures are rising

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1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007ytd

GDP deflator

Consumer Price Index (CPI)

Corporate Goods Price Index (CGPI)

% chg yoy

Source: CEIC, Goldman Sachs Economics Research.

Exhibit 2: Strong M3 growth in recent months

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Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07

M2

M3 proxy*

June

May

* M3 proxy includes net foreign assets and domestic credits, "other assets" are not included in this graph as the level is only attainable since 2006, however, it should not have much impact on the growth rate of overall financial assets due to its small share and stable performance.

% chg yoy



Issue No: 07/02 2 2Q2007

2Q2007 data summary: % change, unless otherwise stated

GDP 2Q 1Q 4Q 3Q 2Q 1Qyoy 11.9 11.1 10.8 11.0 11.9 10.8qoq (sa) 3.8 3.0 2.2 2.3 3.2 2.7

June M ay Apr M ar Feb JanActivity Indicators

Industrial Production yoy 19.4 18.1 17.4 17.6 18.5 18.5qoq (sa, ann) 21.4 22.1 25.2 31.2 24.5 19.8m om (sa) 1.3 1.1 1.3 0.8 2.6 1.2

Retail Salesyoy 16.0 15.9 15.5 15.3 16.9 12.7qoq (sa, ann) 19.4 18.6 16.3 14.6 13.9 13.8m om (sa) 1.3 1.7 1.4 1.7 1.1 1.0

Fixed Asset Investm entyoy 28.5 27.5 25.8 26.9 23.4 23.4qoq (sa, ann) 45.6 48.2 49.2 46.8 39.7 28.5m om (sa) 2.8 3.0 3.2 3.3 3.5 3.5

Price Indicator

Consum er Price Indexyoy 4.4 3.4 3.0 3.3 2.7 2.2qoq (sa, ann) 5.3 3.7 2.4 3.4 4.7 5.1m om (sa) 1.1 0.5 0.0 1.0 -0.4 0.0

Producer Price Indexyoy 2.5 2.8 2.9 2.7 2.6 3.3qoq (sa, ann) 3.7 2.2 1.3 1.4 1.3 0.7m om (sa) 0.5 0.4 0.4 0.2 -0.2 0.2

Trade Indicators

Exportsyoy 27.1 28.7 26.8 6.9 51.6 33.0qoq (sa, ann) 11.8 -17.9 36.6 44.9 50.2 11.4mom (sa) 0.3 3.3 18.7 -27.9 20.0 10.8

Im portsyoy 14.2 19.1 21.3 14.5 13.1 27.5qoq (sa, ann) 11.4 13.2 21.3 25.3 18.7 10.2mom (sa) -1.7 1.1 3.6 -3.1 3.4 4.1

Trade Balance (USD bn) 26.9 22.5 16.8 6.9 23.7 15.9

Financial IndicatorsM 2 yoy 17.1 16.7 17.1 17.3 17.8 15.8qoq (sa, ann) 16.2 13.8 20.4 20.0 22.0 16.1mom (sa) 1.3 1.1 1.3 0.8 2.6 1.2

Total Loans yoy 16.3 16.0 16.0 15.7 16.6 15.4qoq (sa, ann) 16.3 14.7 19.3 21.0 22.6 17.3mom (sa) 1.0 1.2 1.6 0.6 2.2 1.9FX Reserves (USD bn) 1333 1293 1247 1202 1157 1105Proprietary Indicators

GSCA 12.6 12.4 12.1 10.9 13.2 13.2CEMAC-GS Coincident Indicator 102.48 102.45 102.10 102.01 102.05 101.67CEMAC-GS Leading Indicator 103.18 103.33 103.08 102.54 102.77 102.98GS China FCI 107.4 107.3 106.9 107.1 107.2 107.8

20062007

Source: NBS, CEMAC, PBOC, CEIC, Goldman Sachs Economics Research.


Issue No: 07/02 3 2Q2007

Is China overheating? This article was first published on July 20, 2007.

Aggregate demand growth is clearly outpacing supply capacity, evident by rising inflationary pressures in the overall economy.

However, within aggregate demand, the domestic demand component can at best be described as lukewarm, ...

...because the surging trade surplus, fueled by the significantly undervalued currency, has been increasingly “crowding out” domestic demand.

Therefore, in our view, an optimal tightening package should involve faster currency appreciation and less restraint on domestic demand. The 11.9% real GDP growth for 2Q2007 and 4.4% CPI inflation in June have again raised the question of whether the Chinese economy is overheated. 2004 was the last time this issue was seriously raised. As nerdy economists, we need to define what constitutes overheating first before answering this question. Traditionally, economists classify an economy as being overheated when its growth in aggregate demand (= consumption + investment + net exports) outpaces its domestic supply capacity, resulting in 1) upward pressures in inflation and 2) a deficit in current account. Using this definition, the Chinese economy has shown the first symptoms of overheating (rising inflation), but not the second one (a trade deficit). Is the Chinese economy overheating already? Or is inflation pressure only temporary because of transitory supply shocks? In our view, aggregate demand is already overheated in China, but total domestic demand (including domestic investment demand) is lukewarm at best. Specifically, From a macro perspective, aggregate demand growth is clearly outpacing the supply capacity, evident by: • Even with a potential growth rate as high as 9%-

10% in China, the latest 11.9% growth rate clearly suggests that the economy is growing above its potential, and the output gap is likely to be positive (see Exhibit 1).

• There is no overcapacity at the macro level, and

few even at the micro level. In other words, overall capacity utilization is very high. For instance:

Exhibit 1: China’s growth has been running above its potential

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78 80 82 84 86 88 90 92 94 96 98 00 02 04 06

Real GDP growth*

HP filtered trend

% chg yoy

* Real GDP growth in 2007 is our forecast. Source: CEIC, Goldman Sachs Economics Research. Exhibit 2: Electricity production growth is approaching its high in 2004

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Electricity production

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Issue No: 07/02 4 2Q2007

Exhibit 3: Inventory level is at historical low Industrial Enterprise Inventory Level (Days of Sales)

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99 00 01 02 03 04 05 06 07 ytd(May)

days


1. The power sector is running very tight despite wide-spread expectations of overcapacity in the sector this year due to significant capacity expansion in recent years. In fact, the electricity production growth rate has now reached close to its peak level in 2004 (see Exhibit 2).

2. As a result of the strong demand for power

generation, the demand for coal is so strong that China was a net coal importer in 1Q2007, the first time in history.

3. The inventory to sales ratio for industrial

enterprises is running at historical low levels (see Exhibit 3).

• Both nominal and real wage growth rates have

shown signs of acceleration, indicating the tightness in the labor market (see Exhibit 4).

• Inflation rates are on the rise. Not only CPI

inflation is already above 4% and poised to move higher, but the GDP deflator and the central bank’s Corporate Goods Price Index have all been moving upward (see Exhibit 5). Although year-on-year PPI inflation has not risen yet, its sequential growth rate has moved up already, and we expect this inflation measure to trend up soon as well.

However, within aggregate demand, the domestic demand component can at best be described as lukewarm Despite the record high top-line GDP growth in more than a decade, the real growth rate of domestic demand has been falling (see Exhibit 6). In other words, the main contributor to China’s ever-rising GDP growth in the last 4 years has been China’s ever-rising trade surplus:

Exhibit 4: Wage growth on the rise Year-to-date Urban Average Wage Per Staff

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Mar-03 Sep-03 Mar-04 Sep-04 Mar-05 Sep-05 Mar-06 Sep-06 Mar-07

Nominal

Real

% chg yoy


Exhibit 5: Inflationary pressures are rising

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1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007ytd

GDP deflator

Corporate Goods Price Index (CGPI)

Consumer Price Index (CPI)

% chg yoy


Exhibit 6: Stark divergence between the growth rates of domestic vs. aggregate demand

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% chg yoy, constant price



Issue No: 07/02 5 2Q2007

For instance, the level of China’s nominal GDP has only doubled between 1H2003 and 1H2007, but the level of its trade surplus has risen by 27 times in 4 years! Such stark dichotomy between the growth rates of domestic demand vs. net exports has highlighted the policy failures so far to rebalance the economy, in particular, failures to appreciate the currency in real terms, meaningfully. The renminbi (CNY) has only appreciated by 9.5% vs. the USD since the July 2005 revaluation, but a meager 5.2% in real trade-weighted terms (including the initial revaluation.). More importantly, since 2002, the CNY has depreciated by 11% in real terms following the USD’s fall, although it should have been appreciated significantly during this period because of China’s much faster productivity growth. Not surprisingly, China’s trade surplus has continued to rise, not just in level terms, but also as a percent of GDP. The flip side of this development is the falling share of domestic demand. Furthermore, without a moderation in export growth, there is limited room for domestic demand to expand without creating macro overheating pressures. When aggregate demand growth began to show signs of overheating, the brunt of demand deceleration fell on domestic demand, particularly on investment demand, during the 2004 and 2006 policy tightening episodes. As a result, the economy has become even more imbalanced in terms of its reliance on net exports.

Time to address the root cause of overheating In our view, the authorities would need to tighten macro policies significantly in the near term to reduce the overheating pressures in the overall economy. Letting the currency appreciate faster will help China reduce its trade surplus, induce downward pressures on inflation,1 and help the central bank regain monetary policy independence. On the other hand, a policy adjustment package without adequate adjustment in the CNY may succeed in bringing down headline growth, but will likely fail to rebalance the economy, or could even worsen the imbalances. Therefore, we maintain our 12-month forecast of 9% CNY/USD appreciation, and our Global Economics Team has recommended going short USD/CNY via 2-year non-deliverable forwards as #9 of our Top 10 Trades (see Top 10 Trade #9: Go short $/CNY via a 2-year NDF, Global Viewpoint, July 19, 2007). Hong Liang

1 See China: How significant is the exchange rate pass-through effect on CPI inflation? Asia Economics Flash, July 20, 2007.


Issue No: 07/02 6 2Q2007

Real GDP growth came in at 11.9% and CPI inflation 4.4% for June—readings of the 2Q2007 data This comment was first published on July 19, 2007 1. Activity growth showed significant acceleration Real GDP growth accelerated to 11.9% year on year (yoy) in 2Q2007 from 11.1% in 1Q2007, despite a significantly high base last year. 1 On a quarter-on-quarter (qoq); seasonally-adjusted annualized basis, GDP growth accelerated to 3.8% from 3.0% in the first quarter (see Exhibit 1). Net exports remain a key growth driver; its contribution to nominal GDP remained high at 23% in 2Q2007 (see Exhibit 2). Monthly activity indicators showed significant acceleration in June. Industrial production (IP) growth accelerated to 19.4 % yoy in June from 18.1% yoy in May, despite the high base (IP growth was 19.5% yoy in June last year). Fixed asset investment growth picked up to 28.6% yoy in June, up from 27.5% yoy in May. Retail sales growth inched up to 16.0% yoy in June, compared with 15.9% yoy in May.

2. Headline inflation rate exceeded 4% in June Headline CPI inflation accelerated to 4.4% yoy in June from 3.4% yoy in May, partly due to higher pork prices. Sequential growth accelerated to 5.2% qoq sa. ann. from 3.8% qoq (see Exhibit 3). The yoy reading of PPI inflation in June softened to 2.5% from 2.8% in May due to high-base effects. Its sequential momentum picked up to 3.7% qoq from 2.2% qoq.

3. We expect the government to conduct policy tightening using a combination of tools We expect the government to tighten policy decisively in 2H2007. In the near term, we expect the government to use a combination of 1) a cut/elimination of the interest income tax; 2) issuance of Rmb500 billion of special bonds (the net liquidity withdrawal impact will likely be very little), and 3) a 27 bp hike in both the lending and deposit rates (we see a 50% probability for this to happen in July). Furthermore, if loan expansion continues to accelerate in 3Q2007, we believe the central bank will intensify its use of administrative measures to curb lending, such as stepped-up moral suasion on commercial banks and the issuance of “special” central bank bills to designated banks. 1 The NBS revised 2006 GDP data recently. 2Q2006 GDP growth was initially reported to be at 11.5% and was recently revised upward to 11.9%.

Exhibit 1: Growth accelerated in 2Q2007 China GDP Growth Path

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qoq (RHS)

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GS Forecast

Source: National Bureau of Statistics (NBS), CEIC, Goldman Sachs Economics Research. Exhibit 2: External demand continues to be an important driver for growth while M3 growth remained high

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28Share of domestic demand contribution to nominal GDP growth

M3 growth (% yoy, RHS)

% % chg yoy

* M3 proxied by the sum of Net Foreign Assets and domestic credit. 2Q2007 growth is proxied by April and May data. Source: NBS, CEIC, Goldman Sachs Economics Research. Exhibit 3: Rising CPI inflation

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yoy

qoq sa an

% chg CPI

Source: NBS, CEIC, Goldman Sachs Economics Research.


Issue No: 07/02 7 2Q2007

4. However, necessary policy adjustments may be delayed The policy making process in the near future could be complicated by political events as the Chinese leadership is expected to be reshuffled around the 17th National Congress of the Chinese Communist Party in the fall of 2007. We expect the core leadership to remain unchanged, which assures policy continuity and stability. However, during the run-up to the election, we may see a slower-than-usual policy making process because of the uncertainties surrounding personnel decisions. Hong Liang Yu Song

Box 1: The timeline of policy tightening in China

2003-2004 September 2003 The reserve requirement ratio (RRR) was increased by 100 bp to 7% from 6%. March 24, 2004 The RRR was increased by 50 bp for non-state owned banks whose capital adequacy ratios (CAR) are below an unspecified level. March 24, 2004 The central bank lending rate was increased by 63 bp, and re-discount rate raised by 27 bp, effective on March 25. April 11, 2004 The RRR was increased by 50 bp to 7.5% for most commercial banks, and by 100 bp to 8.0% for commercial banks that met certain CAR criteria. April 28, 2004 Capital requirement hiked for steel, aluminum, cement and the property companies. April 28, 2004 Rumored suspension of bank lending. April 29, 2004 A local steel project in Jiangsu province was suspended and people involved in that project received severe reprimands. October 29, 2004 Both the benchmark 1-year deposit and lending rates were increased by 27 bp. 2006 April 27, 2006 The benchmark 1-year lending rate was increased by 27 bp. April, 2006 The Governor of Inner Mongolia was reprimanded for his role in an unauthorized power plant project. May 29, 2006 New property measures ruled that 70% of all new residential units have to be below GFA 90 sqm; down payment was raised from 20% to 30% for larger flats.


Issue No: 07/02 8 2Q2007

Box 1: continued

June 16, 2006 The RRR was increased by 50 bp, effective on July 5. July 21, 2006 The RRR was increased by 50 bp, effective on August 15. July 24, 2006 Restrictions on foreign ownership of property. July 26, 2006 State Administration of Taxation reinforced collection of capital gains tax if property is sold within 5 years of purchase. August 18, 2006 Both the benchmark 1-year deposit and lending rates were increased by 27 bp. August-September 2006 The State Council ordered the National Development and Reform Commission and other ministries to conduct an investigation on investment projects started in 2006. September 14, 2006 China announced new measures to adjust the export VAT rebate to discourage exports that draw heavily on natural resources. November 3, 2006 The RRR was increased by 50 bp, effective on November 15. 2007 year to date January 5, 2007 The RRR was increased by 50 bp, effective on January 15. February 16, 2007 The RRR was increased by 50 bp, effective on February 25. March 17, 2007 Both the benchmark 1-year deposit and lending rates were increased by 27 bp. April 5, 2007 The RRR was increased by 50 bp, effective on April 16. May 18, 2007 The PBOC raised the 1-year deposit rate by 27 bp and the 1-yr lending rate by 18 bp as well as the reserve requirement ratio by another 50 bp. May 18, 2007 The PBOC widened the USD/CNY trading band from +/-0.3% to +/-0.5% around the central parity. May 30, 2007 The MOF raised the stamp duty on A and B shares to 0.3% from 0.1% overnight. June 18, 2007 The MOF announced a series of export tax rebate adjustments affecting about 37% of China's export categories. July 20, 2007 The PBOC raised both the 1-year deposit rate and the 1-year lending rate by 27 bp, effective July 21, 2007.


Issue No: 07/02 9 2Q2007

Raising our growth and inflation forecasts for 2007 and 2008This comment was first published on July 19, 2007

We have raised our growth and inflation forecasts for 2007 and 2008 on the back of the stronger- than-expected macro data in 1H2007 and given the limited policy adjustments so far (see Exhibit 1). Specifically: 1) We have raised our real GDP growth forecasts to 12.3% for 2007, up from 10.8% previously, and to 10.9% for 2008 from 10.0% previously. Although we foresee some slowdown in sequential growth momentum in the rest of the year, the year-on-year real GDP growth rates are projected to be above 12% in 2H2007 because of the low base in 2006 (see Exhibit 2). 2) We have also raised our CPI inflation forecasts to 4.0% for 2007, up from 3.6% previously, and to 3.7% in 2008 up from 2.6% previously. We foresee monthly inflation to stay high in the range of 4.5%-5% in 2H2007, and we believe there are significant risks for inflation to rise above 5% in some months (see Exhibit 3). 3) Our forecasts assume decisive policy tightening taking place in 2H2007, in particular a significant slowdown in monetary expansion (M3 growth). These tightenings might involve 2 more 27-basis-point interest rate hikes, more aggressive withdrawal of liquidity by the central bank (possibly through the help of the issuance of the special bonds for the new FX investment corporation), stepped-up moral suasion on commercial banks to curb lending, and other administrative measures to curb investment demand.

Exhibit 2: Quarterly real GDP growth path China GDP Growth Path

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Source: NBS, Goldman Sachs Economics Research. Exhibit 3: Quarterly CPI growth path

China CPI Path

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Source: NBS, Goldman Sachs Economics Research.

Exhibit 1: Forecasts comparison

REAL SECTOR GDP by expenditure (at 1990 prices) Revised* Old New Old New Old

GDP 11.1 10.7 12.3 (10.5)** 10.8 10.9 (9.9) 10.0Domestic demand 9.1 9.1 10.0 9.8 9.9 10.0

Private consumption 7.8 7.8 9.6 8.0 9.5 8.5Government consumption 8.6 8.6 9.4 9.4 11.8 11.8Fixed investment 10.6 10.6 11.1 10.2 10.3 10.2

Net exports (contribution to growth) 2.6 2.2 3.1 1.8 2.1 0.9Exports (G&S) 18.6 18.0 20.0 16.8 16.3 15.3Imports (G&S) 16.6 16.6 18.0 16.2 15.8 15.8

CPI inflation (period average) 1.5 1.5 4.0 (3.1) 3.6 3.7 (3.0) 2.6

2008F(percentage change, unless otherwise indicated)

2006 2007F

* Recent revision to China’s 2006 GDP data incorporated. ** Consensus forecasts in parenthesis. Source: National Bureau of Statistics (NBS), Goldman Sachs Economics Research.


Issue No: 07/02 1 0 2Q2007

4) In addition, we expect faster CNY appreciation in the next 12 months than the pace we have seen in 1H2007. We maintain our forecast of 9% appreciation in the CNY/USD exchange rate over the next 12 months. Given we have already hit our 3-month CNY/USD forecast (made 3 months ago), we have updated our 3, 6, and 12-month levels of CNY/USD forecasts to 7.40, 7.25 and 6.93 respectively. 5) We see risks on the upside to our growth and inflation forecasts. In particular, if policy tightening is more muted or delayed than expected, we believe growth would run even higher than our forecasts, so would inflation. In that case, the risks for some more pronounced cyclical volatilities in the next 12 months would significantly rise. Hong Liang


Issue No: 07/02 1 1 2Q2007

How significant is the exchange rate pass-through effect on CPI inflation? This article was first published on July 20, 2007

Both theoretical literature and empirical work suggest exchange rate appreciation could induce downward pressure on domestic CPI via the pass-through effect.

Our estimates show a 10% appreciation of the CNY nominal effective exchange rate will likely reduce CPI inflation by 1.2 percentage points in 1 year and by a cumulative 1.5 percentage points in 2 year’s time.

Therefore, we argue that, besides interest rate hikes and liquidity withdrawal, faster CNY appreciation could also help China combat the rising inflation pressures.

Our Global Economics Team has recommended going short USD/CNY via 2-year non-deliverable forwards as #9 in our Top 10 Trades. With the CPI inflation breaching the 4% mark in June, much attention has been focused on what policy adjustments may take place to combat the re-emerging inflation pressures in the economy. Besides interest rate hikes and liquidity withdrawal, questions have also been raised on how much currency appreciation may help this cause. In this article, we examine the pass-through effect of exchange rate changes on domestic prices in China. Both theoretical literature and empirical work suggest exchange rate appreciation is likely to induce downward pressure on domestic CPI inflation. Our estimates show that a 10% appreciation of the renminbi (CNY) nominal effective exchange rate (NEER) will likely reduce CPI inflation by 1.2 percentage points over 1 year and by a cumulative 1.5 percentage points over a 2-year horizon. Therefore, we argue that faster CNY appreciation can help China combat the rising inflation pressures, as well as reduce its external imbalances. Our Global Economics Team has recommended going short USD/CNY via 2-year non-deliverable forwards (NDF) as #9 in our Top 10 Trades (see Top 10 Trade #9: Go short $/CNY via a 2-year NDF, Global Viewpoint, July 19, 2007).

Exchange rate pass-through to domestic prices The degree to which changes in the exchange rate pass through to domestic prices is an important issue in the discussion about the appropriate monetary and exchange rate policies. For instance, currency appreciation tends to reduce import prices expressed in local currency terms, which in turn may be passed through to final consumer prices and thereby reduce CPI inflation. Empirical studies have found such exchange rate pass through to import and consumer prices to be positive but incomplete, and it differs significantly across countries.

Exhibit 1: Visible relationship between the exchange rate and CPI inflation in China

Nomnal Effective Exchange Rate Changes and CPI Inflation

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What affects the extent of the pass-through effect? A large economic literature has developed over the past 2 decades on exchange rate pass through. Traditional literature has focused on microeconomic factors, such as the role of market power and price discrimination in international markets.1 An alternative view is advocated by Taylor (2000) who argues that the magnitude of the pass-through effect is also affected by monetary policy because of its impact on inflation expectations. 2 Specifically, the exchange rate pass through tends to be

1 For a survey of this literature, see P. Goldberg and M. Knetter (1997), Goods prices and exchange rates: What have we learned? Journal of Economic Literature, Vol. 35, pp. 1243-92. 2 John Taylor, 2000, Low inflation, Pass-through, and the pricing power of firms, European Economic Review, Vol. 44, pp. 1389 – 1408.


Issue No: 07/02 1 2 2Q2007

higher in a high-inflation environment because firms respond more to cost increases (due to exchange rate depreciation or other factors). Quite a few empirical studies have found evidence supportive of the Taylor hypothesis. Meanwhile, empirical evidence also appear supportive of the hypothesis that the exchange rate pass-through effect is higher for low-income developing economies than for developed economies, either because they tend to have higher inflation rates, or because they tend to have a higher share of tradable goods in their consumption3 (see Box 1 for a discussion on the import content in the consumption basket).

Estimation of the exchange rate pass-through for China and other countries Empirical studies have in general found a lower pass-through effect in industrialized economies than that for developing economies. For instance, Choudhri and Hakura (2002)4 estimated the pass-through effect for the U.S. is 0.00, 0.02 and 0.06 over 1, 4 and 20-year horizons and -0.01, 0.02 and 0.03 respectively for the U.K. Their estimated pass-through effect for China is 0.04, 0.30 and 0.41 over 1, 4, and 20 years. Using more recent data, another study by Ca’Zorzi, Hahn, Sanchez (2007)5 finds a 10% exchange rate change will induce an accumulated change in consumer price levels by 0.8% in 1 year and 7.7% in 2 years. Using quarterly data from 1992 to 1Q2007, we estimate that, holding everything else constant, a 10% appreciation of the CNY NEER will on average lead to a 1.2 percentage points reduction in CPI inflation in 1 year, 3 Corrinne Ho and Robert N McCauley, 2003, Living with flexible exchange rates: issues and recent experience in inflation targeting emerging market economies, BIS working paper, No. 130. 4 Ehsan Choudhri and Dalia Hakura, 2001, Exchange rate pass-through to domestic prices: does the inflationary environment matter? IMF working paper, WP/01/194. 5 Michele Ca’Zorzi, Elke Hahn, Marcelo Sanchez, 2007, Exchange rate pass-through in emerging markets, ECB working paper series No. 739.

by a cumulative 1.5 percentage points in 2 years, and by 1.6 percentage points in 3 years (please see Appendix for details). Compared with previous studies, our estimates are slightly higher than others’ over the short term, but lower over the long term. Undoubtedly these estimates need to be taken with a few grains of salt. In particular, our estimated pass-through based on data over the past 15 years may under- or over-state the true underlying parameter at the present time because of rapid structural changes in China. For instance, the degree of openness in China, as measures by the share of trade in GDP, has risen to about 67% as of 2006, from 34 % in 1992. The more open a country is, the more significant any exchange rate changes may affect domestic prices through its higher import content in consumption. However, the picture can be more complex as empirical evidence also suggests inflation is negatively correlated with the degree of openness, as the product markets in an open economy may be more flexible and firms more competitive. Nevertheless, even though the underlying parameter may have shifted, we believe both our estimates and other empirical evidence confirm there are some non-trivial, positive pass-through effects between CPI inflation and NEER changes in China, consistent with the evidence others find for other emerging markets.

Policy implications The recent upside surprise in growth and inflation data has confirmed our view that there are budding overheating pressures being built in the economy. Given the monetary expansion since 2H2006, as measured by M3 growth,6 we expect sequential CPI inflation to stay elevated for the remainder of the year. We expect the year-on-year reading of the CPI to stay above 4.5% for the rest of this year, and we see upside risks to this forecast (see Real GDP growth came in at 11.9% and CPI inflation 4.4% for June—readings of the 2Q2007 data, China Views, July 19, 2007, and Raising our 6 See China: M2 growth may have understated the speed of monetary expansion, Asia Economics Flash, July 6, 2007 and China: Why should we care about M3 growth? Asia Economics Flash, July 9, 2007.

Box 1: Estimating the import content in domestic consumption There is little official or academic research on the degree of import content in the domestic consumption basket for China. Here, we begin with some back-of-the-envelope estimation of this parameter. China’s imports are about 32% of GDP in 2006, and about half of the total imports are used in the processing trade with the final destinations overseas. The remaining part (equivalent of 16% of GDP) serves domestic investment and consumption. Since more imports are likely to be directly consumed for domestic-investment purposes rather than for consumption, we assume a 6:4 split between investment-related vs. consumption-related imports within these domestic-demand oriented imports. That is, goods imported directly for domestic consumption purpose may constitute roughly 6.4% of GDP. If consumption is about 50% of GDP, the direct import content in domestic consumption might be about 13%. Of course, import prices could also indirectly affect consumer prices through their impact on the costs of investment-related goods.


Issue No: 07/02 1 3 2Q2007

growth and inflation forecasts for 2007 and 2008, China Views, July 19, 2007). The exchange rate pass-through effect we examined in this article suggests that if the monetary authority in China could allow the currency to appreciate more in trade-weighted terms, it could help “dis-inflate” the economy, while reducing the foreign exchange inflows and facilitating the rebalancing of the economy. Furthermore, recent experiences of currency appreciation in neighboring economies (such as Korea and India) suggest that bolder currency appreciation, coupled with monetary tightening through higher interest rates, are effective in reining in inflation pressures in the economy while exerting limited negative impact on overall growth.

Faster CNY appreciation ahead After some successful “gradual” upward adjustments in the CNY over the past 2 years, it appears the Chinese authorities have already started to increase the pace of appreciation against the USD (see Exhibit 2). We expect the authorities to become bolder in using the currency tool to cool down domestic inflation pressures, and maintain our forecast of 9% appreciation of CNY/USD over 12-months’ time. Our Global Economics Team has therefore recommended going short USD/CNY via 2-year NDF as #9 of our Top 10 Trades. The 2-year NDF is currently standing at about 6.97, implying a less than 8% cumulative appreciation in 2-year’s time. Hong Liang Helen (Hong) Qiao

Exhibit 2: CNY appreciation has picked up speed since April 2007

-12-9-6-30369

12151821242730

08/01/05 10/30/05 01/28/06 04/28/06 07/27/06 10/25/06 01/23/07 04/23/07 07/22/07

Annualized weekly CNY appreciation rateTrend (HP filtered)

% appreciation, annualized

week starting



Issue No: 07/02 1 4 2Q2007

Appendix: Estimation of the exchange rates pass-through effect We have followed a similar research methodology that adopted by Coudhri and Haura (2001) to examine the pass-through effect. Specifically, we take the log difference of price, exchange rate and output and estimate the following reduced-form equation:

( ) ( ) ( ) ttttt YdLSdLPdLPd επππβ ++++= − loglogloglog 32110 where tP represents the home consumer price index, tS and tY are the trade-weighted NEER and the output level

(represented by industrial production), and tε is the error term in quarter t. Note that ( )L1π , ( )L2π and ( )L3π are lag polynomials. We ran the regression with quarterly data from 1992 to 1Q2007. With the estimation results of the lag polynomials, we then calculate the exchange rate pass-through to CPI over T periods by summing the partial effect of a 1 percentage point

change in the NEER in period t on the CPI over period t+T-1 (∑−

=

+

∂∂1

0 loglogT

t

t

SP

τ

τ ).

Exhibit A1: Estimation results of the reduced-form equation

Dependent Variable: DLOG(PRICEINDEX) Method: Least Squares Date: 07/12/2007 Time: 14:34 Sample (adjusted): 3Q1992 1Q2007 Included observations: 59 after adjustments

Variable Coefficient Std. Error t-Statistic Prob.

DLOG(PRICEINDEX (-1)) 0.711442 0.087593 8.122140 0.0000 DLOG(NEER) -0.046548 0.029049 -1.602412 0.1148

DLOG(IPLEVEL) 0.017298 0.012227 1.414776 0.1628 C 0.002491 0.001999 1.246126 0.2180

R-squared 0.598404 Mean dependent var 0.012181 Adjusted R-squared 0.576499 S.D. dependent var 0.019249 S.E. of regression 0.012527 Akaike info criterion -5.856540 Sum squared resid 0.008630 Schwarz criterion -5.715690 Log likelihood 176.7679 F-statistic 27.31785 Durbin-Watson stat 2.919863 Prob(F-statistic) 0.000000

Source: Goldman Sachs Economics Research.


Issue No: 07/02 1 5 2Q2007

Special treasury bonds to be issued for the new state foreign exchange investment agency—How will they affect monetary operations? This article was first published on June 25, 2007.

We expect the top legislature body in China to authorize the Ministry of Finance to issue US$200-250 billion worth of special treasury bonds to fund the new state foreign exchange investment agency.

In our view, the benefits of this bond issuance include extending the duration of the government’s sterilization bonds and making any potential loss from the foreign exchange investments an explicit fiscal cost.

However, it does not have any impact on the size of the foreign exchange inflows that the central bank still needs to sterilize, and therefore, it does not reduce the upward pressures on China’s exchange and interest rates.

In addition, how these bonds will be issued and priced will have an effect on bond yields and financial institutions’ profitability. In our comments published during the National People’s Congress (NPC) in March, we highlighted the imminent establishment of a new foreign exchange (FX) reserve management agency 1 and its need to purchase FX reserves of US$200–250 billion from the central bank for its investment. A recent news release on the website of the Standing Committee of the NPC confirms that this top legislature body would discuss the issuance of special treasury bonds by the Ministry of Finance (MOF) during its session on June 24–29, 2007. If authorized, the new FX reserve management company will use the funds raised in renminbi (CNY) to purchase FX reserves from the State Administration of Foreign Exchange in order to make overseas investments. In this article, we discuss the potential impacts of this special treasury bond issuance on monetary policy operations and interest rates. In our view, the benefits of this bond issuance include extending the duration of the government’s sterilization bonds and making any potential loss from the FX investments an explicit fiscal cost. However, it does not have any impact on the size of the FX inflows that the central bank still needs to sterilize, and therefore it does not reduce the upward pressures on China’s interest rate and exchange rate. In addition, how these bonds will be issued and priced will have an effect on bond yields and financial institutions’ profitability.

1 See China Views: NPC comment (#3): New foreign exchange reserve management agency to be set up, March 15, 2007.

What may change because of the issuance of these special treasury bonds?

First, the issuance of these bonds potentially lengthens the duration of the sterilization instruments in the future by retiring some of the shorter-duration central bank bills and replacing them with longer-term treasury bonds. Since April 2004, short-term (3 months and 6 months) central bank bills have been decreasing in proportion to the total outstanding sterilization debt. Currently, the outstanding central bank sterilization bills are overwhelmingly dominated by those of longer maturity [1-year and 3-years] (see Exhibit 1). Exhibit 1: The major sterilization tool has been central bank bills of 1-3 year duration

Oustanding Sterilization Bills by Maturity

0

10

20

30

40

50

60

70

80

90

100

Apr-03 Oct-03 Apr-04 Oct-04 Apr-05 Oct-05 Apr-06 Oct-06 Apr-07

3-month

6-month

1-year & above

% of total



Issue No: 07/02 1 6 2Q2007

In our view, the government is likely to have a bias towards issuing long-term special bonds to fund the FX reserve management firm, because: 1) the investment scope of this company is long, and 2) it is relatively inexpensive to issue long-term bonds now, given the yield of 10-year treasury bonds is at low levels (below 4.5%). Second, a significant portion of the sterilization costs will be shifted from the central bank’s balance sheet directly to the MOF’s. So far, the People’s Bank of China (PBOC) has been bearing most of the direct operational costs to maintain domestic monetary control, as it relies on central bank bill issuance and reserve requirement ratio hikes to conduct sterilization. Since the central bank holds FX assets and domestic debt, it will book a loss (in CNY) if the pace of CNY appreciation against major reserve currencies is greater than the interest differential across currencies. In the future, the special treasury bonds issued will bear a portion of the sterilization costs directly. Third, the cost of the treasury bonds may be slightly lower than the PBOC bills. In the past few months, there has been speculation that the new investment firm would issue corporate bonds in CNY, or swap the existing central bank sterilization bills held by commercial banks. The proposed arrangement suggests the special treasury bonds backed by the MOF should enjoy a slightly lower rate because of its explicit sovereign and tax-free status.

What will not change because of the issuance of these special bonds? First, since the issuance of these special bonds will not have any impact on FX inflows, it will not change the amount of sterilization needed to keep macro stability. In other words, the pressures on monetary policy management will not be fundamentally changed if China needs to continue to sterilize large quantities of FX inflows, currently at about US$1 billion per calendar day, no matter whether such sterilization operation is done through PBOC bills, government treasuries, or bonds issued by another government entity such as the new state-owned FX investment company (Exhibit 2). Second, the issuance of these bonds and the FX investment undertaken by the new investment company will have no impact on the total government-held FX asset positions. Therefore, we believe these policy adjustments will not fundamentally reduce the total FX risk exposures for the overall economy, even though the FX assets might be classified under a different name than “official reserves.”

Exhibit 2: Rapid build-up of sterilization debt in tandem with foreign exchange reserve accumulation

Official Foreign Exchange Reserves and Sterilization Debt

0

4

8

12

16

20

Mar-03 Sep-03 Mar-04 Sep-04 Mar-05 Sep-05 Mar-06 Sep-06 Mar-0710

20

30

40

50

Outstanding sterilization debt

Official foreign exchange reserves (RHS)

% of GDP % of GDP


Potential complications from this special treasury bond issuance 1. Who gets to buy these special bonds will have different monetary implications If only commercial banks are allowed to purchase these bonds, it will limit the banks’ capacity in credit expansion, and it will have the same impact on the monetary aggregate like the PBOC bills. On the other hand, if the special bonds are released to non-bank financial institutions and the public, it is just another form of money creation, and it does not restrict bank lending capability. In particular, a potential problem from the latter practice is that it also introduces distortion to the traditional definition of monetary aggregates as the difference between M2 and M3 will widen. 2. How these bonds are allocated and priced will affect market interest rates and financial institutions’ profitability If the special bonds are auctioned in the market, they could potentially help build the yield curve in China’s domestic debt market while inserting upward pressure on the whole yield curve. However, higher market interest rates would increase the total costs for sterilization and thereby reduce the returns of the FX reserve investment. Therefore, the MOF may have a strong incentive to allocate and price these bonds through non-market means. If so, the yields on these bonds could be depressed artificially, and financial institutions’ profitability might be squeezed, especially given the heightened inflation risks recently.


Issue No: 07/02 1 7 2Q2007

3. The pace of this bond issuance will also have an impact on bond yields It has been reported that as much as US$200-250 billion (Rmb1.5-2 trillion) of special bonds will be launched. This is equivalent to half the existing stock of government bonds, or almost 1/3 of central bank bills (see Exhibit 3). In a relatively underdeveloped bond market, such a large issuance of long-term bonds will likely steepen the yield curve by pushing up yields on the long end. 4. Will issuance of these treasury bonds make the government more or less likely to raise interest rates or the exchange rate? Everything else being equal, the issuance of these special bonds is likely to make the MOF an opponent to any upward adjustments in interest rates and the value of the CNY in the future. The reason is simple: assuming that the MOF needs to pay 5% for its long-term bonds, and the CNY appreciates by 5% a year vs. the USD, the MOF (through the new FX investment company) needs to make at least a 10% annual return in USD terms to break even! Any significant upward adjustments in interest rates or the currency could potentially result in explicit fiscal losses for the MOF. Hong Liang Helen (Hong) Qiao

Exhibit 3: The launch of special treasury bonds will likely have a significant impact in an underdeveloped bond market

The Structure of China's Domestic Debt Market

0

500

1000

1500

2000

2500

3000

3500

4000

4500

Governmentbonds

Central bankbills

Financial bonds Corporatebonds

Commercialpapers

Rmb bn



Issue No: 07/02 1 8 2Q2007

M2 growth may have understated the speed of monetary expansion This article was first published on July 5, 2007.

We find that the M3 growth rate has been faster than that of M2 since 2Q2006, ...

…likely reflecting the fast accumulation of capital-market-related financial assets, such as mutual funds and bonds held by non-financial institutions.

The speed of monetary expansion, as measured by the M3 growth rate, has now approached its peak level as of mid-2003.

As a result, we see upside risks to growth and inflation, as well as risks of more decisive policy tightening in 2H2007. Data from China has continued to show strength in the economy since the beginning of this year. At this moment, few investors are concerned about any imminent slowdown in growth, but anxiety is running high on the near-term trajectory of inflation, as well as potential policy responses given the buoyancy in the economy. In our view, the key for assessing the near-term growth-inflation outlook goes to how monetary expansion has been, or has not been, controlled. In this context, we find that some recent developments in the Chinese financial markets may have complicated the assessment of monetary expansion compared with earlier periods. Specifically, we noticed that the M3 growth rate has been faster than that of M2 since 2Q2006, likely reflecting the fast accumulation of capital-market-related financial assets. Indeed, we believe the growth rate of M3 has now approached its peak level as in mid-2003, highlighting the need for swift policy actions to rein in excess demand growth and control inflation pressures. We believe delays in monetary tightening will increase the risks of macro volatilities of a similar magnitude as those in the 2003-2004 tightening episode.

M3 growth has been much faster than M2 since 2Q2006 M2 supply in China includes currency in circulation, demand deposits, time deposits and savings deposits in banks, plus the customer clearing reserves in non-bank financial institutions.1 M3 is defined to include M2, plus deposits in non-bank financial institutions other than customer clearing reserves, and securities issued by financial institutions. In other words, total M3 liabilities should equal the amount of total financial assets of the overall banking system (including the central bank). 1 M2 supply statistics first started to include customer clearing reserves in 2006.

In the past, the growth rate of M2 had tracked that of M3 very closely, because changes in non-M2 liabilities in China’s financial system were relatively small. However, the growth rates of these two series have begun to diverge noticeably since 2Q2006: M3 growth has remained on an overall expansionary track while M2 growth has moderated except for an up-tick in January-February 2007 (see Exhibit 1). By April 2007, the gap in these two growth rates has widened to 2.1 percentage points. While M2 growth edged down to 17.1% year on year (yoy), M3 growth picked up to 19.2% yoy. M2 supply growth moderated further to 16.7% yoy in May, but with credit growth staying flat and trade surplus growth picking up, it is highly likely that M3 growth had inched up further and the gap had widened more in May. Exhibit 1: Growth of M2 supply and overall financial assets in the banking system started to diverge in 2Q2006

12

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15

16

17

18

19

20

21

22


M2

M3 proxy*

May

April

% chg yoy

* M3 proxy includes net foreign assets and domestic credits, "other assets" are not included in this graph as the level is only attainable since 2006, however, it should not have much impact on the growth rate of overall financial assets due to its small share and stable performance. Source: CEIC, Goldman Sachs Economics Research.


Issue No: 07/02 1 9 2Q2007

Fast accumulation of capital-market-related financial assets is responsible for this divergence Upon more detailed analysis of the balance sheets of financial institutions, we find faster bond issuance to the public and surging equity-related deposits are the key driving forces behind the divergence between M3 growth and M2 growth. Specifically, the rise in “bonds held by non-financial institutions” and “deposits in financial institutions not including M2” has contributed most to the rapid build-up in non-M2 liabilities (see Exhibit 2).2 Bonds issued to non-financial institutions have been growing at 30%+ yoy as of April 2007. In the meantime, “non-M2 deposits by other financial institutions,” albeit off a lower base, increased by 63% yoy in April. These non-M2 deposits include mutual funds, retained gains from investments and funds transferred from “other channels.” Micro-level evidence suggests that the dramatic increase in this item is connected to the stellar equity market performance.

Why is M3 becoming a better indicator for monetary expansion in China? With ongoing fast development in the capital markets, we believe that a broader money supply measure, such as M3, would increasingly be a more useful parameter to assess the extent of monetary expansion and to forecast future changes in aggregate demand. Economists define “money” as properties that carry three functions: 1) unit of account; 2) store of value and 3) medium of exchange. In our view, the “power” of those

2 See Box I for a detailed examination of financial institutions’ balance sheet.

non-M2 items have become increasingly similar to the traditional M2—bonds issued to the public can now be priced and exchanged in liquid markets, and equity-related financial institution deposits, such as mutual funds, are as liquid as, if not more liquid than, savings deposits. For example, the flip side of the diverging M2 and M3 growth is the swift rise of equity-market-associated financial institutions in China. In our view, their rapid asset accumulation is now contributing a non-trivial share to the overall monetary expansion. Therefore, M2 supply growth alone might have been understating the true extent of monetary expansion by leaving out part of the most vibrant segment of the financial sector. For the same reason, we have revamped the Goldman Sachs China Financial Conditions Index (GS China-FCI) in January to incorporate equity prices as an important parameter in gauging monetary policy stance. 3 We argued that the equity market expansion is becoming a more important force in driving growth in China. Our new GS China-FCI shows that with the rapid increase in asset prices and equity market capitalization, current financial conditions in China are more accommodative than the narrower measures of monetary policy suggest (see Exhibit 3) Furthermore, our GS China-FCI rightly predicted the pickup in activities growth in 1H2007, and has flagged further need for monetary tightening.

Implications of rapid M3 expansion: Strong activity growth and elevated inflation pressure in the near term In our view, inflation risks in China are driven by monetary easing and the resulting over-expansion of

3 See China: Financial conditions loosening and asset price inflation, Asia Economics Flash, January 19 2007.

Exhibit 2: China financial institutions’ balance sheet (including the central bank) by end-April 2007 Rmb trillion (% chg yoy)

Total outstanding financial assets 44.0 (19.2)Domestic credit (DC) 30.4 (14.7)Net foreign assets (NFA) 11.3 (38.5)Other financial assets* 2.4 (2.5)

Total outstanding financial liabilities 44.0 (19.2)M2 36.7 (17.1)Non-M2 liabilities 7.3 (30.9) Bonds issued to non-financial sectors 2.8 (30.3) Paid-in capital 1.6 (40.2) Deposits not included in M2 1.1 -(5.9) Deposits of other financial institutions** not included in M2 1.8 (62.8)

* Other financial assets are mainly made up of the asset injections for NPL disposal in 2003 and 2005, the total amount has not changed much since then. ** Other financial institutions include insurance companies, securities companies, stock exchange, trust companies etc. Source: CEIC, Goldman Sachs Economics Research.


Issue No: 07/02 2 0 2Q2007

aggregate demand relative to the economy’s supply capacity. 4 Domestic food price inflation also mainly reflects buoyant aggregate demand, although it could be set off by supply-side factors, or rising global food prices. Since M3 growth has been hovering over 19% yoy in recent months, we are likely to see continued acceleration in activities growth, and as a result, elevated inflation pressures in the near term. Fast monetary expansion has also highlighted the need for decisive monetary tightening to rein in the excess demand and avoid the risk of another overheating episode similar to the one in 2003-2004. The experience from the 2003-2004 tightening cycle suggests that the longer the authorities put off decisive policy actions, the higher the risk of blunt administrative measures being used by policymakers, in an attempt to get back on the curve. Therefore, we expect macro policy to maintain a tightening bias and more tightening measures to be introduced in the near term. We continue to expect two more 27-basis-point lending and deposit rate hikes in the remainder of the year, and 9% CNY appreciation in 12 months. In the meantime, tighter controls on credit expansion and investment demand are also likely to be enforced more strictly. We maintain our top-of-the-consensus CPI inflation forecast of 3.6% in 2007, which implies an average of over 4% CPI inflation in the rest of the year. Given our forecast of more decisive tightening in 2H2007, we continue to expect CPI inflation to ease to 2.6% in 2008. Hong Liang Eva Yi 4 See Growth-inflation nexus part 1: China, Asia Economics Analyst, May 26, 2006 and Assessing inflation risks in China, Asia Economics Flash, March 26, 2007.

Exhibit 3: Our GS China-FCI suggests that financial conditions are more accommodative than indicated by the changes in M2

12

13

14

15

16

17

18

19

20

21

22

23

1999 2000 2001 2002 2003 2004 2005 2006 2007

105.5

106.5

107.5

108.5

109.5

110.5

111.5

M2 supply

GS China-FCI (RHS, inverted)

% chg yoy Index

Tightening of financial conditions



Issue No: 07/02 2 1 2Q2007

Box 1: Deciphering the banking system’s balance sheet (including the central bank)

In this section, we investigate the combined balance sheet of all financial institutions (including the central bank) in order to find out the driving forces behind the recent divergence between M2 and M3 growth. In the official “Depository Corporation Survey” published by the central bank, there are two items under “assets”—net foreign assets (NFA) and domestic credits (DC), and five items under “liabilities”—M2, bonds held by non-financial institutions, paid-in capital (PIC), deposits not included in M2 and net other liabilities (see Exhibit B1). Exhibit B1: Official banking system balance sheet (including the central bank) from the “Depository Corporation Survey” in April 2007

Domestic Net foreign Bonds held by Paid-in Deposits not Net other credit (DC) Assets (NFA) non-financial inst. capital (PIC) included in M2 liabilities

Rmb tn 30.4 11.3 36.7 2.8 1.6 1.1 -0.6(% yoy) (14.7) (38.5) (17.1) (30.3) (40.2) -(5.9) (level at Jan-2006: -Rmb1.3 tn)

=+ + +M2 + +

Source: CEIC, Goldman Sachs Economics Research. On the liability side, M2 growth has significantly underperformed those “non-M2 liabilities” (17% yoy vs. 31% yoy in April 2007), resulting in much higher total asset, i.e., M3 growth compared with that of M2. But what’s been driving the higher growth of non-M2 liabilities? We find that the rise in “bonds held by non-financial institutions” and “other net liabilities” have contributed the most to the growth in overall non-M2 liabilities. Bonds held by non-financial institutions have been growing at 30%+ yoy, while “other net liabilities,” albeit off a lower base level, has surged to -Rmb0.6 trillion in April 2007 from -Rmb1.3 trillion in January 2006. The later increase was mostly driven by a rise in “other liabilities” by 63% yoy as of April (see Exhibit B2). These liabilities are the financial institutions’ deposits in the “other financial institutions”5 that are not included in the M2 statistics,6 including mutual funds, retained gains from investments and funds transferred via other channels. Micro-level evidence suggests that the dramatic increase in this item is associated with the stellar equity market performance. Exhibit B2: A transformed and more comprehensible banking system balance sheet (April 2007)

Domestic Net foreign Bonds held by Paid-in Deposits not Net other credit (DC) assets (NFA) non-financial inst. capital (PIC) included in M2 liabilities

Liabilities to other financial institutions

Move to the "Asset" side

Otherassets

-

+ = ++ +M2 +

Therefore:

Domestic Net foreigncredit (DC) assets (NFA)

Bonds held by Paid-in Deposits notnon-financial inst. capital (PIC) included in M2

Rmb tn 44.0 36.7 2.8 1.6 1.1(% yoy) (19.2) (17.1) (30.3) (40.2) -(5.9) (62.8)

M3Deposits of other financial

institutions not included in M21.8

M2 + + + +≡

+ +Otherassets

M3 ≡

Source: CEIC, Goldman Sachs Economics Research. 5 “Other financial institutions” include insurance companies, securities companies, stock exchange, trust companies, etc. 6 Only the “customer clearing reserves” part financial institutions’ deposits in “other financial institutions” are covered by M2 statistics, the rest are excluded from M2 and categorized under “other liabilities to other financial institutions.”


Issue No: 07/02 2 2 2Q2007

Why should we care about M3 growth? This article was first published on July 9, 2007.

In this article, we address a few questions raised by investors following our latest article on M3 growth and fast monetary expansion.

We argue that investors should care about M3 growth because it offers us a better explanation for why growth and inflation have surprised so much on the upside since 2H2006.

But more importantly, we believe it gives us a better tool to assess potential upside risks for growth and inflation in the future. Many clients have followed our latest article on China’s monetary expansion with great interest and more questions (see China: M2 growth may have understated the speed of monetary expansion, Asia Economics Flash, July 6, 2007). In this article, we try to address a few common issues raised by investors, in particular those on why it is important to watch M3 growth in China.

Question 1: The question being asked the most: Why should we care about M3 growth? Because we believe M3 growth offers us a better explanation for why growth and inflation have surprised so much on the upside since 2H2006. But more importantly, we believe it allows us to better assess the upside risks for growth and inflation in the future. M3 is a more comprehensive indicator for monetary expansion, and a better leading indicator for activity growth and inflation for most mature economies. In the case of China, capital-market-related assets were so small that M2 growth (which includes mostly liabilities in the banking system) was a good enough indicator for monetary expansion. However, China’s financial markets are changing so fast that we believe investors need to watch closely for what may have been left out significantly by M2 statistics. The differences between M1, M2, and M3 are mostly related to the differences in liquidity of the underlying financial assets involved, with M1 including only cash and demand deposits, M2 having term deposits, and M3 also containing bonds and equity-related assets. With fast development in the capital markets, many financial assets that are only included in M3 have now arguably been as important and as liquid as deposits in the banking system. For example, open-ended mutual funds can be bought and sold easily by investors but are not included in the M2 statistics. Moreover, Chinese households have been reallocating their financial assets out of bank deposits (M2) into equities (some of which are only included in M3) in the past 18 months.

Exhibit 1: Growth of M2 and M3 supply in the banking system started to diverge in 2Q2006

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14

15

16

17

18

19

20

21

22


M2

M3 proxy*

June

May

% chg yoy

* M3 proxy includes net foreign assets and domestic credits, "other assets" are not included in this graph as the level is only attainable since 2006, however, it should not have much impact on the growth rate of overall financial assets due to its small share and stable performance.


Therefore, we believe monitoring a money supply indicator broader than M2 growth has become important.

Question 2: What does M3 tell us about the cycle? While M2 growth has moderated since 2H2006 except for an up-tick in January-February 2007, M3 growth has been hovering around 18%-19% for a year, and now approaching its peak level as in mid-2003 (see Exhibit 1). Not surprisingly, demand growth and inflation have surprised on the upside. In our view, the economy is already running above its potential, but more importantly, is still gaining more momentum. Such above-trend growth in aggregate demand will translate into heightened supply constraints (such as in the power and transportation sectors) and inflation pressures.


Issue No: 07/02 2 3 2Q2007

Question 3: What is the near-term growth outlook? Broad money expansion leads to higher activities growth with about a 3-6 months’ lag. Therefore we are likely to see stronger activities growth (GDP, industrial production, investment, corporate profits etc.) in the coming quarter. Given the low-base of 3Q2006, we are likely to see 12% GDP growth, 20% industrial production growth, and 30%+ fixed asset investment growth in 3Q2007.

Question 4: The most important implication of fast M3 growth—inflation • How long does it take for M3 growth to translate

into CPI inflation? • What is the M3-implied CPI quarterly path? • When and at what level would CPI inflation peak? Broad money supply tends to translate into inflationary impulse with about a 12 months’ lag. Hence, the pickup in inflation we see in 2Q2007 likely reflected the over-expansion of M3 supply in 2Q-3Q in 2006. Using M3 growth as a leading indicator, we see sequential CPI inflation to stay high in the remainder of the year. The year-on-year reading of the CPI may peak in 3Q2007 (with an average of over 4%), due to its low base in 3Q2006 and high base in 4Q2006. However, we see upside risks to this forecast. Given our assumption of more decisive tightening in 3Q-4Q in 2007, the sequential CPI inflation rate may start softening in 1Q2008. However, that said, the potential evolution of CPI inflation is very much dependent on the timing of decisive monetary tightening. Delays in policy actions could result in higher inflation that also sticks around for longer.

Question 5: Does the central bank care about M3 growth? It is our understanding that the People’s Bank of China has been paying attention to M3 growth for a while, although it still only sets an annual operating target for M2 growth. However, as the market starts to pay more attention to M3 growth, and growth and inflation continue to be stronger than what would have implied by the M2 growth rate, we believe the central bank would also begin to watch for changes in M3. Hong Liang Eva Yi

Question 6: What are the likely policy responses in the near term? Will the recent correction in the A-share market alleviate policy concerns on overheating? In our view, inflation, including food-price-related price pressures, is a much more pressing concern for policymakers than the performance of the equity market. Therefore, as more signs point to broad-based overheating pressures in the economy, we believe the government will take decisive actions to slow down and “dis-inflate” the economy. Since we believe CPI inflation is likely to breach the 4% level very soon, we expect policymakers to start taking actions soon. We maintain our forecast of two more 27-basis-point hikes in the remainder of the year and 9% CNY appreciation in 12 months’ time. Other possible measures include the abolition of the Interest Income Tax, more trade tax adjustments, more window guidance on lending, and more intensified sterilization operations. If policy adjustments are put off for too long, we believe inflation could run higher, and the risks for a more blunt and full-fledged administrative tightening would increase.

Question 7: What are the important data points to watch? First and foremost is CPI inflation, especially the food price component, because it not only takes up one-third of the basket weight but is also a very politically sensitive component. Apart from downstream inflation, we would also watch for any signs of supply constraints and upstream inflation, such as power shortage or any signs of bottlenecks re-emergence. In addition, we would continue to closely monitor bank lending and fixed asset investment growth.


Issue No: 07/02 2 4 2Q2007

China’s 17th Party Congress: Implications and complications This article was first published on June 22, 2007.

The Chinese leadership at both the provincial and central levels is expected to be reshuffled around the 17th National Congress of the Chinese Communist Party in the fall of 2007.

We expect the core leadership to remain unchanged, which assures policy continuity and stability.

Meanwhile, the upcoming party congress will likely give rise to a group of new young leaders, from whom the core leadership for Generation V will be selected based on their performance in the next five years.

However, during the run-up to the election, we may see a slower-than-usual policy making process because of the uncertainties surrounding personnel decisions. This may lead to higher macro volatilities in the near term. 2007 is an election year for the Chinese Communist Party (CCP). During the 17th National Congress of the CCP, a large proportion of party leaders, including some top economic and financial decision makers are expected to retire from their current posts and be replaced by younger ones. We expect the core leadership, namely, President Hu Jintao and Premier Wen Jiabao, to most likely remain at the helm of the government for another 5-year term. In addition, their emphasis on governing by consensus and making policy decisions collectively will likely continue as well. Meanwhile, we expect the 17th Party Congress to unveil a pool of new leaders, from which Generation V leaders will likely be selected to take over after the next National Party Congress in 2012. Within the next five years, these candidates are expected to demonstrate their capabilities and skills in policymaking as well as political maneuvers before the consensus on the next generation core leadership is formed within the CCP. However, due to uncertainties about potential personnel changes, current policymakers could shy away from adapting harsh tightening measures to reduce the overheating pressures in the economy or to cool down the excessively exuberant domestic asset market. A delay in the decisive implementation of a new round of policy tightening when it is necessary could introduce more cyclical volatility.

The tradition of the party congress Since 1977, the CCP has kept the tradition of holding a national congress every five years. During these important meetings, new leadership is elected, and sometimes new themes of the party’s leading thoughts and national policies are released. When the 16th Party Congress was held in 2002, Jiang Zemin and Zhu Rongji of the Generation III leadership handed over the helm to Hu and Wen, which marked the beginning of the Generation IV leadership era. Furthermore, during the same congress, “the Three Representations” defined by Jiang were also identified as the central theme for the party in the following years. During the 17th Party Congress this year, over 60% of the members of the Central Committee and about half of the members of the Politburo will either retire or be promoted from their current posts, while their positions will be filled by a new class of party cadres.1 With the congress scheduled to take place in late September – early October, it implies that by the end of this year, the Standing Committee of the Politburo, Central Secretariat and the Politburo will all have a large proportion of new and younger leaders (see Exhibit 1). Among these new faces will emerge the candidates for some top economic and financial decision makers for the next cabinet. Given the fact that three vice-premiers and all five state councilors will likely vacate their positions due to retirement or promotion next year after the 11th 1 Cheng Li, Anticipating Chinese Leadership Changes at the 17th Party Congress, China Brief. 7, No. 6 (March 2007): 5-8.


Issue No: 07/02 2 5 2Q2007

National People’s Congress (NPC), 2 the change of Politburo members this year in the party congress will likely shed some light on who would serve in these important positions and influence future economic and financial decisions in China. Potential candidates for these important positions will likely be involved in the reshuffling of future leadership positions possibly in the People’s Bank of China, China Security Regulatory Commission, National Development and Reform Commission, State-owned Assets Supervision and Administration Commission, Ministry of Commerce, and provincial leaders from Guangdong, Beijing, Tianjin, and Chongqing, etc.

Complications in policy making in the near term During the run-up to the election, the current policymakers’ decision-making process could be affected by the perspectives of their future appointments. To maintain “stability” in current economic policies, there might be strong incentives for the policymakers to shy away from adapting harsh tightening measures to reduce the overheating pressures in the economy or to cool down the excessively exuberant domestic asset market. 2 Cheng Li, 2007.

Compared to a non-election year, when policymakers usually start to introduce tightening measures right after they see the budding overheating signs from the 1Q data, there seems to be more foot-dragging in decisive policy actions this year. In our view, the aversion against policy changes in the near term is concerning, especially at a time when overheating pressures are building, inflation is rising and the asset market continues to run with hefty valuations. Despite the policymakers’ original intension of smoothing out the fluctuations in the economy, a delay in the decisive implementation of a new round of policy tightening at this stage could actually induce more cyclical volatility, and perhaps more challenges to the forthcoming new cadre of leaders.

We expect continuity in core leadership and policy After the 17th Party Congress, President Hu Jintao will most likely serve as the core leader of Generation IV for their second 5-year term, before the next generation of leadership is identified. Although we expect Premier Wen Jiabao to continue to lead the next cabinet, there

Exhibit 1: The structure of the National Congress of the Chinese Communist Party

Source: http://cpc.people.com.cn, Goldman Sachs Economics Research.

National Congress of the Chinese Communist Party

Central Committee

Central Commission for Discipline Inspection of the Chinese Communist Party

General Secretary

Standing Committee of the Political Bureau

Politburo Secretariat of the Central Committee


Issue No: 07/02 2 6 2Q2007

have been noises on a potential early retirement due to his extraordinarily heavy workload.3 We expect Hu and Wen to continue to place economic development as their policy priority and guide China toward a more open and market-oriented economy. Judged from the experience in the past five years, we believe Generation IV will likely maintain their gradualist working style and avoid drastic changes, while sticking to collective decision-making and acting upon a consensus. It also implies that after the new team of economic and financial decision makers takes office, it may still take a while before any consensus can be formed on introducing any bold new reform initiatives.

Who’s next? The cadre of Generation V It has been argued that the most important mission of the 17th Party Congress is to elect the next generation of leadership, Generation V, into the Politburo. This is because for both Generation III and Generation IV, all four major leaders (Jiang, Zhu, Hu and Wen) had entered the Politburo a few years before they were assigned to key leading positions. For example, Hu Jintao has served on the Politburo for 10 years before taking over from Jiang in 2003. If this tradition is to be continued, candidates for Generation V leaders would probably come from the current Politburo members or the upcoming ones after the Party Congress this year. Due to the retiring age limit that has been more strictly enforced in recent years, the current members of the Politburo and its Standing Committee are unlikely to become the core leadership of Generation V in another five years. Therefore, the new leadership will more likely come from those entering the Politburo or its Standing Committee in 2007. Therefore, we expect a new cadre of younger leaders to step up after the party congress later this year and take up vice-premier and state councilor positions in early 2008, and work to prepare themselves for future core leadership with continuity and stability in economic and social policies.

Challenges for future leadership For these future leaders, the challenges in the economic, social and political areas will likely turn out to be much greater than before, given the scale of the economy will only become larger, the degree of global integration 3 According to Reuters, the spokesperson of the Ministry of Foreign Affairs of China denied the reports by Kyodo News that Premier Wen Jiabao would not pursue a second term. See Reuters report on June 4, 2007 at http://cn.today.reuters.com/news/newsarticle.aspx?type=macroEconomic&storyid=2007-06-04T094122Z_01_CN0095269_RTRIDST_0_ZHAESMA00441.XML&src=rss&rpc=361.

higher, and the pace of changes in all areas quicker than they have ever been. It requires an unprecedented amount of expertise, competence, charisma as well as patience for a pair of (or more) new rising forerunners to outperform their peers and convince the public that they will be able to carry out the ongoing reforms and lead the country into a new era. In addition, perhaps one of the greatest challenges for these leaders would be to work out a more open system to attract talent into the government in the future. Admittedly, the current incentive system of selecting public servants among young talent is unlikely to offer a promising pool of the most skilled, committed and competent candidates to rule the country in twenty years, especially considering the drastic difference in terms of attractiveness to new graduates of public service versus working in large multinational firms or going abroad to attend graduate schools.4

The timeline The personnel discussions and decisions for the new Politburo, Central Secretariat and Standing Committee will likely be made in late summer. These will likely remain secret until the 17th Party Congress takes place this fall. In spring 2008, the 11th National People’s Congress will elect the premier and vice-premiers and formalize the shifts in the ministerial levels within the cabinet. This will be the key event to watch for next year before the Beijing Olympics in August. Helen (Hong) Qiao Hong Liang

4 China’s Leadership Gap, John Thornton, Foreign Affairs, Nov/Dec 2006.


Issue No: 07/02 2 7 2Q2007

Time to anchor asset inflation expectations in the A-share market This article was first published on May 10, 2007.

Notwithstanding strong fundamentals, negative real interest rates are fueling excessive exuberance in the A-share market very quickly.

If left unchecked, asset inflation may soon advance into treacherous territory…

…rendering the hope of a future soft landing in the A-share market unattainable.

But more importantly, we believe an overly-stretched A-share valuation and its eventual correction could severely impair households’ balance sheets, exacerbate income and wealth distribution, and set back years of progress made on capital market reform.

Therefore, in our view, it is critical for the government to take actions now to prevent excesses from being built up further, beginning with an adjustment in the negative real interest rates. In our article published in early February, we argued that, while the resurgence of China’s A-share market has been supported by strong fundamental underpinnings, a negative real interest rate, an undervalued currency, and non-market-based supply functions are all on the margin fueling some excesses.1 Indeed, such excesses have been rising quickly in recent months: • The A-share index has gone up another 50% year-to-

date on top of the 130% gain last year, despite a sharp, but brief, correction in late February.

• The average price-to-(2006) earnings ratio has now

reached above 50 times. • The weighted average premiums of A shares vs. H

shares for the same company have reached 57%. • Both daily turnover and new individual account

openings have continued to skyrocket (see Exhibit 1).

In the meantime, the macro underpinnings continue to feed the exuberance of domestic investors with accelerating aggregate demand, rising inflation expectations, and muted policy actions. In particular, the absence of any interest rate adjustment in April, substituted by a mere 50-basis-point (bp) reserve requirement ratio hike, is likely to validate rising expectations of asset inflation, leading to further P/E multiple expansions in the A-share market.

1 See China: Should and will the equity market be the next policy tightening target? Asia Economics Analyst, February 5, 2007.

Exhibit 1: Market turnover and new account openings are skyrocketing

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

99 00 01 02 03 04 05 06 070

200

400

600

800

1,000

1,200Monthly new individual accounts in A and B shares

A share annualized monthly turnover as % of free-floatmarket cap (RHS)

%Thousand

Source: CEIC, Goldman Sachs Economics Research. Our Strategy Team believes that current A-share valuations are demanding, 2 but not outrageous yet, thanks to some meaningful upside surprise in earnings growth. However, if the asset inflation expectations are left unchecked, A-share valuations could soon advance into clearly unsustainable territory. Therefore, to ensure the sustainability of the market over the medium term, we believe policymakers need to act quickly. Delays in policy actions will run the risks of severely impairing households’ balance sheets, exacerbating income and wealth distribution, and setting back years of progress made on capital market reform.

2 See A-share market: Strenuous valuations, China Portfolio Strategy, May 10, 2007.


Issue No: 07/02 2 8 2Q2007

Asset inflation expectation is a dangerous thing in China Inflation tends to be a very unstable process in China, because the majority of households’ financial assets are in the form of cash and bank deposits, which now stand at US$2.5 trillion, roughly 88% of GDP, and 390% of the free float capitalization of the A-share market. But these deposits are now earning a 2.23% after tax return, compared with 3.3% CPI inflation as of March, and 15.9% nominal GDP growth in 1Q2007 (see Exhibit 2). Therefore, household deposits tend to flow out of the banking system quickly when people feel the value of their assets is eroded by inflation. In the mid-1990s, the double-digit CPI inflation rate led people to stockpile consumer goods. In recent years, real estate price inflation has led to rising property investment, and in the past 18 months, domestic A shares have become the new hottest commodity in town. As a result, leaving inflation expectations ill-anchored, be it the inflation expectations in goods and services or in assets, can be a very risky proposition in China. Once such inflation expectation becomes widespread and entrenched, a soft landing of the market, or the economy, would be much harder to achieve.

Time to raise interest rates, and to deepen capital market reforms In our view, the fundamental challenge for Chinese policymakers is how they can keep the economy from building up excesses, particularly in the asset markets, with a risk-free rate set at below 3% but an economy growing at 10% in real terms. This challenge has become even more stark when officially reported CPI inflation crosses the 3% line. That is, even using the most

conservative inflation measure, the real interest for Chinese depositors has now become negative. Monetary policy is clearly behind the curve. Exhibit 3 shows China’s interest rates have lagged significantly behind the rise in growth and earnings. Not surprisingly, the economy has periodically accelerated to overheating territories during the past 4 years, while policymakers have so far resorted mostly to administrative tightening measures with very slow interest rate or currency adjustments. However, as the cycle becomes more mature and equity market exuberance accelerates, we believe delays in raising rates now increase the risk of more aggressive rate hikes in the future, as well as risks of more blunt administrative measures that would bring down the expectations of future growth. Exhibit 3: Interest rates significantly lag the cycle in China

0

5

10

15

20

25

30

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007ytd

0

10

20

30

40

1-year deposit rate (RHS)

Nominal GDP growth

Return on equity (China offshore listed companies) *

% p.a.% China

* Return on equity for 2007 is our estimate. Source: CEIC, Goldman Sachs Economics Research.

Exhibit 2: Most of Chinese households’ financial assets are still in the form of cash and bank deposits, but equity holdings have been rising quickly

US Japan Germany(% of GDP) 1999 2007 ytd 2006 2006 2005

Total household financial assets 92.8 124.1 317.9 303.4 190.1

Cash and deposits 79.8 87.8 50.4 153.3 66.6Securities 8.2 23.6 157.5 42.8 63.4

Equities 8.2 18.2 97.1 21.4 22.0Govt. & corporate bonds 0.0 0.2 21.6 6.7 18.4Other securities 0.0 5.2 38.7 14.7 23.0

Life insurance reserves 0.0 4.9 8.4 45.2 46.6Pension fund reserves 0.0 3.0 92.0 33.4 10.8Others 4.7 4.7 9.6 28.6 2.6

China

*

* Mortgage securities and mutual funds. Source: CEIC, Goldman Sachs Economics Research.


Issue No: 07/02 2 9 2Q2007

Besides interest rate adjustments, a few other equity market reform initiatives have also made slow progress, including: 1. Launching the stock futures product to facilitate the

price-discovery process and provide investors with risk-hedging instruments.

2. Launching the QDII scheme to allow domestic

investors to arbitrage the huge price differentials between the A and H-share markets.

3. Expanding the QFII quota to build a global

institutional investor base for A shares. 4. Setting up a market-driven IPO listing and pricing

mechanism. 5. Taking decisive action against insider trading and

share price manipulation. These reform initiatives may help dampen some of the excessive exuberance in the A-share market, and therefore it would be better to introduce them at a time when the market fundamentals are still robust. On the other hand, if market fundamentals have already become shaky because of stretched valuations, implementation of these reform measures, which are critical to the long-term health of China’s capital market, may be further delayed due to concerns that they may “pop the bubble.”

Why a bust in equity markets may matter more this time? Decisive policy action to prevent A-share valuations from forming another asset bubble is of crucial importance, because a bust in the equity markets this time around is likely to have far more serious consequences than the bust after 2001, for the following reasons: 1. Equity market participation is much more wide spread now than in the past As of April 30, total number of domestic individual equity accounts has reached 94 million,3 or over 7% of population. This contrasts with a 5% equity participation rate in 2001. Moreover, new account opening is accelerating at a lightning pace—new individual account openings on April 30 alone exceeded 1 million, and total new individual account openings in the month of April exceeded the sum of years 2005 and 2006! As a result, about 17% of the total existing accounts were opened just in the past 4 months.

3 This includes domestic individual accounts in A share, B share and mutual funds.

2. Therefore, a correction in the equity market may have a much larger negative wealth effect on consumers Total A-share market capitalization now stands at 72% of GDP, and households own about 21% of this pool, roughly equal to 15% of their estimated total financial assets (see Exhibit 2 on page 3). In comparison, at the 2001 peak, total A-share market capitalization was only 52% of GDP. 3. It would also set back progress made in financial market reforms for years The turnaround of China’s onshore stock market has come after years (2001-2005) of investors’ anguish over falling share prices and policymakers’ painstaking reform efforts to address the irregularities in the market. More importantly, for investors who have been concerned about the Achilles’ heel of China’s development model, the revival of the domestic stock market begins to offer hopes that China may be able to gradually offload some of the systematic risks from its banking system. However, if an asset bubble is built in the A-share market again, much of the progress of the past few years may be undone. Not only would the renewed funding capability of the domestic equity market be eroded, but the medium-term prospects for Chinese households to diversify their huge savings into assets other than bank deposits would also be impaired, leaving one of the systematic risks facing China’s banking system unmitigated. In addition, the perceived high returns in equity investment vs. the low borrowing costs is likely to induce rising leverage by investors through borrowings from banks, pawn shops, or even curb markets. Therefore, the longer the asset bubble is allowed to run up, the more damages it could eventually cause to the balance sheets of banks and consumers. 4. The impact on markets in the rest of the world is likely to be bigger A case in point is the February 2007 global markets sell-off that followed the close to 10% drop in the A-share market. More importantly, if a large equity market correction exerts any non-trivial negative impact on the real economy, through damages to either consumer or corporate (including banks’) balance sheets, it could also negatively affect growth outside China given deepening globalization and China’s rising importance in the world.


Issue No: 07/02 3 0 2Q2007

Then, what should the government do? In our view, given the elevated expectations in the market, policymakers need to move swiftly in the following areas to anchor investors’ expectations: 1. Raise the benchmark deposit and lending rates

decisively. 2. Launch the QDII schemes with sufficient scale to

allow domestic investors more asset choices other than A shares.

3. Liberalize the IPO and subsequent fund-raising

processes, in particular, those related to price setting. 4. Act against fraudulent and illegal market activities,

such as insider trading and falsifying information, decisively and transparently.

On the other hand, we maintain our view that any proposal for raising transaction or capital gains taxes should be examined with caution, not only because there are non-negligible efficiency costs associated with taxes, but also because tax increases would tilt national income distribution further towards the state at the expense of consumers, and thereby run against the medium-term goal of the government to boost domestic consumption. But, what will likely happen in the near term? In our view, policy actions taken so far have been inadequate to contain the bubbling overheating pressures in the broad economy, while little has been done to anchor inflation expectations. The 50 bp reserve requirement ratio hike in late April had little teeth given commercial banks’ excess reserve ratio stands well above 2%, and the absence of any adjustment in interest rates will continue to feed exuberant asset demand. Therefore, we maintain our view that the central bank will likely raise interest rates 3 more times this year, by 27 bp each time. In addition, the government will likely take further actions to curb loan growth and fixed asset investment expansion, as well as trying to warn investors of the risks in investing in the A-share market. However, we believe delays in effective policy actions now will increase the risks of a more painful landing than otherwise the case in the broad economy and the A-share market down the road. Therefore, China should not miss the opportunity to get the equity market right for its medium-term development when it is still not too late. Hong Liang


Issue No: 07/02 3 1 2Q2007

Will the wealth effect of equity prices be significant in China? This article was first published on June 11, 2007.

In this article, we analyze how the equity market boom may affect consumer spending via the wealth effect channel, by drawing on the experience of the U.S. and Japan.

Empirical evidence on the wealth effect in China has been weak in the past, but the current equity market boom could be different because of much wider and deeper household participation.

Therefore, we may see a more noticeable positive wealth effect from the current equity market boom on consumer demand over the 1-2 year horizon.

A deep market correction is perhaps unlikely at this valuation level, but if the market excess continues to build up, an eventual correction in the market could also dampen consumer spending down the road.

We believe it is critical for policymakers to act early to prevent any asset bubble from being built up in order to reduce the risks of a boom-bust cycle in consumer demand. In our article published in early May, we highlighted the risks of asset inflation advancing into treacherous territory, fueled by negative real interest rates. 1 In particular, we pointed out that a potential severe correction in the equity market could impair household balance sheets and exert a negative impact on consumer demand through a negative wealth effect. In this article, we analyze the potential wealth effect from the current equity market boom on consumer spending in China by drawing references from previous experiences in the U.S. and Japan. Empirical evidence on the wealth effect in China has been weak in the past, but the current equity market boom could be different because of a much wider and deeper household participation. As a result, the 18 straight months of A-share market resurgence would probably lead to a positive wealth effect playing out more noticeably this time. Other countries’ experiences have shown that both the magnitude and duration of the equity market boom-bust cycle matter for the volatility in the consumption cycle. If the market stays around at the current valuation levels, we expect the positive wealth effect to spread out to consumer expenditure gradually. However, if the market excess continues to build up, an eventual correction in the market could also dampen consumer spending down the road. Therefore, we believe it is critical for policymakers to act early to prevent any asset bubble from being built up in order to reduce the risks of a boom-bust cycle in consumer demand.

1 See China: Time to anchor asset inflation expectations in the A-share market, Asia Economics Flash, May 10, 2007.

The wealth effect of asset prices According to economic theories, asset price changes can induce people to adjust consumption expenditures when they realize (or merely perceive) a gain/loss in their wealth. When land or equity prices rise, households usually spend more, and cut their expenditure if otherwise. Empirical studies tend to find a positive correlation between real consumption and real household net worth, as shown by US data (see Exhibit 1).

Exhibit 1: Real consumption expenditure growth has a high correlation with the growth of real household net worth in the U.S.

Real Consumption Expenditure in the U.S. and Household Net Worth

-4

-2

0

2

4

6

8

1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006-15

-10

-5

0

5

10

15

Personal consumption expenditures

Household net worth (RHS)

% chg yoy % chg yoy

Source: Federal Reserve Board, U.S. Department of Commerce, Goldman Sachs Economics Research.


Issue No: 07/02 3 2 2Q2007

How big was the wealth effect in other countries?

Due to data limitations, we have to gauge the wealth effect in China by drawing references from studies on the wealth effect in the U.S. and Japan.2 According to our U.S. economists’ estimates, 3 U.S. consumers increase their consumption by US$2–3 for each US$100 gain in the stock market after 5 quarters, which is roughly in line with the general expectation on the marginal propensity to consume (MPC). Their study shows that from 1995 to late 1998, the rise in equity prices left a favorable shock of US$119 billion in overall household consumption levels and pushed up consumption growth by 2.3 percentage points (pp), which was translated directly into a 0.5 pp boost to real GDP growth (without considering a possible multiplier effect).4 In addition, the estimates of our Japan Economics Team on the wealth effect in Japan shows that the elasticity of household consumption to equity wealth change is similar in magnitude with that in the U.S.5 We expect the wealth effect from equity price changes to be greater in China now than it was in the past, given the rise in equity holdings in household net worth and the market cap-to-GDP ratio. Considering the growing importance of the wealth effect and the equity cost of capital, we have added an Equity Price Index to our China Financial Conditions Index (GS China-FCI) during the last recalibration. 6 The equity component weight derived from our estimation turned out to be greater than the weights on real market-cap-to-GDP ratios used in other FCIs, because our nominal equity index incorporates the feedback effect from output. Since February this year, the equity price surge in the domestic A-share markets has contributed 50 basis points of financial condition easing accumulatively.

2 To estimate the aggregate wealth effect properly, the ideal method is to set up a vector-autoregressive (VAR) model to regress the real consumer expenditure on lags of disposable income, real interest rate and real household net worth to receive the estimation results. Unfortunately, quarterly data on consumption and disposable income are not available in China, and there is no reliable data series on household outstanding assets and liabilities in properties, bonds, insurance, and pension arrangements. 3 See The Goldman Sachs Financial Conditions Index: The right tool for a new monetary policy regime, William Dudley and Jan Hatzius, June 8, 2000. 4 See Wall St. and Main St. intersect, U.S. Economics Analyst, Alex Patelis, November 6, 1998. 5 See Consumption recovery: Challenging the market consensus again, Tetsufumi Yamakawa and Naoki Murakami, Japan Economics Analyst, February 9, 2007. 6 See China: Financial conditions loosening and asset price inflation, Asia Economics Flash, January 19, 2007.

Assuming the marginal propensity to consume in China is lower than the U.S. and Japan, 7 we think it is reasonable to assume that for every Rmb100 gain in equity assets, Chinese households are likely to adjust their consumption expenditure up by roughly Rmb1–1.5 within the next two years. In aggregate, we believe the magnitude of a windfall of wealth increase on the close to 100 million individual equity account holders, or 7% of the population, would be anything but trivial. From the turnaround of the A-share market in late 2005 till the end of this April, as much as Rmb4.5 trillion of equity wealth has been created just from the market capitalization increase, of which about Rmb3.1 trillion was directly owned by retail investors. Of the total wealth gain, we estimate that Rmb31–47 billion would likely be allocated for consumption, which could boost household consumption by 0.4–0.6 pp. On the other hand, a substantial downturn in the equity market could also place a drag on consumption and in turn on GDP growth. A deep correction is perhaps unlikely at this valuation level (see A-share market: Strained valuations, China: Portfolio Strategy, May 10, 2007), but if the market excess is allowed to run much further and longer, it could become a real threat in the future.

The duration and magnitude of the market correction will matter

As indicated earlier, the impact of the wealth effect comes with a significant time lag, because it takes consumers up to a year to fully realize that the income shock is permanent and make changes to their spending patterns accordingly. Given the delay in consumption behaviors, a short-lived correction after an equity boom that resurrects itself rather quickly should induce only a limited impact. On the other hand, if a sizable loss is set in for a protracted period of time, people are more likely to cut back their expenditures visibly. As Exhibit 2 shows, it took longer for U.S. households to return to the previous real net worth levels after the 1973–1974 bear market and the internet bubble after 2001 than after the 1987 market crash, as the equity price drops in those two periods were more significant and long-lasting. As a result, the impact on consumption expenditure during and after the 1973–1974 bear market was much more significant than that in 1987 due to the protracted negative consequence on consumers’ balance sheets.

7 The marginal propensities to consume in the U.S. and the U.K. have been estimated to be approximately 80%, while China’s below 70%.


Issue No: 07/02 3 3 2Q2007

In addition, the nature of the investors could also influence the impact of the wealth effect. If the market sentiment is largely geared towards long-term investment, most people will tend to overlook the short-term fluctuations and keep their investment and consumption relatively stable. In contrast, investors focusing on short-term speculation could be spooked by price declines more easily and have more volatility in their net worth.

Yet, empirical evidence on the wealth effect in China has been weak in the past Notwithstanding the theories and reasoning, we have found little evidence empirically in support of the wealth effect from equity price changes in China in the past (see Exhibit 3). We find such results hardly surprising, considering: 1) the proportion of households’ direct equity holdings in total financial assets has been small historically, and 2) the domestic stock market experienced fleeting booms and busts, with most of the remaining periods filled by a lack of active trading activity. As a result, the impact from equity valuation changes on consumption expenditure was almost indistinguishable. However, things could be different this time. The substantially wider degree of market participation combined with a more sustained equity market boom will likely encourage the wealth effect to fully play out. Although we have yet to observe trend-breaking growth in the retail sales data, especially in real terms, the initial stage of the wealth effect is likely to have surfaced in China, in various markets such as the real estate, luxury goods, antiques, and arts.

The inter-play of equity price and property price inflation In our view, the buoyancy in the equity market could very well be translated into the property market, as the wealth effect percolates from one market to the other. Past experience in the U.S. and Japan suggests there is a high correlation between equity and property prices (around 70%), since they are likely to be driven by the same macro forces such as low interests rates and strong economic growth. In China, since the underlying root causes of asset inflation—namely the undervalued exchange rate and ultra-low real interest rates relative to the strong economic growth—still remain in place, they will likely continue to push prices higher in the property and equity markets. Therefore, we believe more needs to be done to tighten the financial conditions so as to ensure the budding positive wealth creation process, buttressed by robust economic growth, would not end up in tears.

Exhibit 2: It takes much longer for household real net worth to recover after a protracted bear market than a brief market correction

US Household Real Net Worth

0

50

100

150

200

250

300

70 73 76 79 82 85 88 91 94 97 00 03 06

Index

1973 - 1974 1987 The internet bubble

Source: Federal Reserve Board, Goldman Sachs Economics Research.

Exhibit 3: Household consumption seems to have been little affected by fluctuations in the value of their equity holdings

Consumption and Equity Assets Growth

0

2

4

6

8

10

1998 1999 2000 2001 2002 2003 2004 2005 2006-40

-20

0

20

40

60

80

Household consumption

Equity wealth directly held by individual investors (RHS)

% chg yoy % chg yoy

Source: CEIC, Goldman Sachs Economics Research. Helen (Hong) Qiao Hong Liang


Issue No: 07/02 3 4 2Q2007

China’s financial market: Time to overcome its fear of opening This article was first published on May 14, 2007.

China’s financial market remains one of the least open sectors in the economy…

…and is also much less efficient compared with the more open manufacturing sector.

The renewed challenges facing the domestic A-share market highlight the strains caused by the lack of openness in the domestic capital market. In general, the performance of the financial sector should reflect the performance of the underlying real economy. However, in China’s case, the performance of China’s financial sector, be it the banking system or the financial market, has clearly lagged that of the real economy. In our view, the main reason for this dichotomy is that the financial market remains one of the least open sectors in the economy, to both domestic private and foreign investors. Exhibit 1 shows that, compared with the manufacturing sector, which has attracted billions of dollars of foreign direct investment over the past decade, the financial sector is much less open, but also much less efficient. While deregulation and opening-up have been the key factors for the success of Chinese manufacturing companies, the disappointing performance of its financial industry should be blamed on limited competition and heavy government involvement in the sector. The renewed challenges facing the Chinese A-share market have put the spotlight on this dichotomy again. In our latest article, we outlined our concerns of an over-exuberant domestic A-share market and the potential damage a severe equity price boom-bust could do to the real economy.1 However, we remain bullish on the H-share market, 2 i.e., the Hong-Kong-listed Chinese companies, a few of which are also listed in the domestic A-share market. The simple reason for our different recommendations is that the H-share valuation at 17 times price-to-(2007) earnings (P/E) is much more defensible than the 32 times P/E multiples for A shares. However, if we dig deeper on the reasons why there exists such a large valuation gap and why investors cannot arbitrage away the A-H premium (see Exhibit 2), lack of openness in the domestic capital market comes up on top. 1 See China: Time to anchor asset inflation expectations in the A-share market, Asia Economics Flash, May 10. 2007. 2 See Remain bullish on H but cautious on A, China Portfolio Strategy, May 11, 2007.

Exhibit 1: Divergent productivity growth between the manufacturing vs. financial industries

1997-2003

-5

0

5

10

15

20

25

30

35

0 1 2 3 4 5 6 7 8Foreign direct investment as % of industry GDP

Rea

l pro

duct

ivity

gro

wth

(% c

hg y

oy)

Banking and insurance industries

Manufacturing industry

Source: CEIC, Goldman Sachs Economics Research. Exhibit 2: A-H share premium has widened sharply

0%

20%

40%

60%

80%

100%

120%

140%

160%

May-05 Aug-05 Nov-05 Feb-06 May-06 Aug-06 Nov-06 Feb-07 May-07

Simple average

Total market cap. weighted average

A-H Share Premium

Source: Goldman Sachs Strategy Research.


Issue No: 07/02 3 5 2Q2007

First, foreign investors have limited access to the A-share market. The domestic investor base continues to be dominated by retail investors, and foreign participation is negligible (see Exhibit 3). The total QFII quota is merely about US$10 billion, compared with a US$2.1 trillion A-share market capitalization. Second, domestic investors have very limited access to the overseas equity markets. The latest QDII scheme approved by the China Banking Regulatory Commission (CBRC) (about US$7 billion) is of considerable high entry barrier, and therefore inaccessible to millions of retail investors. As a result, the US$2.5 trillion household deposits continue to have limited investment choices other than the domestic A-shares. The costs of these controls are squarely born by the domestic Chinese investors: the weighted average premiums of A shares versus H shares for the same company have now reached 60%, and may go even higher. More importantly, overly-stretched A-share valuations and their eventual correction could severely impair households’ balance sheets and exacerbate income and wealth distribution. Therefore, we believe building up a healthy and robust capital market is of crucial importance for China’s growth over the medium term, while China has fulfilled many of its WTO commitments in financial sector opening, it can do more to improve the efficiency of its capital markets. India, another BRICs country, at a much lower level of per capita income, has built a more developed and open securities market than China, with 30% of its investors being foreign institutions. Why can’t China? China has built a world-class manufacturing powerhouse in less than a decade by opening up to global capital. It can repeat the same success in the financial industry if it overcomes its fear of opening. Hong Liang

Exhibit 3: Foreign institutions’ participation in China’s domestic equity market is negligible

Composition of Equity Market Investors

22.6

22.6

38.7

40.2

21.537.2 42.0

30.039.9

76.428.0

1.0

0

20

40

60

80

100

120

China* Taiwan Korea Hong Kong

Retail investors Domestic institutions Foreign institutions

% of total market cap.

* % of tradable market cap. Source: Goldman Sachs Strategy Research.


Issue No: 07/02 3 6 2Q2007

The PBOC raised the 1-yr deposit and lending rates to 3.33% p.a. and 6.84% p.a. respectively as well as the RRR to 11.5% The People’s Bank of China (PBOC) hiked benchmark lending and deposit rates twice since the end of 1Q (on May 18 and July 20). The 1-year benchmark deposit rate was raised to 3.33% p.a. from 2.79% p.a. and the 1-year lending rate was raised to 6.84% p.a. from 6.39% p.a. The central bank also raised the reserve requirement ratio (RRR) on May 18 by 50 bp to 11.5% from 11%. We believe these are positive policy moves by the central bank to keep overheating pressures in check and anchor the excessively exuberant expectations in the A-share market. In addition, the fact that these rate hikes came relatively soon after the last rate hike in mid-March suggests that the authorities may be more willing to use the interest rate tool to manage the economy now compared with the past (the rate hike intervals in the past 3 years have ranged from 4 months to 1.5 years). However, we believe these policy changes are insufficient, because 1) the real interest rate remains too low relative to the cycle; 2) the commercial banks continue to have a 2%-3% excess reserve ratio, rendering the RRR a non-binding constraint for banks’ lending capability. In particular, the adjustments on the interest rates 1) have left the banks’ lending margin largely unchanged, and thereby their incentives to lend unchanged; 2) are likely to have little impact on corporates’ and households’ borrowing incentives given buoyant earnings and income growth, and 3) have left the after-tax deposit rates negative in real terms. Therefore, we believe these policy moves are positive, but very small steps along China’s long march towards monetary policy normalization, because these measures are unlikely to truly address the overheating pressures in the broad economy or in China’s asset markets. Consequently, we believe the upward pressures on the interest rate and the currency will remain elevated in the near term. Notwithstanding the on-going debate on decoupling, Chinese monetary policy has clearly decoupled from that of the US, as the PBOC hiked its benchmark interest rates for the fourth time since the Fed stopped last June. Behind these divergent policy trajectories are the divergences in growth and cyclical profiles of these two economies. Going forward, we expect the PBOC to continue withdrawing liquidity and raise both the benchmark interest rates in the remainder of this year. In addition, the government will likely take further actions to curb loan growth and fixed asset investment expansion, as well as trying to warn investors of the risks in investing in the A-share market. Hong Liang Helen (Hong) Qiao Yu Song


Issue No: 07/02 3 7 2Q2007

Initial thoughts on the CBRC’s permission of overseas equity investment for high-net-worth bank clientsThis comment was first published on May 11, 2007. The China Banking Regulatory Commission (CBRC) has issued an announcement this evening to allow commercial banks to invest clients’ funds in overseas equity markets. This is a form of China’s Qualified Domestic Institutional Investor (QDII) scheme. However, banks are limited to allocate only up to 50% of the value of the wealth management product in equities. In addition, the minimum investment requirement for high-net-worth individuals is Rmb300,000 (about US$39,000, or 20 times of GDP per capita as of 2006). This is quite a high hurdle that prevents millions of retail investors in China from accessing overseas equity products. The move in QDII has been long-waited (see QDII: The vanguard for Chinese money, China Portfolio Strategy, April 21, 2006, by Thomas Deng), although the scope of the scheme is more limited than we expected with a considerably high entry barrier. As a result, the impact of this measure on anchoring the elevated expectations in the domestic A-share market and diverting fund flows from it may also be limited. In the meantime, more information will have to be explored on the potential size and qualified destinations of this scheme. Hong Liang Helen (Hong) Qiao


Issue No: 07/02 3 8 2Q2007

The PBOC widened the USD/CNY trading bandThis comment was first published on May 18, 2007. The People’s Bank of China (PBOC) announced today that the USD/CNY daily trading band will be widened from +/-0.3% currently to +/-0.5% around the central parity, effective on May 21, 2007. This new measure has been largely expected, which we regard as a positive but very small move to introduce more daily volatility into the CNY exchange rate. After the trading band expansion, the CNY will likely be allowed to appreciate faster against the USD during intra-day trading. Furthermore, increased fluctuations on both directions will help the central bank create some two-way traffic for the CNY. From a reform point of view, it also facilitates banks, insurance firms and non-financial firms to gradually adapt to foreign exchange risks. Following this move on the USD/CNY trading band, we also expect the non-USD/CNY trading band (of +/-3% currently) to be widened further in the near future. Otherwise, it creates arbitrage opportunities that could arise when the USD had more volatile daily movement vis-à-vis other major currencies than implied by the non-USD/CNY trading band. In our view, expanding the USD/CNY trading band to increase the CNY flexibility is a symbolic but laudable development in China’s foreign exchange reform. We have long argued that the under-valuation of the CNY has been the main root cause of the imbalances of the economy. We believe CNY appreciation will help rotate China’s growth drivers away from external demand towards domestic demand, and reduce the risk exposure of a potential slowdown in external demand. In addition, it will likely lower the risk premium of inefficient administrative tightening measures, and help correct the resource misallocation they induced. Hong Liang Helen (Hong) Qiao


Issue No: 07/02 3 9 2Q2007

China raised the stamp duty overnightThis comment was first published on May 30, 2007. The Ministry of Finance raised the stamp duty on A and B shares to 0.3% from 0.1% overnight, effective from today. We expect this to have some modestly negative impacts on the market. However, we maintain our view that tax measures are associated with non-negligible efficiency costs and tend to distribute national income further towards the state at the expense of consumers, and thereby run against the medium-term goal of the government to boost domestic consumption. Hong Liang Yu Song


Issue No: 07/02 4 0 2Q2007

China should cut the import tax more This comment was first published on May 31, 2007. The Ministry of Finance has recently announced a series of export and import tax adjustments. Specifically, starting from June 1 2007, a 5%-10% export tax will be levied on a list of 114 commodity products, including steel, non-ferrous metals and several other raw materials. In the mean time, the import value-added tax (VAT) rates will be cut for 209 commodity products, by 3%-9% for selected machinery and machinery parts, and by 5%-16% for a variety of small household appliances, household electronics as well as consumer goods.1 In our view, such micro adjustments in trade taxes are a rather inefficient way to address China’s trade surpluses. We believe a more efficient approach, aside from an outright appreciation of the currency, is to cut both the import VAT tax and the export VAT rebate by equal amounts, or better still, to eliminate both taxes completely. Levying an import VAT and refunding an export VAT is a common practice adopted by countries that operate under a VAT system. The rationale is to eliminate the differences in prices caused by different taxation systems, i.e., VAT (used in China, the EU) vs. GST (used in the US) so that export goods produced do not contain prepaid VAT until they reach the final consumer. For that reason, the export VAT rebate rate should be on par with the import VAT rate to avoid relative price distortions. Therefore, any asymmetric or ad hoc adjustments in these trade-related taxes incur three types of efficiency costs: 1. A unilateral cut in the export tax rebate (or hike in

the export tax rate) without a cut in the import tax is equivalent to currency appreciation plus an increase in the import duty.2 This is an inferior policy option for real currency appreciation compared with general inflation.

2. Micro adjustments of individual products’ tax rates

by the government’s “visible hand” (300+ individual products were involved in the latest round) undermine the market mechanism of resource allocation.

1 For details on the adjustments in the exports/imports tax for different commodities, please refer to http://www.mof.gov.cn/news/20070522_2047_26505.htm 2 For details on the VAT vs. GST tax system, see Why is a export tax rebate cut a much less efficient policy option compared with CNY appreciation? China Views, June 3, 2006.

Exhibit 1: The import VAT rate is too high relative to the export VAT rebate rate

2.5

3.5

4.5

5.5

6.5

7.5

8.5

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

effective average import VAT rate *effective average export VAT rebate rate

%

* Effective average import VAT rate = total import VAT revenue/ total imports. Effective average export VAT rebate rate = total export rebate expenditure/ total exports. Source: CEIC, Goldman Sachs Economics Research. Exhibit 2: Plenty of room for the government to cut import VAT rates

0

50

100

150

200

250

300

350

400

450

500

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Total export VAT rebate expenditure

Total import VAT revenue

Rmb billion

Source: CEIC, Goldman Sachs Economics Research. 3. Frequent changes in tax rates incur additional

efficiency losses because it increases regulatory uncertainty (there is no market to hedge tax rate risks even in a mature market economy). Note that there have already been four large-scale trade tax rate changes in the past twelve months.

A better approach to achieve real appreciation without trade distortion is to eliminate both the export tax rebate and the import VAT tax, or at least reduce both rates by equal amounts. Indeed, China has plenty of room to cut the import VAT to boost domestic import demand. The effective import VAT rate has been close to 8%, much higher than the effective export VAT rebate rate of 5.5% (see Exhibits 1 and 2). However,


Issue No: 07/02 4 1 2Q2007

because of a much higher base of exports relative to imports, eliminating both taxes would be a budget neutral operation. That is, the tax revenue loss for the government would only be about Rmb68 billion (1.8% of total fiscal revenue in 2006). In our view, compared with measures aimed at suppressing export growth, policy changes that boost import demand (without generating inflation) will likely bear more fruit in narrowing China’s ever-growing trade surplus. We believe real exchange rate appreciation and tax cuts are optimal policy tools to achieve this goal. With a very modest loss of tax revenue, a complete elimination of both the export tax rebate and the import VAT tax is equivalent to a 6%-7% real currency appreciation, and can help rotate demand away from exports to imports with few efficiency losses. Hong Liang Eva Yi


Issue No: 07/02 4 2 2Q2007

China announced adjustments to export tax rebates This comment was first published on June 20, 2007. The Ministry of Finance announced a series of export tax rebate adjustments on June 18, 2007. These adjustments will affect about 37% of China's export categories. Starting from July 1, 2007, the export tax rebate on 553 types of products, including cement, salt, leather, certain wood products and fertilizer, will be abolished. In the mean time, the rebate rates on 2268 types of products, including apparel, toys, plastic products, rubber products and furniture, will be reduced by 5–13 percentage points. Refunding an export VAT is a common practice adopted by countries that operate under a VAT system. The rationale is to eliminate the differences in prices caused by different taxation systems, i.e., VAT (used in China, the EU) vs. GST (used in the US) so that export goods produced do not contain prepaid VAT until they reach the final consumer. For that reason, the export VAT rebate rate should be on par with the import VAT rate to avoid relative price distortions. We believe a unilateral cut in the export tax rebate without a cut in the import tax is equivalent to a currency appreciation plus an increase in the import duty and therefore does not support import demand growth. We reiterate our view that such measures are less efficient and less effective compared with currency appreciation in reducing China’s external imbalances. Hong Liang Yu Song


Issue No: 07/02 4 3 2Q2007

China cut the tax on interest income to 5% from 20% This comment was first published on July 20, 2007. The State Council announced on July 20 that the 20% tax on bank deposits’ interest income will be cut to 5%, effective from August 15, 2007. We view this as a positive move. The cut of the interest tax by 15 percentage points is equivalent to raising the after-tax return on 1-year deposit by 50 basis points (bp),1 therefore, we believe it may be helpful in anchoring exuberant asset inflation expectations. Furthermore, the tax cut is in line with the government’s medium-term goal of boosting domestic demand by increasing household income. The government’s tax revenue from interest income stands at Rmb46 billion or 0.2% of GDP in 2006. However, we believe interest rates remain too low in China. The after-tax effective real deposit rate is still negative. Even after the tax cut on interest income, the after-tax nominal deposit rate currently stands at 3.16% p.a.,2 compared with 4.4% CPI inflation, 17 % nominal GDP growth and return on equity in the mid-teens. In fact, the after-tax deposit rate is still lower than that in 1998 when the economy was in recession. Furthermore, we believe the tax cut is mildly expansionary since it will have the effects of stimulating household consumption. Therefore, we expect further tightening measures to be implemented in 2H2007, including further interest rate hikes, more intensified withdrawal of liquidity by the central bank (possibly through the help of the issuance of the special bonds for the new FX investment corporation), stepped-up moral suasion on commercial banks to curb lending, and other administrative measures to curb investment demand. Hong Liang Yu Song Eva Yi

1 1-year benchmark deposit rate = 3.33% p.a., 0.5 = 3.33 * 15%. The same applies for deposit rate for other durations, and the longer the deposit duration, the higher the effective rate hike. 2 Real effective deposit rate =1-year benchmark deposit rate* (1-5%) – CPI inflation (June).

Goldman Sachs Economics Research China Economics Quarterly

Issue No: 07/02 4 4 2Q2007

Charting China

Monthly Activity Indicators Exhibit 1: The coincident indicator continued to strengthen while the leading indicator remained firm

98

99

100

101

102

103

104

2000 2001 2002 2003 2004 2005 2006 200794

95

96

97

98

99

100

101

102

103

CEMAC-GS Leading Indicator

CEMAC-GS Coincident Indicator (RHS)

Index 1996=100 Index 1996=100

Source: CEIC, Goldman Sachs Economics Research. Exhibit 2: GSCA growth also accelerated...

GSCA

0

2

4

6

8

10

12

14

16

18

20

Jun-97 Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06

% yoy

% qoq (sa, ann)

% chg


Exhibit 3: ...driven by strong growth in industrial production, investment, and electricity production

0

5

10

15

20

25

30

IP RetailSales

FAI Exports Imports ElectricityProduction

HouseholdIncome

PassengerVolume

FreightVolume

April 2007

May 2007

June 2007

% chg yoy Components of the GSCA

Note: these variables are measured in real terms.

Source: CEIC, Goldman Sachs Economics Research. Exhibit 4: Industrial production growth has posted strong growth since the start of the year

0

5

10

15

20

25

30

35

Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07

yoy

qoq

% chg Industrial Production



Issue No: 07/02 4 5 2Q2007

Exhibit 5: Fixed investment growth strengthened

-10

0

10

20

30

40

50

60


% yoy

% qoq sa ann

% chg Fixed Investment


Exhibit 8: Corporate profitability growth has been robust and rising

Year-to-date Industrial Enterprise Profits to Sales Ratio

0

1

2

3

4

5

1999 2000 2001 2002 2003 2004 2005 2006 2007

All industries

Downstream industries

%


Exhibit 6: The share of fixed asset investment financed by bank loans continued to fall

15

20

25

30

35

40

45

50

55

60

May-00 May-01 May-02 May-03 May-04 May-05 May-06 May-07

Self raised

Domestic loans

% share of total FAI Fixed Asset Investment by Source of Funding


Exhibit 9: Retail sales growth accelerated on the back of higher CPI inflation

6

8

10

12

14

16

18

Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07

Value

Volume

% chg yoy Retail Sales


Exhibit 7: Growth of investment in the pipeline softened

Rmb tn (ytd) % mom % yoy Rmb tn (ytd) % mom % yoy

Jan-05 7.0 — 21.4 0.5 — -6.6Feb-05 7.0 — 21.4 0.5 — -6.6Mar-05 9.4 34.3 29.4 1.0 117 7.3Apr-05 10.8 14.7 26.2 1.6 52 13.5

May-05 11.9 10.6 28.7 2.1 35 24.9Jun-05 13.2 10.7 28.6 3.0 41 24.8Jul-05 14.1 7.3 26.1 3.5 18 28.5

Aug-05 14.8 4.7 29.7 4.0 14 28.4Sep-05 15.2 2.9 27.9 4.5 13 27.9Oct-05 15.9 4.2 27.8 5.1 12 28.5Nov-05 16.5 4.3 28.8 5.5 10 28.4Dec-05 17.8 7.9 29.7 6.5 17 32.4Jan-06 9.8 — 39.8 0.6 — 33.4Feb-06 9.8 — 39.8 0.6 — 33.4Mar-06 12.2 25.0 30.1 1.5 131 42.0Apr-06 13.9 13.9 29.2 2.1 42 32.2

May-06 15.1 8.6 26.9 2.6 26 23.6Jun-06 16.6 10.2 26.3 3.7 39 22.2Jul-06 17.4 4.3 22.8 4.2 15 19.3

Aug-06 18.0 3.6 21.6 4.5 6 11.4Sep-06 18.8 4.6 23.6 4.9 9 7.5Oct-06 19.4 3.3 22.6 5.3 9 4.4Nov-06 20.1 3.2 21.3 5.7 9 3.7Dec-06 21.7 8.0 21.4 6.7 17 3.4Jan-07 10.7 — 9.3 0.4 — -35.9Feb-07 10.7 — 9.3 0.4 — -35.9Mar-07 14.2 32.7 16.0 1.3 210 -13.9Apr-07 16.4 15.8 18.0 2.0 61 -2.2

May-07 17.5 6.9 16.1 2.8 37 6.1Jun-07 19.3 9.8 15.8 3.9 39 6.4

New Investment ProjectsInvestment Under Construction


Exhibit 10: Strong growth in automobile sales

-20

-10

0

10

20

30

40

50

60

70

80

90

Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07

Total automobile sales

Sedan sales

% chg yoy



Issue No: 07/02 4 6 2Q2007

Price Indicators Exhibit 1: CPI inflation picking up, largely driven by higher food prices

-2

-1

0

1

2

3

4

5

6


CPI

Core (excluding food)

CPI% chg yoy


Exhibit 4: The CNY REER appreciated on the back of higher domestic inflation

82

84

86

88

90

92

94

96

98

100

Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07

NEER

REER

Index, Jan 2001=100


Exhibit 2: Sequential growth of PPI has been edging up

-8

-6

-4

-2

0

2

4

6

8

10

12

14


yoy

qoq sa an

% chg PPI


Exhibit 5: The pace of CNY/USD appreciation has accelerated noticeably in recent weeks

-12-9-6-30369

12151821242730

08/01/05 10/30/05 01/28/06 04/28/06 07/27/06 10/25/06 01/23/07 04/23/07 07/22/07

Annualized weekly CNY appreciation rateTrend (HP filtered)

% appreciation, annualized

week starting Source: CEIC, Goldman Sachs Economics Research.

Exhibit 3: Property price inflation accelerated

0

2

4

6

8

10

12

Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07

% chg yoy Property Price Index

Note: quarterly data before July 2005, monthly since then. Source: CEIC, Goldman Sachs Economics Research.

Exhibit 6: Lower daily volatility of the CNY exchange rate

0.0000.0020.0040.0060.0080.0100.0120.0140.0160.0180.0200.0220.0240.026

7/22/2

005

10/15

/2005

1/8/20

06

4/3/20

06

6/27/2

006

9/20/2

006

12/14

/2006

3/9/20

07

6/2/20

07

USD/CNY daily trade range (high-low)

Trend (HP Filtered)

USD/CNY

1

Note: quarterly data. Source: CEIC, Goldman Sachs Economics Research.


Issue No: 07/02 4 7 2Q2007

Trade Indicators Exhibit 1: Trade surplus reached a new record high

-20

-10

0

10

20

30

40

50

60

70

80

Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07-20

-10

0

10

20

30

40

50

60

70

80

Trade balance (RHS)

Exports

Imports

US$ bn% chg yoy


Exhibit 4: Processing and domestic-demand-driven imports both holding up

China Imports

(10)

-

10

20

30

40

50

60

70

Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07

Processing imports

Non-processing imports

% chg yoy 3mma


Exhibit 2: Exports to non-traditional markets showed particularly strong growth

0

10

20

30

40

50

60

70

80


EUUSAJapanNon-Japan AsiaRest of the world

% chg yoy, 3mma China Exports by Destinations


Exhibit 5: Growth in non-tech exports showed more volatility

-10

0

10

20

30

40

50

60

70

80

90


IT exports

Non-IT exports

% chg yoy


Exhibit 3: Growth of imports from all destinations has been relatively stable

-10

0

10

20

30

40

50

60

70


EUUSAJapanNon-Japan AsiaRest of the world

% chg yoy, 3mma


Exhibit 6: China’s exports have become less dependent on the US

Exports to the US as % of China's Total Exports(Adjusted for Re-exports through Hong Kong)

22

24

26

28

30

32

34

36

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

%

ytd



Issue No: 07/02 4 8 2Q2007

Financial Indicators Exhibit 1: Credit growth remained strong in the second quarter

10

13

16

19

22

25


M2

Total loans

% chg yoy China


Exhibit 4: Yield curve hardly moved after the latest interest rate hike

1.5

2.0

2.5

3.0

3.5

4.0

4.5

3 M* 6 M 1Y 2Y 3Y 4Y 5Y 7Y

Latest: July 25, 2007

Before the last interest rate hike: July 20, 2007

End of 2006: December 29, 2006

% p.a.

Source: Bloomberg, Goldman Sachs Economics Research.

Exhibit 2: FX reserve growth picked up

0

10

20

30

40

50

60

70

80

Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07

FX reserves

Reserve money

% chg yoy

Decrease due to US$45 bn injection into the banking sector

US$15 bn injection into

ICBC


Exhibit 5: Domestic stock markets rebounded strongly after earlier correction

40

90

140

190

240

290

340

Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07

Shenzhen composite

Shanghai composite

H-share

Index Jan 2000 = 100

Source: Bloomberg, CEIC, Goldman Sachs Economics Research.

Exhibit 3: Sterilization by PBOC bill issuance has slowed down

-400

-200

0

200

400

600

800

Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-070

400

800

1200

1600

2000

2400

2800

3200

3600

4000

4400

Net issuance

Amount outstanding (RHS)

Rmb bn Rmb bn

Source: Bloomberg, Goldman Sachs Economics Research.

Exhibit 6: The GS China-FCI tightened in the second quarter

2

4

6

8

10

12

14

16

97 98 99 00 01 02 03 04 05 06 07

105

107

109

111

Activity growth (GSCA)

GS China-FCI (RHS, inverted)

% chg yoy Financial Conditions Index

means tightening financial conditions



Issue No: 07/02 4 9 2Q2007

Annual Macroeconomic Indicators Exhibit 1: GDP per capita rising steadily

0

2

4

6

8

10

12

14

16

1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 20060

500

1000

1500

2000GDP per capita (RHS)

Real GDP growth

US$% chg yoy


Exhibit 4: Domestic demand has remained firm, while growth contribution from external demand stable

-7

-2

3

8

13

18

23

1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

Net exports

Fixed investment

Private consumption

Government consumption

pp contribution to GDP growth


Exhibit 2: Cyclical volatility has been significantly reduced

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 060

1

2

3

4

5

6

7

8

9

10

11

GDP growth

CPI inflation (RHS)

% yoy Standard Deviation of yoy Growth (6-year Rolling Window)

period ending

% yoy


Exhibit 5: Manufacturing growth has outpaced other sectors

-2

0

2

4

6

8

10

12

14

16

1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

ServicesConstructionIndustryPrimary industry

pp contribution to GDP growth


Exhibit 3: The saving investment imbalance continued to grow

32

34

36

38

40

42

44

46

48

50

52

1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006-3

-2

-1

0

1

2

3

4

5

6

7

Savings-investment balance (RHS)

Savings

Investment

% GDP % GDP


Exhibit 6: Household income and expenditure growth remain strong

-10

-5

0

5

10

15

1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

Real household income

Real household expenditure

% chg yoy



Issue No: 07/02 5 0 2Q2007

Summary Indicators (Annual) (percentage change, unless otherwise indicated)

2000 2001 2002 2003 2004 2005 2006 2007F 2008FREAL SECTOR GDP by expenditure (at 1990 prices)

GDP 8.4 8.3 9.1 10.0 10.1 10.4 11.1 12.3 10.9Private consumption 8.1 5.7 6.5 6.3 7.1 6.7 7.8 9.6 9.5Government consumption 12.8 11.1 7.9 6.0 7.3 9.7 8.6 9.4 11.8Fixed investment 10.0 9.0 12.9 16.5 12.1 11.4 10.6 11.1 10.3Domestic demand 7.6 8.8 8.8 10.5 10.0 8.3 9.1 10.0 9.9Net exports (contribution to growth) 1.2 0.0 0.7 0.1 0.6 2.5 2.6 3.1 2.1

Exports (G&S) 26.5 7.1 24.7 26.9 27.7 20.8 18.6 20.0 16.3Imports (G&S) 26.6 8.1 26.1 29.7 29.0 18.5 16.6 18.0 15.8

GDP by IndustryAgriculture & resources 2.4 2.8 2.9 2.5 6.3 5.2 5.0 5.2 5.0Industry 9.4 8.4 9.8 12.7 11.1 11.7 13.0 13.2 12.4

Manufacturing 9.8 8.7 10.0 12.8 11.5 11.6 13.0 13.5 12.7Construction 5.7 6.8 8.8 12.1 8.1 12.6 9.5 10.2 9.0

Services 9.7 10.2 10.4 9.5 10.0 10.5 10.8 11.0 10.0

Goldman Sachs China Activity Index (GSCA) 8.9 6.9 9.8 12.9 13.1 11.6 11.5 — —

PRICES CPI inflation (period average) 0.4 0.7 -0.8 1.2 3.9 1.8 1.5 4.0 3.7 CPI inflation (period end) 1.5 -0.3 -0.4 3.2 2.4 1.4 2.0 4.8 3.0 GDP deflator (period average) 2.0 2.0 0.6 2.6 6.9 4.2 3.2 6.3 4.5

EXTERNAL SECTOR (USD bn unless otherwise indicated) Current account balance 20.5 17.4 35.4 45.9 68.7 160.8 249.9 332.9 393.2

(as percent of GDP) 1.7 1.3 2.4 2.8 3.6 7.1 9.3 9.8 9.5Exports 299 318 388 520 701 904 1144 1398 1623Imports 278 301 352 474 632 743 895 1065 1230

Capital and financial account 1.9 34.8 32.3 52.7 110.7 63.0 10.0 93.8 46.8Foreign direct investment 37.5 37.4 46.8 47.2 53.1 67.8 60.3 68.4 73.1Portfolio, net -4.0 -19.4 -10.3 11.4 19.7 -4.9 -67.6 -10.0 -35.0Other capital flow -31.5 16.9 -4.1 -5.9 37.8 0.1 17.3 35.3 8.6

Net errors and omissons -11.9 -4.9 7.8 18.4 27.0 -16.8 -12.9 0.0 0.0Overall balance (as percent of GDP) 0.9 3.6 5.2 7.1 10.7 9.1 9.1 12.6 10.6

MONETARY & FINANCIAL SECTOR Latest in boldMoney Supply M2 12.3 17.6 16.9 19.6 14.5 16.3 17.0 17.1 (Jun)Domestic Credit 10.8 7.1 37.5 19.5 9.2 10.8 15.7 14.0 (May)Stock price index (Shanghai composite) 38.2 4.0 -19.9 -6.3 1.0 -22.2 41.3 128.5 (Jun)Lending rate (3m, %pa) 3.51 3.51 3.02 2.97 3.50 3.60 3.60 3.60 (Jun)Deposit rate (demand deposit, %pa) 0.99 0.99 0.74 0.72 0.72 0.72 0.72 0.72 (Jun)

Memo itemsForex reserves (USD bn) 166 212 286 403 610 819 1066 1333 (Jun) months of imports 8.8 10.5 11.6 11.7 13.0 14.9 16.2 17.5 (Jun)Exchange rate (end of period, USD/CNY) 8.28 8.28 8.28 8.28 8.28 8.08 7.81 7.25 6.83Real Effective Exchange Rate Index (period avg) 84.5 89.6 87.5 82.1 80.0 79.3 80.5 — —

Per capita GDP (2006): 1998 USD Total population (2006): 1.3 bn

Source: NBS, CEMAC, PBOC, CEIC, Goldman Sachs Economics Research.


Issue No: 07/02 5 1 2Q2007


Issue No: 07/02 5 2 2Q2007

K Goldman Sachs Economics Research China Economics Quarterly

Things to Watch

Issue No: 07/02 5 3 2Q2007

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2Q2007 China Economics Quarterly Final - ghsl.cn...Goldman Sachs Economic Research China Economics Quarterly Issue No: 07/02 2 2Q2007 2Q2007 data summary: % change, unless otherwise