BMI Special Report China 2012 From Miracle To Meltdown 2011-09-01

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2011
chIna 2012: FRoM MIRacLe to MeLtdown?

sPecIaL RePoRt
Published by Business Monitor International Ltd.
China 2012: From miraCle To melTdown?
Contents
executive Summary.................................................................................................. 5
TABLE: CHINAECONOMIC ACTIVITY................................................................................................................................................5
introduction ..........................................................................................................6-9
Could 2012 Be The Year of The Chinese hard landing?....................................................... 6
CHArT: AN INCrEAsINgLY INEffICIENT grOwTH sTOrY ...........................................................................................................6 China - Investment, Output & Returns CHArT: DIMINIsHINg rETurNs China - GDP Growth And Equity Market Returns CHArT: THE grEAT wALL Of LIquIDITY .........................................................................................................................................7 China - Money Supply (M2), CNYtrn CHArT: PrINTINg PrEssEs gOINg fuLL TILT ...............................................................................................................................7 US and China - Money Supply (M2), US$trn CHArT: INVEsTMENT BOOMs DONT END wELL ...........................................................................................................................7 Asia - Fixed Investment, pp contribution to real GDP growth CHArT: rEBALANCINg wILL NOT BE EAsY ....................................................................................................................................8 China - Real GDP Growth Forecasts, % CHArT: rAILwAY sTOCks IN frEEfALL..........................................................................................................................................8 China - China Railway Group, CNY CHArT: BANks uNDEr PrEssurE ..................................................................................................................................................9 China - 3-Month Shanghai Interbank Offered Rates (SHIBOR), % CHArT: NO rEfOrM HErE ................................................................................................................................................................9 China - Index Of Economic Freedom
economic activity ..............................................................................................10-14

Three Scenarios For Growth ................................................................................................. 10
CHArT: 7% Is THE NEw 10% ......................................................................................................................................................... 10 China - Real GDP Growth, % chg CHArT: sErVICE PMI JOINs MANufACTurINg IN THE DOLDruMs ........................................................................................ 10 China - HSBC Services Purchasing Managers Index CHArT: CHINA IN A wOrLD Of ITs OwN .....................................................................................................................................11 Gross Fixed Capital Formation, Percentage Point Contribution To Growth CHArT: fLYINg TOO HIgH ...............................................................................................................................................................11 Gross Fixed Capital Formation, % of GDP TABLE: COrE sCENArIO .................................................................................................................................................................12 CHINAECONOMIC ACTIVITY ..........................................................................................................................................................13 TABLE: sCENArIO 2.........................................................................................................................................................................13 TABLE: sCENArIO 3.........................................................................................................................................................................14
real estate outlook ..........................................................................................15-17

Property market: all The hallmarks of a Top ..................................................................... 15
TABLE: CHINAMONETArY POLICY ...............................................................................................................................................15 CHArT: ExPECT A suB-ZErO PrINT ............................................................................................................................................. 16 China - Official House Price Index, % chg y-o-y CHArT: A wOrrYINg COMBINATION ........................................................................................................................................... 16 China - M2 Money Supply Growth And CPI (% chg y-o-y) CHArT: CHEAP BuT sET TO gO CHEAPEr.................................................................................................................................... 17 China - Shanghai Composite Index
investment outlook .........................................................................................18-23

China Bubble: Case Study The rise & Fall of high-Speed rail ........................................ 18
CHArT: HIgH sPEED ECONOMY ....................................................................................................................................................18 Chinas High Speed Railways
Business Monitor International Ltd
SPeCial rePorT
China Bubble: Case Study 2 luck running out For macau Casinos .................................. 19
CHArT: uNCErTAINTY grOws OVEr HIgH sPEED sPENDINg ................................................................................................ 19 China Railway Infrastructure Industry Value Forecasts CHArT: sIgN Of THINgs TO COME? .............................................................................................................................................19 China - China Railway Group, CNY CHArT: THE HOusE HAs BEEN wINNINg ....................................................................................................................................20 Macau - Gross Gaming Revenue, MOPmn CHArT: wOrLDs fAsTEsT grOwINg ECONOMY ...................................................................................................................... 20 Macau - Real GDP Growth, % CHArT: CHINEsE gAMBLErs PuNCHINg ABOVE THEIr wEIgHT ............................................................................................ 21 Macau - Average Tourist Spending Per Visit CHArT: TurNINg Off THE TAPs .................................................................................................................................................. 21 China - M2 Money Supply Growth, % chg y-o-y CHArT: ANOTHEr ruN AT THE LOws...........................................................................................................................................22 MGM Resorts International Equity Price MGM China Equity Price CHArT: wYNNINg sTrEAk OVEr ..................................................................................................................................................22 Wynn Macau Equity Price & RSI CHArT: TrIPLE NEgATIVE DIVErgENCE wArNs Of MAJOr TOP ............................................................................................ 23 Galaxy Entertainment Group Equity Price & RSI
Banking Sector outlook ...................................................................................24-25

Banking Sector instability Playbook .................................................................................... 24
TABLE: CHINA - BANkINg sECTOr OVErVIEw ............................................................................................................................ 24
Consumer outlook ................................................................................................ 27

dont Count on The Consumer ............................................................................................. 27
TABLE: CHINAgDP BY ExPENDITurE, % Of gDP ..................................................................................................................... 27 CHArT: ExPOrTs & rETAIL sALEs COrrELATED ...................................................................................................................... 27 China Retail Sales & Exports CHArT: CONsuMErs CONfIDENCE NOT IMMuNE TO AN ExPOrT sLOwDOwN ................................................................... 27 Consumer Confidence Indicator TABLE: CHINAgDP CONTrIBuTION TO grOwTH ...................................................................................................................... 28 CHArT: A TEMPOrArY BOOsT ......................................................................................................................................................28 China - Passenger Car Sales, 000s CHArT: PrIVATE CONsuMPTION sMALLEr THAN INVEsTMENT .............................................................................................. 29 Nominal GDP of Selected Countries, US$trn Chinese Private Consumption, % Of GDP
10-Year economic outlook .................................................................................... 31

7.0% is The new 10.0% ........................................................................................................ 31
TABLE: CHINA LONg-TErM MACrOECONOMIC fOrECAsTs ..................................................................................................... 31 CHArT: A MOrE suBDuED grOwTH OuTLOOk ......................................................................................................................... 31 China - Real GDP Growth, % chg CHArT: DEMOgrAPHIC DETErIOrATION ....................................................................................................................................33 China - Estimated Population Trends
Political outlook .................................................................................................... 34

Socio-economic risks on The rise ....................................................................................... 34
TABLE: POLITICAL OVErVIEw ........................................................................................................................................................34
Global implications: Case Studies ........................................................................ 37

if China Sneezes, australia Catches Pneumonia ................................................................. 37
CHArT: DEBT INTErEsT BurDEN uNsusTAINABLE ................................................................................................................... 37 Australia - Debt Interest Payments, % of Disposible Income CHArT: ExPONENTIAL BOOMs OfTEN LEAD TO BusTs ............................................................................................................ 37 Australian Iron Ore Exports To China, AUDmn CHArT: TrADE surPLus ON sHAkY grOuND ........................................................................................................................... 38
Australia - Trade Surplus, US$mn CHArT: COMMODITY BOOM fAILs TO YIELD A surPLus ......................................................................................................... 38 Australia - Current Account, AUDmn
how To Play a Sharp Slowdown in China ............................................................................ 39

CHArT: TOO LEVErAgED, TOO ExPOsED.....................................................................................................................................39 Australia - Banking Statistics For Big 4 CHArT: A sIgN Of THINgs TO COME fOr HOusE PrICEs........................................................................................................ 39 China - Shanghai Property Index CHArT: fINANCIALs HAVE furTHEr TO fALL............................................................................................................................. 40 China - Shanghai Composite Index, Hang Seng Financials CHArT: DONT LOOk DOwN ...........................................................................................................................................................40 Ratio Hang Seng Financials/Shanghai Composite CHArT: sTILL BONDs OVEr sTOCks LONg TErM...................................................................................................................... 40 Australia - ASX200 Equity Index,10-Year Bond Index CHArT: DEBT BEATs EquITY ..........................................................................................................................................................40 Ratio - 10year Bond Index/ASX200 CHArT: gErMANY BETTEr PLACED ............................................................................................................................................. 41 German Dax Versus Australian ASX200 CHArT: AussIE OuTPErfOrMANCE wONT LAsT ...................................................................................................................... 41 RatioDax/ASX200 CHArT: A MAJOr TOP .....................................................................................................................................................................42 Galaxy Entertainment Group Equity Price CHArT: NEgATIVE DIVErgENCE ....................................................................................................................................................42 Weekly RSI CHArT: wEDgED IN .........................................................................................................................................................................42 ChinaCNY 12-Month NDF CHArT: suggEsTINg wEAkNEss .................................................................................................................................................42 Daily RSI
ratings methodology ............................................................................................ 43

outline of ratings ................................................................................................................ 43
TABLE: BMI rIsk rATINgs .............................................................................................................................................................43 TABLE: LONg TErM POLITICAL rATINgs .....................................................................................................................................44 TABLE: LONg TErM ECONOMIC rATINgs ....................................................................................................................................45 TABLE: sHOrT-TErM ECONOMIC rATINgs ..................................................................................................................................46
Global assumptions .............................................................................................. 49

Global outlook ..................................................................................................................... 49
TABLE: gLOBAL AssuMPTIONs .....................................................................................................................................................49 TABLE: gLOBAL & rEgIONAL rEAL gDP grOwTH, % CHg Y-O-Y ............................................................................................ 50 TABLE: DEVELOPED sTATEs rEAL gDP grOwTH fOrECAsTs, % CHg Y-O-Y ........................................................................ 51 TABLE: EMErgINg MArkETs rEAL gDP grOwTH fOrECAsTs, % CHg Y-O-Y ..................................................................... 52 TITLE: CHINA MACrOECONOMIC fOrECAsTs .............................................................................................................................53 TITLE: AusTrALIA MACrOECONOMIC fOrECAsTs ....................................................................................................................54 TITLE: MACAu MACrOECONOMIC fOrECAsTs ........................................................................................................................... 55 TITLE: wOrLD MACrOECONOMIC fOrECAsTs .......................................................................................................................... 56 TITLE: DEVELOPED MArkETs MACrOECONOMIC fOrECAsTs ................................................................................................ 56 TITLE: EMErgINg MArkETs MACrOECONOMIC fOrECAsTs .................................................................................................. 57
SPeCial rePorT
executive Summary
China 2012: From miracle To meltdown?
In this report we outline the likelihood and the consequences of Chinas multi-decade investment boom coming to an abrupt end. With the global economy slowing and the housing market showing increasing signs of fragility, the clock is ticking on Chinas stellar growth run. Although we do not forecast an outright collapse, our forecast of sub-8.0% growth by 2012 puts us more in the hard landing than the soft landing camp. We believe the risks to our forecasts are tilted to the downside, with the probability of an outright recession running at around 30%. Chinas housing market is exhibiting signs typically seen at the end of a bubble. The next phase of the cycle will likely see prices begin to fall as developers offload inventory. We estimate house prices need to fall by 30% nationwide before price excesses are unwound. Tangible evidence of Chinese malinvestment is starting to surface. After cautioning that the massive build-up of high-speed rail should be regarded as a red flag, the Macau casino boom, dependent upon cheap liquidity, could be the next sign of Chinas bubble bursting. As the repayment capacity of loans extended to local government investment vehicles comes under threat, we continue to expect instability in Chinas banking system and a surge in non-performing loans. In the event of a pronounced correction in investment spending, a slump in exports and potential banking sector instability, we find it highly unlikely that the Chinese consumer will be able to shoulder the burden of growth. An economic slowdown will raise the likelihood of further protests. The major political risk to the economy comes from the ruling party seizing more economic power in response to perceived threats to its political interests. While no country would be immune from a Chinese hard landing, we would argue that Australia is most precariously positioned. A Chinese hard landing would push the Australian economy over the edge, likely ushering in a recession and potentially triggering a financial crisis. Regional asset markets do not appear priced for a sharp slowdown in China. H-financials (Chinese financial companies listed in Hong Kong) are set to underperform, while disinflationary forces will weigh on Australian risk assets and support bonds. Consensus expectations of continued yuan strength are not likely to be met.
CHINAECONOMIC ACTIVITY
2008
Nominal GDP, CNYbn Nominal GDP, US$bn Real GDP growth, % change y-o-y GDP per capita, US$ Population, mn Industrial production index, % y-o-y, ave Unemployment, % of labour force, eop 31,490.2 4,531.4 11.7 3,411 1,328.3 12.9 4.2
2009
34,502.4 5,050.5 9.2 3,783 1,334.9 11.1 4.8
2010
39,788.7 5,878.0 10.3 4,382 1,341.3 14.4 4.4
2011f
45,890.9 7,087.4 9.2 5,259 1,347.6 10.8 4.4
2012f
51,215.5 8,008.7 8.1 5,917 1,353.6 7.8 4.3
2013f
56,708.2 8,957.6 7.5 6,590 1,359.4 8.2 4.2
2014f
62,439.2 10,064.2 6.9 7,374 1,364.8 8.5 4.2
2015f
68,612.7 11,284.9 6.8 8,239 1,369.7 8.0 4.1
Notes: National Bureau of Statistics (NBS), BMI. f = BMI forecasts.
introduction
Could 2012 Be The Year of The Chinese hard landing?
BMI View: Chinas economic growth story has rapidly turned from one underpinned by productivity gains to one engineered by inflationary monetary and fiscal policies, and the quality of growth has suffered considerably as a result. Several years of poor capital allocation will have to be unwound eventually, leading to much slower headline expansion, and with the global economy stuttering in H211, we caution that 2012 could be the year of the Chinese hard landing.
an increasingly inefficient Growth Story
China - Investment, Output & Returns
70 60 50 40 30 20 10 0
1991 1996 2001 2006 2011f
China is getting less bang for its buck. This increasingly inefficient growth story is echoed at the micro level. Despite strong and rising nominal GDP growth, total returns on the MSCI China Index are slumping (see chart below). Clearly, then, not everything is quite as rosy as it seems.
diminishing returns China - GDP Growth And Equity Market Returns
25 A view supported by the declining returns on Chinese equities 200 150 100 50 0
20
15
Jan-03
Jan-05
Jan-07
Jan-09
4.5 3.5 2.5 1.5
Nominal GDP, % chg y-o-y (LHS) MSCI China Gross Total Return, % chg y-o-y
Source: Bmi, Bloomberg
Fixed Investment, % of GDP (LHS) Incremental Capital-Output Ratio (ICOR)

*ICOR is a metric that assesses the marginal amount of investment capital necessary to generate the next time periods unit of production. Source: BMI, NBS. f=BMI forecasts.
At face value, Chinas economy remains a picture of strength. Real GDP growth clocked a forceful 9.5% y-o-y in the second quarter of 2011. Retail sales and fixed asset investment, meanwhile, were running at a healthy clip of 17.0% y-o-y and 25.0% y-o-y, respectively, in August. These numbers paint a picture of a rapidly expanding, albeit gradually moderating, economy. Nonetheless, the robust headline numbers mask a worrying deterioration in the quality of Chinese economic growth. The countrys incremental capital output ratio (ICOR), a metric that assesses the marginal amount of capital required to generate an extra unit of output, is at a 10year high. What this tells us is that with record levels of capital spending (fixed investment is on course to account for a whopping 48.6% of nominal GDP in 2011),
We believe that this disconnect between the quantity and quality of growth can be largely attributed to the policies implemented by Beijing following the onset of the global financial crisis back in 2008. Faced with massive demand destruction across key export markets in the EU and US, China unleashed unprecedented monetary and fiscal expansion, which saw credit growth skyrocket virtually overnight. As the chart on page 6 shows, it has taken China just two years to add the same amount of new money at roughly CNY2trn that had been created in the six years previously. This has, in turn, seen Chinas existing monetary stock (M2) overtake and far exceed that of the US (US$12.0trn versus US$9.3trn) despite its economy being less than half the size. The scale of money and credit creation has been truly remarkable, and is a major reason why we have seen Chinas investment boom take off since 2008. History suggests that investment bubbles do not end well (think back to the Soviet Union in the 1960s, Japans 1980s boom, or South East Asia in the 1990s). With so much
Jan-11
China Joins WTO Investment has not only become increasingly vital to grow th but also increasingly inefficient
6.5 5.5
10 -50 5 -100
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capital allocated on the basis of state-led directives rather than sound profit-driven decision making, it appears to us only a matter of time before we see a material unwinding of Chinas investment bubble, which would in turn drag overall economic growth much lower.
annum between 2011 and 2016 against the IMFs 9.5%), our baseline scenario is for a significant correction and not an imminent crash. Nevertheless, we find the case for a severe growth collapse much more credible now than 12 months ago (or indeed anytime in recent history). Below, we outline the factors why 2012 could yet be the year of the Chinese hard landing.
investment Booms dont end well
The Great wall of liquidity

China - Money Supply (M2), CNYtrn
80
Asia - Fixed Investment, pp contribution to real GDP growth
60
Six years worth of money creation has taken place over the past two years...
15 10 5 0 -5
40
20
Jan-01
Jan-03
Jan-05
Jan-07
Jan-09
Jan-11
Japan (T=1984) Thailand (T=1991) Malaysia (T=1991) Korea (T=1990) China (T=1990)
T T+1 T+2 T+3 T+4 T+5 T+6 T+7 T+8 T+9 T+10 T+11 T+12 T+13 T+14 T+15 T+16 T+17 T+18 T+19 T+20 T+21
Source: BMI
-10 -15 -20
Source: BMI, PBoC
Havent We Heard All This Before? None of this should come as a major surprise given the vast array of bearish China-focused literature that has hit the headlines in recent months and quarters. Many doomsayers have been wrong in the past and timing is, of course, everything. For our part, while we are well below consensus on Chinas 2012 growth prospects (8.1% versus a Bloomberg median of 8.8%) and more so over the long-term (average expansion of 7.6% per
Printing Presses Going Full Tilt
US and China - Money Supply (M2), US$trn

...which has seen China's nominal monetary stock exceed that of the US 14 12 10 8 6 4 US Money Supply (M2), US$trn China Money Supply (M2), US$trn 0
Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11
Signs That Poor Investment Is Starting To Unravel: Tangible evidence of Chinese malinvestment is starting to surface. Back in February 2011, for instance, we indentified the massive build-up of high-speed rail as a classic example of the overinvestment taking place across the country, cautioning that huge debt levels at the Ministry of Railways (MoR) and poor economic viability of major projects should be regarded as red flags. Since then, the sectors fall from grace has been astonishing. Aside from a tragic train crash (which the government has conceded was due to poor safety standards), the MoR announced record losses of CNY3.8bn in the first quarter, new investment has been shelved, and the two companies we earmarked for share price downside China Railway Group and China Railway Construction Company have sunk over 40% respectively. With so much money channelled into other areas of infrastructure which are likely to yield poor rates of return (not least the real estate segment), the next example of malinvestment does not appear far off. Banking Sector Awash With Bad Debt: The Big Four of Chinas banking sectorIndustrial and Commercial
Source: BMI, PBoC
Bank of China, China Construction Bank, Agricultural Bank of China and Bank of Chinacontinue to post healthy bottom line numbers. However, their exposure to local government investment vehicles (LGIVs) is a major concern amid tightening monetary conditions. Bank lending to local governments could be as much as CNY14.2trn according to some estimates, equivalent to 37.5% of 2010 GDP and 28.6% of total loans in the banking system. Even under a moderate default scenario, non-performing loans are set to spike significantly (in a sign of things to come Yunnan Highway Development Investment informed its creditor banks back in April that it would repay interest but not principal on its debt obligations). Given the primary role of credit in the recent investment boom, should banks be forced to write down losses, this would bode ill for economic growth. Adding to our concerns is the lack of concrete data on bank exposure. We have to look no further than the US subprime crisis of 2007-2008 to see the deleterious impact of poor information flow on credit markets and, worryingly, Chinese interbank rates have risen by 25% already this year.
symptomatic of a lacklustre US economy. While further stimulus measures proposed by US President Barack Obama may provide some comfort at the margin, US domestic demand growth will not return to its long-term trend anytime soon. Across the Atlantic, the eurozone continues to battle with a protracted and painful debt crisis. The end-game will not be conducive to economic recovery, with purchasing managers indices across the continent signalling that the rebound is already losing steam. For 2012, we are pencilling in sober real GDP growth forecasts of 1.6% and 1.2% in the US and eurozone, respectively, suggesting that demand for Chinese goods could eventually start to falter. We believe that a US recessionary scenario, which cannot be ruled out at this stage, would almost certainly tip the balance in favour of a Chinese hard landing.
China - China Railway Group, CNY
8 7 BMI Goes Bearish Railway Stocks 6 5
railway Stocks in Freefall
rebalancing will not Be easy

China - Real GDP Growth Forecasts, %
BMI
Nov-09 Nov-10 May-09 May-10 May-11 Nov-11 Sep-09 Sep-10 Sep-11 Jan-09 Jan-10 Jan-11 Jul-09 Jul-10 Mar-09 Mar-10 Mar-11 Jul-11
4 3
Consensus
Bloomberg Consensus
10 IMF
9
Source: BMI
6 2011 2012 Long-Term
Source: BMI, IMF, Bloomberg
Global Backdrop Has Soured: An enduring bright spot in 2011 has been the performance of Chinese exports, which have continued to soar to new heights in the likes of the US, Germany and the UK. Going forward, however, we are now less optimistic on the state of developed world demand than we were 12 months ago. A double dip in the housing market and anaemic job creation are both
Political Risk Can No Longer Be Ignored: The march of revolution across the Middle East and North Africa has sent shockwaves through Beijing. Labour unrest and social disharmony in China have become increasingly commonplace, forcing the government into a hardline response. In June, for instance, violence broke out in the coastal Zhejiang province, as villagers fought with riot police over compensation of land seized for development. We would argue that many of these problems have been long in the making. While Chinas growth at all costs model has undoubtedly created jobs, it has also seen a widening of income disparities, a rise in corruption, and greater levels of state interference in the economy. Data from the
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Heritage Foundations Index of Economic Freedom shows that Chinas economy is as tightly controlled today as it was in 1995 (see bottom chart). With this in mind, we are wary that a material economic slowdown may be self reinforcing. As the economy loses steam over the coming quarters, a rise in unemployment could persuade workers already aggrieved with their local governments to take more aggressive action.
China - 3-Month Shanghai Interbank Offered Rates (SHIBOR), %
7 6 5 4 3
whammy of weaker mining sector growth, a declining trade surplus and a reversal in portfolio inflows. Such a scenario would be sufficient, in our view, to tip the economy into recessionary territory, and potentially a financial crisis.
China - Index Of Economic Freedom
no reform here
Banks Under Pressure
China's economic freedom score is the same now as in 1995
57 56 55 54 53 52 51 50
1995
1997
1999
2001
2003
2005
2007
2009
2 1
Source: BMI, Heritage Foundation
Jul-07
Jul-08
Jul-09
Jul-10
Oct-06
Oct-07
Oct-08
Oct-09
Oct-10
Jan-07
Jan-08
Jan-09
Jan-10
Apr-07
Apr-08
Apr-09
Apr-10
Jan-11
Apr-11
Jul-11
Source: BMI
Global Implications Of A Worst Case Scenario A major collapse in China would have serious repercussions for the rest of the world, such has been the enormity of the countrys appetite to consume raw materials and capital goods. To be sure, China has become the number one export destination for a plethora of countries in recent years, including Japan, Germany, Brazil and South Korea. Hence, a collapse in demand in the Asian giant would undoubtedly be felt across the globe. One economy that looks particularly vulnerable to a Chinese slump is Australia. Despite record terms of trade in 2011, buoyed by high commodity prices, Australia has run a persistent current account deficit financed primarily via hot money and short-term overseas commercial borrowings. The country is already facing domestic frailties, with home prices grinding lower, consumer sentiment falling precipitously, and business credit contracting in year-on-year terms for 26 consecutive months. Should Chinese demand for raw materials dry up, Australia could be in line to face a triple
On the flipside, we believe that India could actually benefit (at least in relative terms) from a Chinese hard landing. To be sure, the South Asian country is not without its own problems, with the rising cost of capital, vulnerability to high oil prices, poor project execution and a series of damaging corruption scandals all choking growth in 2011 to date. Nevertheless, Indias economy is primarily driven by internal demand and is, as such, less exposed than most to China. Structurally, too, lower wages and an ambitious infrastructure drive could tempt multinationals to shift manufacturing hubs southwards. Indias favourable demographics, lower levels of leverage, and more stable economic make-up (the consumer accounts for around 60% of the economy versus 35% in China) suggest to us that India will outperform China over the medium term. A Chinese collapse in 2012 could see this process play out sooner rather than later.
2011
economic activity
Three Scenarios For Growth
BMI View: Chinas economy is clearly entering a slow patch as both the manufacturing and services sectors feel the strain of higher interest rates and tightening money supply conditions. The big question is whether this will prove temporary or whether it will continue and intensify. Our core view on Chinas growth rate is that we are past the boom phase and we are entering a period of much weaker expansion, with headline real GDP growth set to fall to 7.5% by 2013. Despite being below consensus, we believe the risks to our forecasts are tilted to the downside.
China - Real GDP Growth, % chg
16 14 12 10 8 6 4 2 0
2005 2006 2007 2008 2009 2010 2011f 2012f 2013f
will not return until the property market excesses are unwound. Any further stimulus measures would likely seriously undermine the economys ability to grow strongly over the medium term. A Landing Underway Data coming out of China at present is consistent with our view that the economy is experiencing a slowdown, and we maintain our below-consensus real GDP growth forecast for 2011 and 2012 of 9.2% and 8.1% respectively. Indeed, purchasing managers indices (PMI) point to negative growth in the manufacturing sector over July and August, while the HSBC services PMI also shows the service sector teetering on the edge of contraction. While industrial production data remains strong, vehicle sales growth, which is highly sensitive to economic conditions, came in at just 2.5% y-o-y in August, and looks set to fall sharply negative in the coming months. Cement production, electricity production, and freight traffic, all point to a moderation in growth in the coming quarters.
Service Pmi Joins manufacturing in The doldrums
China - HSBC Services Purchasing Managers Index
7% is The new 10%
60 58 56 54 52 50 48
November June
Source: BMI, NBS. f = BMI forecasts
Two years ago we highlighted three potential scenarios for Chinas economic growth trajectory over the coming years. Under our core scenario we argued that growth would be strong in 2010, but delayed action on withdrawing the 2009 stimulus measures would undermine growth in 2011. While we have started to see signs of a slowdown, and our below-consensus view is now gaining credence, our forecasts were too bearish at the time as we believed that the government would take more action to cool money supply growth. As things stand now, having failed to use the past two years to rein in the credit excesses, the government faces a similar dilemma, but with the stakes raised and the payoffs skewed to the downside. Our core view is that a significant slowdown now appears unavoidable and that healthy growth
46
July August
July
September
October
December
January
March
August
April
Source: BMI, HSBC
Exports Holding Up, For Now One area that is not showing any signs of slowing is exports, which continue to post gains despite the ongoing economic difficulties in Chinas major export markets. Export growth picked up to 24.5% y-o-y in August, from 20.4% in July, as outbound shipments
10
February
May
SPeCial rePorT
posted their second highest level ever. Exports to the US, meanwhile, hit a new all-time high, despite the USs renewed economic slowdown. Despite the sustained strong performance of Chinas exports, we continue to believe that a slowdown is inevitable as the savings rates in the developed world increase. At present, then, the Chinese economy is clearly entering a soft patch. The big question is whether this will prove temporary before lower inflation allows looser policy to reignite growth, or whether it will continue and intensify. Below we outline our core scenario and some alternative scenarios for Chinas growth over the coming years. Core Scenario: Prolonged Sharp Slowdown 70% Our core view on Chinas growth rate is that we are past the boom phase and we are entering a period of much weaker expansion, with headline real GDP growth set to fall to 7.5% by 2013. In this regard, although we do not forecast an outright collapse, our call for sub8.0% growth puts us more in the hard landing than the soft landing camp.
Gross Fixed Capital Formation, Percentage Point Contribution To Growth
larger than any that have preceded it, and we believe that the command nature of the economy has meant that much of this investment has been unproductive. The recent examples we have seen with the boom and bust of high-speed rail, the financing problems facing local governments, sharply declining money supply growth and the loss of momentum in the housing market, all suggest to us that now is the time for the boom to end.
Gross Fixed Capital Formation, % of GDP
Flying Too high
60 50 40 30 Japan (T=1984) Thailand (T=1991) Malaysia (T=1991) China (T=1990)

T+10 T+12 T+14 T+16 T+18 T+20 T+2 T+4 T+6 T+8 T
20 10 0
Source: BMI, NBS
China in a world of its own
15 10 5 0 -5 -10 -15 -20 Japan (T=1984) Thailand (T=1991) Malaysia (T=1991) China (T=1990)
T T+1 T+2 T+3 T+4 T+5 T+6 T+7 T+8 T+9 T+10 T+11 T+12 T+13 T+14 T+15 T+16 T+17 T+18 T+19 T+20 T+21
The housing market is a perfect example of this unproductive investment, and it our belief that property prices are set to experience serious downside, which will drag down the entire economy. As we explain in the next section (pages 15-17), we believe that a 30% correction in home prices nationwide is possible, and that this will have a seriously negative impact on the economy as a whole. We are forecasting gross fixed capital formation growth to fall to 8.7% and 6.3% in 2012 and 2013. This compares with a projected 10.8% in 2011 and a whopping 16.4% in 2010. Leverage Will Be Felt By Governments It is often argued, either to reject the idea of a bubble or to suggest that the fall-out from its bursting will be contained, that there is very little leverage associated with the housing boom. We do not share this view. While it may be true that mortgages represent less than 30% of total bank credit, the growth rate has soared in recent years. Furthermore, anecdotal evidence suggests to us the housing loan-to-value ratios are also higher than are widely reported, with banks routinely skirting
Source: BMI, NBS
The main reason we are anticipating a sharp slowdown is our belief that the countrys investment boom has gone on far too long, resulting in serious misallocation of capital, which is finally set to be unwound in the near term. As the accompanying chart shows, Chinas investment boom has gone on longer and has been far
11
official restrictions. Even if consumer leverage is low, it is the debt of property developers and local government investment vehicles that are the source of the bulk of the leverage, as they have taken on huge amounts of debt backed by rising property prices. Indeed, governments rely on land sales for roughly 30% of total revenues, and local government debt is estimated to be as high as 40% of GDP. Once property prices fall, local governments will have an extremely tough time financing projects, and overall investment growth will slow sharply.
Sharp Slowdown Ahead (% chg)
Core Scenario
2010
2011f
2012f
2013f
Private Consumption GFCF Real GDP

f = BMI forecasts. Source: BMI, NBS
8.7 16.4 10.3
9.0 10.8 9.2
8.5 7.5 8.1
8.4 6.3 7.5
section of the economy is highly unlikely to carry the burden of growth. The negative wealth effect of falling home prices is likely to seriously undermine consumer confidence, causing private consumption growth to fall, rather than rise. To put it in perspective, a Shanghai resident who bought a new 100 square metre home two years ago, which currently costs around US$350,000 (the current average selling price according to China Real Estate Index System), is likely sitting on equity of up to US$100,000. To see this equity evaporate would deliver a savage blow to high-end retail, which has performed so impressively over the past few years. We are forecasting private consumption to grow by 8.5% in 2012, down from an expected 9.0% in 2011. Beyond this, private consumption growth should fall further to 8.4% in 2013, albeit outperforming the economy as a whole. The outlook for the export sector is perhaps the biggest unknown in our view. Our core view is that Chinas major export markets will see import growth slow but remain positive as these economies muddle through, which should see Chinese export growth slow sharply from current levels but remain in positive territory. We are forecasting export growth to fall to 8.0% this year and fall further to 5.0% in 2012. This should see net exports contribute negatively to headline growth to the tune of 0.4 percentage points (pp) and 0.6pp., respectively. Will China Stimulate? Money supply growth in China has fallen to a level where the government announced its unprecedented stimulus package in November 2008, and the economy faces headwinds similar to the ones it faced back then. This begs the questionwill China enact another stimulus? Our core view is that they will not. The main reason is that we do not envisage a collapse in growth in the export sector similar to that seen in 2008, and so a similar reaction will likely not be required. Even in the event of a sharp slowdown, we believe that fears over a banking crisis given the hidden bad debts in the system would prevent an all-out stimulus drive being enacted. Meanwhile, the likelihood of interest rate cuts
Upstream Industries Will Be Hit Hard Construction directly accounts for 54% of Chinese steel usage, and once autos and durable goods are added in the share rises to over 60%. We estimate that it could rise to two thirds once property-related infrastructure spending and the investment in new steel capacity are factored in. Chinas steel industry is a mainstay of the economy, accounting for around 45% of global steel production, up from just 15% a decade ago. Cement production, construction equipment, and power generation machinery are just a few examples of industries heavily at the mercy of a property slump and likely to find themselves in a tough operating environment once the housing bubble bursts. Although perhaps of lesser impact on the overall economy, downstream industries such as real estate broking, retail, autos, etc. will also be hit from a downturn in transaction activity. Consumer Will Be Found Wanting As we explain in the Consumer Outlook section (pps 27-30) those looking for a consumer boom to replace the investment boom will likely be disappointed. Indeed, the real estate boom was itself a consumer boom of sorts, which has saddled consumers with unproductive assets. Turning to consumer services and durable goods, this
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in the near term, even if growth cools further, is slim given the high rate of inflation. Scenario 2: Outright Recession 20% Under this scenario, an outright collapse in the housing market as liquidity conditions are further constrained leads to a contraction in investment spending and a sharp slowdown in consumer spending. This scenario also envisages a US recession, which would tip Chinese exports into negative territory. Although it seems to be regarded as impossible by most observers, a contraction in growth in China is not out of the question. Should the property bubble burst aggressively, it is not difficult to imagine a situation where construction spending falls by double digits. Construction spending in the US is currently down 30% from its peak after a similar decline in home prices, and the house prices never fall mentality that drove the construction boom in the US appears even more visible in China today, which we see as a worrying signal. This could easily drag investment growth into negative territory. As an example, should investment spending contract by a similar magnitude as it did in 1989 (the last time GFCF turned negative), then this could send real GDP growth plunging to -5.5% as the top right table shows. As for consumer spending, while we do not envisage a collapse, one cannot be ruled out under an outright property market collapse. While the low savings rate suggests there is tremendous long-term potential for private consumption, a simultaneous drop in exports and investment could trigger a surge in the domestic savings rate, undermining private consumption growth.
Not only is the global economy facing a deleveraging process on a scale never seen before, but Chinas exporters have to compete for a subdued level of external demand with an increasingly strong exchange rate and rising labour costs in coastal regions brought about by the property bubble. In a worst-case scenario we could see export growth turn sharply negative, as was the case in the global financial crisis of 2008-2009.
Outright Recession (% chg)
Scenario 2
2010
2011f
2012f
2013f

f = BMI forecasts. Source: BMI
8.7 16.4 10.3
9.0 10.8 9.2
-0.3 -13.0 -5.5
5.0 2.0 3.3
Under a hard landing scenario, Beijing would likely respond by embarking on another huge stimulus drive. However, given the damage caused to the economic structure and the overcapacity in housing and infrastructure that has resulted from the previous investment boom, any additional measures would be highly unlikely to have as much of a positive effect. If Beijing did throw caution to the wind and fire up the printing presses once again, then Chinas constructive long-term growth outlook would be placed in serious jeopardy. Scenario 3: Goldilocks Scenario 10% Although we assign little probability to this outcome, a continued growth boom cannot be entirely ruled out. In the near term, a re-emergence of strong growth in Chinas key export markets would be essential, as would positive news on the debt situation at local investment
CHINAECONOMIC ACTIVITY
2008
Nominal GDP, CNYbn Nominal GDP, US$bn Real GDP growth, % change y-o-y GDP per capita, US$ Population, mn Industrial production index, % y-o-y, ave Unemployment, % of labour force, eop 31,490.2 4,531.4 11.7 3,411 1,328.3 12.9 4.2
2009
34,502.4 5,050.5 9.2 3,783 1,334.9 11.1 4.8
2010
39,788.7 5,878.0 10.3 4,382 1,341.3 14.4 4.4
2011f
45,890.9 7,087.4 9.2 5,259 1,347.6 10.8 4.4
2012f
51,215.5 8,008.7 8.1 5,917 1,353.6 7.8 4.3
2013f
56,708.2 8,957.6 7.5 6,590 1,359.4 8.2 4.2
2014f
62,439.2 10,064.2 6.9 7,374 1,364.8 8.5 4.2
2015f
68,612.7 11,284.9 6.8 8,239 1,369.7 8.0 4.1
Notes: National Bureau of Statistics (NBS), BMI. f = BMI forecasts.
13
vehicles, to the effect that the situation is not as bad as we currently believe. Stability in the housing market would also be necessary, indicating that the housing market is not as overvalued as our core scenario sugContinued Strong Growth (% chg)
Scenario 3
2010
2011f
2012f
2013f

f = BMI forecasts. Source: BMI, NBS
8.7 16.4 10.3
9.0 10.8 9.2
9.5 9.5 9.2
9.5 9.0 9.1
gests. Over the medium term, productivity gains would be needed to compensate for the slowdown of inputs into the economic growth function (due to slower capital spending growth and labour force growth). Moreover, opening up to further investment and policies to boost labour market flexibility could see growth remain in the high single digits over the coming years.
14
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real estate outlook

Property market: all The hallmarks of a Top
BMI View: Chinas housing market is exhibiting signs typically seen at the end of a property bubble. Transaction volumes have fallen sharply, prices have stagnated, and sellers have begun to offer perks to avoid cutting headline prices. The next phase will likely see more interesting developments ensue. Prices should begin to fall in earnest, and financial problems at developers will exacerbate price declines. We estimate that prices need to fall by 30% nationwide before price excesses are unwound but could fall further in an adverse scenario. Once property prices begin to fall, equities are unlikely to see renewed interest. The continued, albeit minor, price gains seen in Chinas property market over the past six months have come as a surprise to us. We see the hitherto robustness of the market as a testament to the sheer scale of Chinas money supply boom and the rampant expansion of the off-balance sheet banking system that has allowed credit to be extended beyond the regulators already expansionary limits. This has meant that piecemeal
CHINAMONETARY POLICY
2008
Consumer prices, % y-o-y, eop [3] Consumer prices, % y-o-y, ave [3] Producer prices, % y-o-y, eop [3] Producer prices, % y-o-y, ave [3] Wholesale prices, % y-o-y, ave [3] Wholesale prices, % y-o-y, eop [3] M1, CNYbn [4] M1, % y-o-y [4] M2, CNYbn [4] M2, % y-o-y [4] Central Bank policy rate, % eop [1,5] Lending rate, %, eop [4] Lending rate, %, ave [4] Real lending rate, %, eop [2,4] Real lending rate, %, ave [2,4] 1.2 5.9 -1.1 6.9 7.0 -1.5 16,620.0 9.0 47,520.0 17.8 5.31 3.8 3.6 2.6 -2.3
measures have had only localised or temporary success as homebuyers have skirted cooling policies, and momentum on the whole has continued to push higher. Data Is Mixed, But Momentum Is Clearly Waning The data on home prices has been mixed of late, with some agencies reporting substantial price declines and others showing continued gains. According to official statistics, home prices in Beijing and Shanghai stopped rising in July following sustained gains over the past two years, adding to the 14 other cities (of 70 tracked) that showed a reduction in average selling prices. According to China Real Estate Index System, however, residential property prices in 100 major cities were largely flat, with property prices rising in 56 cities and falling in 44. Meanwhile, according to the Beijing Real Estate Association, the citys average home price has dropped by more than 8% year-on-year (y-o-y) in the January-July period, and developers have begun to discount prices aggressively. Transaction Volumes Drying Up While the price data is mixed, transaction volumes are
2009
1.9 -0.7 0.7 -5.5 -5.0 3.4 19,057.8 14.7 60,825.6 28.0 5.31 2.2 3.0 0.3 3.7
2010
4.6 3.3 3.9 3.7 3.9 4.0 21,875.2 14.8 73,781.4 21.3 5.81 2.2 2.2 -2.4 -1.1
2011f
4.8 5.6 3.2 3.2 3.8 3.8 25,240.5 15.4 85,586.5 16.0 6.81 3.5 2.8 -1.3 -2.8
2012f
3.1 3.2 2.9 2.9 3.6 3.6 29,017.7 15.0 95,293.3 11.3 6.56 3.0 3.2 -0.1 0.0
2013f
3.1 3.0 2.6 2.6 3.0 3.0 33,008.8 13.8 105,298.6 10.5 6.81 3.0 3.0 -0.2 -0.0
2014f
3.0 3.0 2.6 2.6 3.1 3.1 37,864.7 14.7 115,723.7 9.9 6.81 3.0 3.0 -0.0 -0.0
2015f
3.0 2.9 2.5 2.5 3.1 3.1 43,438.2 14.7 126,936.3 9.7 6.81 3.5 3.2 0.5 0.3
Notes: e = BMI estimates. f = BMI forecasts. 1 One-Year Lending Rate; 2 Real rate strips out the effects of inflation; Sources: 3 National Bureau of Statistics, BMI; 4 IMF, BMI; 5 Peoples Bank of China, BMI; 6 BMI.
15
starting to dry up, which we see as a clear sign of declining momentum. China Vanke Co, the countrys largest property developer by market share, said sales in August fell from a year ago due to a slower pace of project launches and lower average sales prices. Furthermore, according to China Real Estate Information Corp (CRIC), August new home sales in Shanghai dropped to the lowest in seven years as tighter purchase restrictions further eroded already-slack buying sentiment. This slowdown in transactions should feed through into outright declines in the months ahead as developers inventories swell and their financial conditions deteriorate.
China - Official House Price Index, % chg y-o-y
the current strength of the market. The M2 Headwind Is Getting Strong The main headwind facing asset markets in China at present is the sharp reduction in lending growth. Money supply (M2) growth fell to a seven-year low of 13.5% y-o-y in August, from 14.7% in July. This is by far the biggest headwind for Chinas property market, and we see it continuing to gather pace. While there is growing coverage of rampant underground lending taking place all over China, we do not see this as a sign of still-rampant liquidity as it does not add to the overall money supply but rather represents the scarcity of new funds available to those without political connections.
a worrying Combination
expect a Sub-Zero Print
14 12 10 8 6 4 2 0 -2
Nov-05 Feb-06 May-06 Aug-06 Nov-06 Aug-07 Nov-07 Nov-08 Feb-09 Nov-09 Feb-10 May-10 Feb-07 May-07 Feb-08 May-08 Aug-08 May-09 Aug-09 Aug-10 Nov-10
China - M2 Money Supply Growth And CPI (% chg y-o-y)
CPI
M2
35 30 25 20 15 10 5 0 -5
-4
Feb-11
Source: BMI, National Development & Reform Comission (NDRC)
Developers Feeling The Squeeze As Unsold Inventory Grows In another sign that a peak in the housing market is nearing, developers are offering add-ons rather than cutting prices outright. Developers are also helping buyers secure financing, with Pan Hong Property Group providing bank guarantees for buyers and low interest rate loans. These vendor financing schemes may be a sign that property developers are running short of funds, having built up high levels of land banks in recent quarters. In fact, first half results from Chinas main property developers show that despite a surge in revenues and profits, inventories rose by roughly 40% and cash flow remains negative, suggesting that developers may have to unload if financial conditions deteriorate. Furthermore, as homes are usually pre-sold, with revenues accruing only on completion, these figures likely represent sales that were made several months ago, possibly overstating
Aug-05
Spread
35 30 25 20 15 10 5 0
Source: BMI, NBS, PBoC
30% Correction Needed Although it is tough to put a figure on it, we estimate that property prices could be as much as 50% overvalued nationwide, with rental yields in the 1.0-2.0% range
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1996 1996 1997 1997 1998 1998 1999 2000 2000 2001 2001 2002 2003 2003 2004 2004 2005 2005 2006 2007 2007 2008 2008 2009 2010 2010 2011 2011 2012
SPeCial rePorT
adding support to this view. Our view is that overall prices need to fall by at least 30% before we can say that homes are reasonably priced. While this may seem like a large fall, Chinas banking regulator has been warning of a 50% drop for several months and has used this figure as a stress test for the banking system. The possibility of an outright collapse, where falling property prices trigger an outright recession, leading to a negative feedback loop, is not out of the question. In some areas, where policy-driven construction has run rampant in recent years and continues unabated despite single-digit occupancy rates (such as Ordos in Inner Mongolia), we would not be surprised to see property prices fall by more than half.
Cheap But Set To Go Cheaper
China - Shanghai Composite Index
trading at 2.1X book value and a P/E ratio of 13.2. China Railway Group could be the canary in the coalmine for the broader equity market.
7,000 6,000 5,000 4,000 3,000 2,000 1,000

Jun-01 Nov-01 Apr-02 Sep-02 Feb-03 Jul-03 Dec-03 May-04 Oct-04 Mar-05 Aug-05 Jan-06 Jun-06 Nov-06 Apr-07 Sep-07 Feb-08 Jul-08 Dec-08 May-09 Oct-09 Mar-10 Aug-10 Jan-11 Jun-11 Nov-11
Source: BMI
Will Money Flow Into The Stock Market? We do not put a high probability on a slump in the real estate market leading to a rise in the stock market. While we did see a fall in the equity market leading to a rise in the housing market in mid-2008, it is important to stress that this was the result of the Peoples Bank of China creating new credit and did not represent a simple shifting of portfolios away from stocks amd into housing. In the absence of another forceful stimulus package, we would expect malinvested credit to be destroyed (simply vanishing) rather than heading to the stock market. In fact, we would expect to see the market fall further given the hit to earnings. Equity valuations are historically cheap, but they are by no means at bargain basement levels, with the Shanghai Composite Index
17
investment outlook
China Bubble: Case Study The rise & Fall of high-Speed rail
BMI View: Back in February 2011, we identified Chinas massive high-speed rail expansion as a textbook example of the malinvestment activity taking place across the country. Since then, the sectors fall from grace has been spectacular, with the Ministry of Railways suffering record losses and railway equities plummeting in value. With so much money channelled into other areas of infrastructure that are likely to yield poor rates of return (not least the real estate segment), the next example of malinvestment does not appear far off. On February 25 2011, we published an article entitled Railway Boom Unsustainable, which looked at the financial and economic prospects facing Chinas highspeed rail sector. From our perspective, the poor economic viability of these signature projects was a tell-tale sign of overinvestment in the sector a view we had been running for quite some time at the macro level. We stated at that time that: We have long held a sceptical view of the sustainability of Chinas infrastructure boom, believing that inefficiencies would at some point come back to haunt the government, undermining long-term economic growth. The argument that China has a need for railway infrastructure investment is certainly valid, but we believe there has been too much focus placed on the positive impact of such infrastructure on facilitating near-term economic growth, and not enough focus on the long-term costs associated with these benefits. Using the high-speed rail line connecting Chengdu to Shanghai as an example, it is easy to see how this has been a boon for the local economy. Not only has the project helped create jobs in the region and boost real GDP growth figures, but it has halved travel time between the two cities. However, if this does not make an operating profit, it will act as a long-term drag on the countrys resources, undermining economic growth, particularly given the astronomical debt burden that the Ministry of Railways (MoR) has taken on to build it, and other projects. At a reported cost of roughly CNY2,330 for a top-end ticket, it is questionable whether workers from Sichuan Province, with a GDP per capita of just CNY17,300 per annum, can afford to use this service. With this in mind, we believe that these operations are likely to make a loss for a long time to come.
high Speed economy
Chinas High Speed Railways
Source: BMI
For us, this debt-fuelled spending spree on railway expansion would not be sustainable. We estimated that the MoR had racked up debts worth at least CNY2.0trn by the end of 2010, and with interest rates on the rise, the burden of financing this debt would spike astronomically. Since our warnings, the sectors fortunes have unravelled at a truly remarkable pace. Financial statements released by the Shanghai Clearing House reveal that Chinas Ministry of Railways (MoR) incurred a loss of CNY3.76bn (US$578mn) in Q111. Faced with a liquidity crunch, The MoR attempted to issue US$3bn worth of short-term financing bonds, but these failed to attract sufficient investors despite offering interest rates of 5.18% (double the 2.59% interest for bonds issued by the MoR on July 2010). Furthermore, this was followed in July by a fatal train collision on the high-speed railway line in Wenzhou, Zhejiang prov-
18
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ince. A total of thirty-five passengers were killed and 192 injured in the accident according to official data, making it the countrys worst railway disaster since high-speed railway services began in China in 2008. This is a highly disconcerting statistic, especially given that the government itself has conceded that the accident was due to poor safety standards.
Uncertainty Grows over high Speed Spending
China Railway Infrastructure Industry Value Forecasts
400 350 300 250 200 150 100 50 0
2011f 2012f 2013f 2014f 2015f 2016f 2017f 2018f 2019f 2010e 2020f 2007 2008 2009
slumping 38% and 36%, respectively, and bailouts or bankruptcy for both look likely. Besides railway construction companies, we also believed that Chinese railway equipment manufacturers would face downside pressure in their equity values as questions would be asked about the reliability of their equipment. China South Locomotive , along with Canadas Bombardier, had constructed the trains involved in the accident. More China Railways To Come With all new high-speed rail projects now suspended, our concerns over the overinvestment in the sector have been justified. What is more, with railway investment accounting for around 3% of total capital spending, this is a major factor reinforcing our core view that gross fixed capital formation will fall to a 15-year low of 8.7% next year, with risks heavily weighted to the downside. The unprecedented nature of Chinas credit binge, and the poor price signalling in the market, means that more examples of investment excesses are likely to crop up in the coming months and quarters (particularly in the real estate sector). With this in mind, the troubles facing Chinas railway sector provide a clear micro example of the China slowdown call that we have been gunning for.
100 90 80 70 60 50 40 30 20 10 0
Railways Infrastructure Industry Value, CNYbn Railways Infrastructure Industry Value Real Growth, (%) chg y-o-y
e/f = BMI estimates/forecasts. Sources: National Bureau of Statistics/ China Statistical Yearbook/ILO
Financial Market Implications In our February article, we singled out China Railway Construction Corporation (CRCC) and China Railway Group (CRG) as particularly vulnerable to a substantial correction in the equity markets. Both stocks looked technically awful to us, and despite cheap valuations, we believed that both could well trade below book value. Since then, CRCC and CRG have nosedived,
Sign of Things To Come?
China Bubble: Case Study 2 luck running out For macau Casinos
BMI View: Despite the well-known positive long-term story of Macaus gaming industry and economy, we believe the current growth boom is being driven overwhelmingly by the credit bubble in China. A tightening of liquidity on the mainland, together with a slowdown in growth and a tougher crackdown on corruption, will undermine Macaus gaming revenues. Having identified weaknesses in July, we expect to see further downside moves in a number of casino stocks with heavy exposure to the region. The Bullish Long-Term Case Is Well Known... Booming Macau is expected to turnover five times more in gaming revenues in 2011 than its beleaguered US counterpart Las Vegas. The bullish case for continued rampant growth in the Special Administrative Region (SAR) is clear: world-beating Chinese income growth combined with a cultural love of gambling mean the
China - China Railway Group, CNY

10 BMI goes bearish railway stocks 9 8 7 6 5 4
Apr-10 Oct-10 Nov-10 Aug-10 Sep-10 Dec-10 Apr-11 May-10 May-11 Aug-11 Jan-10 Jun-10 Jan-11 Jun-11 Jul-10 Feb-10 Mar-10 Feb-11 Mar-11 Jul-11
Source: BMI
19
future is bright. The lacklustre performance of Las Vegas in the heart of one of only two US states where growth contracted in 2010, meanwhile, is forcing US casino majors such as MGM Resorts International to shift focus away from the US and towards the roaring eastern market. These forces combined to see revenue growth hit 44.8% year-on-year (y-o-y) in the January-July period, the highest on record, and gaming stocks have rallied aggressively to reflect the tremendous growth potential.
Macau - Gross Gaming Revenue, MOPmn
The house has Been winning
30 25 20 15 10 5 0
On The Gaming Industry, December 2), we called for a sharp slowdown in Macaus gaming industry, which contributed 82.8% of GDP at the time. However, the industry has continued to power ahead, far exceeding our expectations, making us increasingly concerned that a hard landing may result. Real GDP growth came in at 24.0% y-o-y in Q111, led by a 39.0 y-o-y increase in services exports. The driver, of course, was the 47.9% y-o-y growth in gaming revenues, which hit a new monthly high of MOP24.3bn (US$3.0bn) during the month. Highlighting the importance of high-rollers to the SARs top line, the VIP Baccarat tables were the source of an incredible 73.0% of all gaming revenues, equivalent to an estimated 61.0% of GDP.
worlds Fastest Growing economy
Macau - Real GDP Growth, %
Real GDP Growth GFCF Services Exports 100 80 60 40 20 0 -20 -40 -60
Q105 Q205 Q305 Q405 Q106 Q206 Q306 Q406 Q107 Q207 Q307 Q407 Q108 Q208 Q308 Q408 Q109 Q209 Q309 Q409 Q110 Q210 Q310 Q410 Q111 Q211
Source: BMI, Statistics And Census Service
...But The Bearish Case Merits Attention The bearish case, however, merits some serious attention. With 85% of arrivals coming from the mainland and Hong Kong, and roughly half of the revenues generated from these sources reportedly coming from either government officials or senior managers in state-run companies, we caution that Macaus current run of luck could be largely an outgrowth of a Chinese liquidity bubble that is set to burst. Over the long term, Macaus growth story is likely to remain intact, supported by the above-mentioned positive factors. However, a slowdown in the mainland Chinese economy, (particularly given the heavy reliance on the largesse of Chinese officialdom), is a huge concern for us. Indeed, it suggests that a hard landing could await the Macau gaming industry in 2012 as the impact of China monetary boom wears off and the cash available for Chinas local government officials dries up. In a previous BMI Macau report (see Betting The House
Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11
Chinese Officials A Major Source Of Revenue A 2010 study by the Macau Polytechnic Institute suggests that 47% of these Chinese high-rollers are either government officials or senior managers in state-run companies. We have written a great deal about the impact of Chinas money supply boom and the distortions it has caused in the Chinese economy. To put it into perspective, we calculate that the increase in M2 per capita since the start of the stimulus in November 2008 has been equivalent to US$3,500, roughly in line average annual income. With this sort of an increase in cash sloshing around the economy and with a political system that gives excessive power to unaccountable local officials, it is no surprise that some of the funds found their way onto Macaus Baccarat tables. In one high-profile case, Li Weimin, a mayor of small town in
20
SPeCial rePorT
Guangdong, was sentenced to 20 years in prison after gambling away US$12mn in 2006. To circumvent restrictions on the flow of money out of the country, many gamblers are reported to travel on junkets run by companies that lend them money to gamble and then collect debts once they return. Beijing has imposed tighter restrictions on state employees travelling to Macau, limiting the number of trips they can make each year. However, the problem still persists. The Chongqing Evening News recently reported on a local official named Lin Xinyong, dubbed the gambling king, who is currently awaiting the death penalty after allegedly extorting US$4.0mn in bribes and losing US$250,000 during a two-day gambling spree in Macau. Consistent with these widespread reports of embezzlement, according to a recently leaked document from the Peoples Bank of China (PBoC), between 16,000 and 18,000 corrupt Chinese officials have siphoned more than US$120.0bn out of the country in less than two decades.
Chinese Gamblers Punching above Their weight
Macau - Average Tourist Spending Per Visit
to apply the brakes, and we have seen money supply growth drop severely from a peak of 30.05% y-o-y to the current level of 13.5% y-o-y in August. Moreover, local government finances are in terrible shape, with loans extended to investment vehicles during the boom increasingly squeezing local budgets at a time when receipts from land sales (the largest single source of income) are in sharp decline. These factors suggest that the days of virtually unlimited access to funds could be nearing an end, which will put a squeeze on the spending habits of government officials. Private Chinese business leaders who have also seen their wealth skyrocket over the past few years will also likely feel the pinch from a cooling economy and tightening liquidity.
China - M2 Money Supply Growth, % chg y-o-y
Turning off The Taps
32 30 28 26 24 22 20 18 16 14
Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11
3,000 2,500 2,000 1,500 1,000 500
Average Spending, MOP (LHS) Average Spending, % of GDP Per Capita
6 5 4 3 2
Source: BMI, PBoC
12
1
Oceania Europe Mainland China Southeast Asia Hong Kong Americas Taiwan Japan
Major Income Driver Set To Stall Based on the wealth of anecdotal evidence, media reports and studies, we do not believe it is an exaggeration to say that Macaus current economic boom relies overwhelmingly on the cash available to Chinas officialdom. With this in mind, we believe the tables could be turning against the SAR for two main reasons. Firstly, liquidity is drying up. After two and a half years of rampant money supply growth, rising prices are forcing the PBoC
Secondly, official graft is a leading source of public resentment towards the government, and as we have seen in recent weeks, there seems to be a rising intensity in the publics opposition to corruption. Bomb attacks on government offices in the south-east city of Fuzhou, Fujian, and the crackdown on protestors in Lichuan, Hubei, were allegedly both in opposition to corrupt local officials. We expect this kind of opposition to continue to intensify as the economy weakens, leading to an increasingly harsh response by the central government to control wayward local leaders. Combined, these two factors should help to reduce the prevalence of public funds being taken out of the mainland bound for Macau.
21
Parabolic Charts Warn Of Potential Collapse Back in July, we highlighted the unsustainable nature of Macaus gaming industry boom, suggesting that its main growth driver rampant liquidity growth in mainland China was about to lose steam (see Gambling Boom: A House Of Cards?, June 22). We also argued that casino operators with heavy exposure to this boom were extremely overvalued and faced a potential collapse. Since then, a number of gaming counters have experienced significant weakness, and further losses look highly likely. MGM Resorts International, which we maintain could face solvency issues in the near future, is already down by over 25% since we initiated our bearish view, and a further fall back to the all-time low of US$1.80 from the current level of US$9.50 (80% further downside) is not
MGM Resorts International Equity Price
out of the question. The recently launched MGM China is also suffering and looks set to test its all-time low. Wynn Macau has held up relatively well in recent weeks, but the technical chart pattern is pointing to potentially severe losses, having posted bearish divergence on the weekly relative strength index (RSI) following what appears to be a significant topping pattern. A clean break through HKD21.50 would open up a rapid move down to HKD18.00.
Wynn Macau Equity Price & RSI
30
wynning Streak over
25
20
another run at The lows
15
110 90 70 50 30 10 -10
2007 2008 2009 2010 2011
10
5 90 80 70 60 50 40 30 20 10
Oct-09 Feb-10 Mar-10 Oct-10 Mar-11 Jan-10 Jun-10 Jan-11 Feb-11 Nov-09 Dec-09 May-10 Nov-10 Dec-10 May-11 Sep-10 Jun-11 Aug-10 Aug-11 Sep-11 Apr-10 Apr-11 Oct-11 Jul-10 Jul-11
Source: BMI
MGM China Equity Price
Source: BMI
19 18 17 16 15 14 13
14-Jul-11 02-Jun-11 16-Jun-11 30-Jun-11 28-Jul-11
12
11-Aug-11 25-Aug-11
One stock which has held up surprisingly well despite the global sell-off is Galaxy Entertainment. Trading in excess of 8x book value and with an incredibly high price-to-earnings (P/E) ratio of 82, we believe the potential downside for Galaxy is huge. After rallying 40-fold over the past two years, the stock has posted two key reversal weeks in quick succession, and with triple negative divergence on the weekly RSI, a major decline could be around the corner.
Source: BMI
22
SPeCial rePorT
Triple negative divergence warns of major Top

Galaxy Entertainment Group Equity Price & RSI
25
20
15
10
0 100 90 80 70 60 50 40 30 20 10
Oct-08 Oct-09 Oct-10 Dec-07 Feb-08 Dec-08 Feb-09 Dec-09 Feb-10 Dec-10 Feb-11 Apr-08 Apr-09 Apr-10 Aug-08 Aug-09 Aug-10 Apr-11 Aug-11 Oct-11 Jun-08 Jun-09 Jun-10 Jun-11
Source: BMI
23
Banking Sector outlook

Banking Sector instability Playbook
BMI View: As the repayment capacity of loans extended to local government investment vehicles comes under threat, we continue to expect instability in Chinas banking system. In this article, we detail our core views on how the process will play out and its impact on economic growth and local asset markets. In terms of the financial markets, we continue to expect the H-Financials Index to underperform the broader market. Earlier this year, Chinas National Audit Office (NAO) provided some rare insight into the problems faced by Chinas banking system as a result of the proliferation of liabilities racked up to local governments in recent years (so-called local government investment vehicles, LGIVs). These liabilities were estimated by the NAO to have totalled CNY10.7trn at the end of 2010, equivalent to roughly 27% of GDP, and more importantly, there are
Estimate Of Local Government Investment Vehicle Debt, US$trn
7 6 5 4 3 2 1 0 Net External Savings LGIV Debt Foreign Exchange Reserves 2010 GDP
signs that these LGIVs are starting to run into trouble. Yunan Highways Restructuring Could Be Canary In Coalmine As our Infrastructure team highlighted recently, Yunnan Highway Development Investment could be the first domino to fall. The LGIV informed its creditor banks back in April that it would repay interest but not principal on its loans with immediate effect, and since then, the Yunnan government has cancelled its promise to stump up capital for the struggling expressway builder. It appears that financial difficulties at the provincial government itself have forced the LGIV into debt restructuring. The sudden concern with the health of local governments and by extension, the banking system, should not come as a surprise to regular readers of our service. It has been our core view since the beginning of the stimulus measures back in November 2008 that a large number of bad debts would accumulate as a result of the policy-driven lending, which would have wideranging implications (see our online service, January 20 2010, Banking Sector Instability Inevitable). We summarise below our key views on the issue: 1) Total Exposure To Be Greater Than Estimated The total exposure of the banking system to LGIV debt may be even higher than what initial estimates suggest. The Peoples Bank of China (PBoC) has reported that bank lending to local governments and related entities was CNY5.5trn more than accounted for by the NAO. Moodys also announced on July 5 that up to an additional CNY3.5trn of such loans were
lGiV debt in Perspective
Source: BMI, PBoC, IMF, Moodys, NBS
CHINA - BANKING SECTOR OVERVIEW

2008 Client loans, CNYmn Client deposits, CNYmn Loan/deposit ratio, % Loan/asset ratio, % 32,004,870 47,844,421 67 50 2009 42,559,660 61,200,635 70 53 2010 50,122,281 73,337,728 68 52 2011f 54,132,063 79,204,746 68 52 2012f 57,921,308 84,749,078 68 53 2013f 61,396,586 90,681,514 68 54 2014f 65,080,382 97,029,220 67 55 2015f 69,636,008 104,791,558 66 56 2016f 74,510,529 113,174,882 66 57
Notes: f = BMI forecasts.
24
SPeCial rePorT
unaccounted for by the Chinese auditors. This would equate to CNY14.2trn (US$2.2bn), equivalent to 37.5% of 2010 GDP and 28.6% of total loans in the banking system. Once off-balance sheet contingent liabilities are brought into the equation, the end figure may actually exceed Moodys estimates. Moreover, companies whose operations depend on demand from LGIV investments (materials suppliers for instance) will also find it difficult to repay loans if these investment projects slow. 2) NPL Rates Set To Soar A scenario test we performed back in April (see our online service, April 26 2011, Three Scenarios For The Big Four Banks) showed that under our core scenario of a 23% default rate of LGIV loans (in line with estimates from the China Banking Regulatory Commission made back in July 2010), the Big Four banks would face a major shock to their equity buffers. However, with the NAO and Moodys reports suggesting that LGIV debt makes up a much larger share of total loans than what the CBRC initially estimated, total nonperforming loan rates are likely to be much higher than under our base case forecast (and Moodys 5-8% base rate). With this in mind, we expect a number of banks to face insolvency. As a sign of the scale of risks that LGIV debt poses to banks balance sheets, according to Caixin, the CNY100bn loaned to Yunnan Highway more than exceeded the total existing non-performing loans of the institutions that loaned them the funds. 3) A Central Government Bailout To Be Expected We have long argued that Beijing will at least partially stand behind local governments in the event of a rise in LGIV default concerns. Supporting our view, Chinas regulators have reportedly planned to shift CNY23trn (US$$308-463bn) of debt off local governments. Although this has not been confirmed, it may suggest that Beijing is considering its options. Given that a substantial proportion of the loans made over the past two and a half years have been policy loans loans made by semi-private banks to fund fiscal policy goals allowing these banks to take the losses would risk losing the banking system as its major fiscal policy lever, which is something that we do not believe the government would be willing to do. Secondly, there is a risk
that in the absence of central government support, the weak nature of local government balance sheets (and the expected deterioration in income flows as growth cools and property revenues fall) could risk a series of LGIV defaults large enough to cause widespread bank failures. Even under a benign outcome, credit would be sharply curtailed to local governments a major source of economic growth posing serious downside risks to headline growth in the near term. 4) A Banking Crisis Will Be Avoided Although it cannot be ruled out, we do not envisage a banking crisis in China. This largely follows our view that the central government will provide financial support to the banking system. As a large net creditor nation, the government faces no external constraints in economic policy. While the worst-case scenario of capital flight from the banking system could put major strain on the governments balance sheet in the event of a recapitalisation, this is where the PBoCs foreign reserves would act as a major supportive factor. That said, some smaller banks without state backing may be forced into bankruptcy. 5) Lower Medium-Term Economic Growth Will Be The Cost As NPLs and banking sector instability rises, government support would likely mitigate the near-term economic fallout as banks would be able to continue lending, and local governments would be able to continue borrowing. However, we believe that rising NPLs would be
investment Slowdown To Undermine medium-Term Growth
Real GDP Growth, % chg
25
Real GDP
GFCF
20
15
10
0
2011f 2012f 2013f 2014f 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Source: BMI, NBS. f = BMI forecasts
25
symptomatic of the damage that has already been done to the economy as a result of excessive lending for unproductive projects, rather than a cause of economic weakness in it own right. As a result, any governments attempts to bail out the banks would simply come at the cost of future growth. Resources were misdirected as a result of the policy lending, and the ability of resources in the economy to organise in such a way to create goods for current and future consumption has been curtailed. Any bailout by the central government would simply be a reallocation of the debt burden away from the banks and onto the taxpayers and bank depositors. While it is widely believed that high future economic growth will allow the government to reduce its debt burden, or grow itself out of the problem, the longer that current macroeconomic distortions continue, the more difficult it will be for businesses to generate the profit growth needed to pay down government debt.
Shanghai Composite Index, Nominal v Real
7,000 SCI SCI In Real Terms 6,000 5,000 4,000 3,000 2,000 1,000 0
yuan weakness in the event of a large-scale banking bailout and slowdown in global trade. Our average exchange rate forecast of CNY6.3950/US$ remains below consensus (currently at CNY6.0600/US$) given these risks and our long-held belief that the CNY is not undervalued versus the US dollar.
extreme optimism Towards CnY Unlikely To Be rewarded
China Exchange Rate, CNY/US$
Bloomberg Mean Forecast Forward Market BMI Forecast Forecast
8.0 7.5 7.0 6.5 6.0 5.5
lost decade
Source: BMI
Source: SCI, BMI
The stark underperformance of Chinas equity markets since the recovery began, with stock prices in real terms no higher than they were in 2000 (see chart), suggests to us the investors are pricing in sub-par growth that awaits China in the years ahead. 6) Currency Strength Unlikely With the risks facing the Chinese banking system, it is by no means guaranteed that the Chinese yuan will appreciate over the medium term as is the consensus view at present. In fact, we cannot rule out the possibility of
7) Bearish H-Financials Versus Shanghai Composite, CDS To Rise While a banking sector crisis should be avoided, the fate of equity holders in Chinas state-owned banks is less clear cut. With valuations still lofty and not reflective of crisis risks, we turned bearish on the Hang Seng HFinancials index, which is comprised of Chinas largest financial companies, back in July a view which has moved roughly 20% in our favour. Going forward, we still believe the ratio of the Shanghai Composite Index over the H-Financials will continue to head in the SCIs favour. Meanwhile, with banking sector and sovereign credit concerns mounting, the 5-year sovereign credit default swap (CDS) has significant upside potential.
Jul-99
Jul-00
Jul-01
Jul-02
Jul-03
Jul-04
Jul-05
Jul-06
Jul-07
Jul-08
Jul-09
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jul-10
26
Jan-11
Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12
SPeCial rePorT
Consumer outlook
dont Count on The Consumer
BMI View: In the event of a pronounced correction in investment spending, a slump in exports and potential banking sector instability, we find it highly unlikely that the Chinese consumer will be able to shoulder the burden of growth. While we are bullish on the long-term prospects for the consumer sector, Chinas domestic demand rebalancing is likely to be a long, drawn-out process.
exports & retail Sales Correlated
60 50 40 30 20 10 0 -10 -20 -30 -40
Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11
China Retail Sales & Exports
25
20
of Chinas consumer base, the undeveloped nature of organised retail, relatively low penetration of services, and strong scope for premiumisation are all structural positives. These are several of the factors underpinning our view that private consumption will slowly rise as a share nominal GDP from the current nadir of 34.5% over the next decade. We would, however, take issue with the notion that this process can occur without a material slowdown in headline economic expansion. Below, we outline our belief why domestic demand rebalancing in China will result in a much softer rate of real GDP growth.
Consumers Confidence not immune To an export Slowdown
Consumer Confidence Indicator
15
115
10
113 111 109 107 105 103 101 Consumer Confidence

Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11
Exports, % chg y-o-y LHS Retail Sales, % chg y-o-y RHS
99 97 95
Source: BMI, NBS, Customs General Administration
An argument we hear time and time again is that the Chinese consumer can replace the countrys investment boom as the main engine of economic growth. For the China bulls, an acceleration of household spending driven by sizeable personal savings and rising wages would compensate for a reduction in capital outlay, helping to keep the economy motoring along at its current pace of expansion. We would not deny that the vast size
CHINAGDP BY EXPENDITURE, % OF GDP
2008
Nominal GDP, CNYbn Nominal GDP, US$bn Private consumption, % of GDP Government final consumption, % of GDP Fixed capital formation, % Total GDP Exports of goods & services, % of GDP Imports of goods and services, % Total GDP Net exports of goods & services, % Total GDP 31,490.2 4,531.4 35.1 13.3 40.7 34.0 26.4 7.7
Source: BMI, NBS, Customs General Administration
GDP Numbers Mask Size Of Chinese Consumer: Aside from the usual concerns over accounting standards employed by the National Bureau of Statistics and the extent of informal economic activity, we believe that
2009
34,502.4 5,050.5 35.1 12.9 45.4 26.0 21.4 4.4
2010
39,788.7 5,878.0 34.6 12.5 47.9 29.6 25.7 3.9
2011f
45,890.9 7,087.4 34.5 12.5 48.6 29.3 26.1 3.2
2012f
51,215.5 8,008.7 34.6 12.7 48.3 28.6 25.6 3.0
2013f
56,708.2 8,957.6 34.9 12.9 47.8 28.2 25.4 2.7
2014f
62,439.2 10,064.2 35.4 13.2 47.1 27.9 25.4 2.5
2015f
68,612.7 11,284.9 35.9 13.6 46.4 27.7 25.4 2.2
Notes: f = BMI forecasts. Sources: National Bureau of Statistics, BMI.
27
the size of Chinese private consumption could be vastly understatedparticularly if one thinks of the real estate boom as a consumer boom in itself. The only reason housing purchases are considered as investments is because this is how they are recognised in GDP accounting. We believe it may be more accurate to consider property a consumer good, particularly given the speculative nature of a large proportion of housing purchases and the fact that end use is by consumers. When looking at the housing boom in this light, the consumer has not been retrenching at all, and the household savings rate may have even been in decline. By this measure, consumer spending could be approaching 50% of GDP (by no means high but a far cry from the 35% in the official GDP statistics). To put it another way, the biggest contributor to the increase in investments share of GDP has been property construction, which rose from 6% of GDP on average during the 1990s to more than 13% of GDP in 2010. Moreover, given our view that property prices have peaked and are likely to head much lower from here, the impact on the consumer via the negative wealth efChina - Passenger Car Sales, 000s
Government subsidies withdrawn 1,600
fect could provoke a major tightening of purse strings. Consumer Activity Not Immune To Export And Investment Slowdown: The correlated nature of Chinas economy suggests that consumer activity would not be able to weather a sharp correction in exports and investment. The export-processing and construction industries are major employers of Chinese labour, and any retrenchment in either would inevitably lead to an erosion of consumer confidence. Recent history provides a useful guide of what to expect. As the charts on the previous page show, despite holding up in positive territory, year-to-date retail sales growth followed export growth much lower in mid-2008, while consumer confidence slumped to a six-year low. Should China experience a perfect storm of a hard investment landing, double dip in the US and a protracted eurozone sovereign crisis, it seems implausible to us that local retail sales would escape a significant moderation, or even contraction, in growth. Subsidy Boost Has Ended: The strong performance of consumer activity since the global financial crisis can (at least in part) be explained by generous government subsidies. Take the automotive sector for example. In 2009-2010, the government announced a series of subsidies in an attempt to stimulate the industry. For instance, the sales tax on vehicles with engines under 1.6 litres was halved in January 2009, and a total of CNY5bn was also allocated to a scrappage scheme similar to that in the US, with CNY3,000-7,500 per vehicle handed out depending on the size. The subsidies generated results virtually overnight, with passenger car sales growth skyrocketing to a scorching 115.5% year-on-year in January 2010. Unsurprisingly, however,
a Temporary Boost
1,200
Government subsidies introduced
800
400
0
Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11
Source: BMI, NBS, Customs General Administration,
CHINAGDP CONTRIBUTION TO GROWTH

2008
Real GDP growth, % change y-o-y Private final consumption, contribution to real CNY GDP growth (pp) Government final consumption, contribution to real CNY GDP growth (pp) Fixed capital formation, contribution to real CNY GDP growth (pp) Exports of goods and services, contribution to real CNY GDP growth (pp) Imports of goods and services, contribution to real CNY GDP growth (pp) Net exports of goods & services, contribution to real CNY GDP growth (pp)
Notes: f = BMI forecasts. Sources: National Bureau of Statistics, BMI.
2009
9.2 3.2 0.8 8.9 -5.6 -3.1 -2.9
2010
10.3 3.0 0.9 7.5 6.7 7.0 -0.0
2011f
9.2 3.1 1.2 5.2 2.4 2.8 -0.4
2012f
8.1 2.9 1.2 3.6 1.6 1.6 0.1
2013f
7.5 2.9 1.1 3.0 1.7 1.7 -0.1
2014f
6.9 2.9 1.3 2.6 1.6 1.7 -0.1
2015f
6.8 3.0 1.3 2.4 1.6 1.8 -0.1
11.7 3.6 1.5 5.3 1.5 1.3 -0.3
28
SPeCial rePorT
car sales have disappointed following the withdrawal of incentives earlier this year. To a lesser extent, subsidies on durable goods also helped to galvanise retail sales. From an economic standpoint, subsidies would have merely helped to bring forward big ticket purchasing, and as a result, we are unlikely to see a bounce anytime soon now that these costs will have to be absorbed by consumers. Of course, Beijing could introduce further measures to boost the sector, but as we have shown, this merely tackles the symptoms rather than the cause. Consumer Will Ultimately Pay For Banking Largesse: In recent years, the Chinese authorities have kept the cost of capital artificially low in order to fuel investment spending. The main evidence of this comes from the massive discrepancy between nominal GDP growth and nominal interest rates. That the former has outpaced the latter consistently over the past decade is a major reason why we have seen excessive investment and asset bubbles in recent years. From a consumer perspective, the reason why this is important is that artificially low interest rates have essentially penalised savers (ie, households) and rewarded borrowers (ie, local governments). This has, in turn, created huge distortions in the countrys banking system ( see Banking Sector Instability Playbook, July 13 ). Should Chinas commercial banks suffer a major deterioration in asset quality necessitating some sort of state-led bailout, it would be the consumer once more who would ultimately pick up the tab. This would happen via rate cuts, higher taxes and potentially even a currency devaluationall of which would hurt household spending. Long-Term Outlook Good, But In Need Of Reform The arguments outlined above strongly suggest to us that private consumption will see some degree of growth moderation under our core view and could well see a major correction in the event of a collapse in export and investment growth. With this in mind, we believe it is wishful thinking to expect the Chinese consumer to sustain the current rates of real GDP growth going forward. As the chart opposite shows, private consumption in China is roughly the size of the Italian economy, much smaller than that of investment (which rivals the German economy in size).
Over the longer term, we would need to see significant reform to unlock the true potential of the Chinese consumer. So far, policy has been relatively mild. Measures such as hiking minimum wages and increasing the size of the social welfare system (for example, boostPrivate Consumption Smaller Than investment
Nominal GDP of Selected Countries, US$trn
16 14 12 10 8 6 4 2 0
Chinese Investment
United Kingdom
Chinese Consumption
Germany
United States
France
Japan
Chinese Private Consumption, % Of GDP

55
Brazil
India
50 45 40 35 30
The rebalancing process will be gradual and protracted
1980
1990
2000
2010
Italy
f = BMI forecasts. Source: BMI
ing healthcare and pension spending, and ramping up social housing construction) may be desirable from a social perspective, but they do not tackle the underlying cause of weak consumption. In fact, we would argue that such policies are likely to reduce labour market flexibility and increase the already-heavy tax burden, reducing Chinas long-term growth potential. The required structural reformmost notably banking sector reform, financial account liberalisation, and state-owned enterprises privatisationwould allow businesses to focus on producing consumer goods for the domestic market. However, such an agenda is unlikely to come up for discussion anytime soon. Any rebalancing in
2020f
29
favour of the consumer is therefore likely to be a long, drawn-out process, and arguably more indicative of investment weakness rather than consumption strength. Under our base case, therefore, we do not expect to see private consumption reach the 50% of GDP levels last seen in the 1980s for some time to come.
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10-Year economic outlook

7.0% is The new 10.0%
BMI View: Chinas economic growth in the coming decade will be much slower than in the last, as the savings rate declines, the economic liberalisation process slows and population growth falls. These dynamics will result in real GDP growth averaging 7.3% over the next decade as opposed to the 10.7% average seen over the past 10 years. Private consumption will be a major outperformer, averaging growth of 9.1% and rising in importance as a share of GDP. The unprecedented growth boom in China over recent decades has its foundations in the vast improvement made to productivity through economic liberalisation. A major supportive tailwind in the form of demographic trends provided additional support, allowing savings to be accumulated at a rapid rate. Growth in the coming decade will be much slower than the last, as the low hanging fruit of liberalisation has already been undertaken and further reforms are likely to be slow and piecemeal as the Communist Party of China (CPC) would be reluctant to give up too much economic power for fear of losing its political dominance. A harshly deteriorating demographic situation (slowing growth and an ageing population) will further weigh on economic dynamism, resulting in real GDP growth of 7.3% over the next decade compared with the 10.7% average seen over the last 10 years. Consumption will rise as a share of GDP and, as a result, services share of GDP will rise, presenting significant opportunities in consumer-related fields. Lower Investment Rate, Slower Growth It is widely agreed that in order to experience sustainable high rates of growth in the coming years, China must lower its investment rate and boost consumption. Looking at historical precedents, it is clear that an investment share of GDP at 48.6% is too high. However, it is this high savings and investment rate that has allowed the economy to grow so fast over the past decade. A lower rate of savings and investment will therefore mean slower growth.
a more Subdued Growth outlook
China - Real GDP Growth, % chg
16 14 12 10 8 6 4 2 0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2012f 2013f 2014f 2015f 2016f 2017f 2018f 2019f 2011f 2020f
50 Real GDP Grow th LHS Private Consumption Grow th LHS Private Consumption, % of GDP 45 40 35 30 25 20 15 10 5 0
Source: BMI, NBS
Regarding the domestic imbalances that have built up as a result of the high investment ratio, the problem is not high investment itself but the lack of viability of such investment projects (in theory, there is nothing wrong with a high investment rate if all the investments make a profit). Excessive state involvement has resulted in excessive unproductive investment in an all-out attempt
CHINA LONG-TERM MACROECONOMIC FORECASTS

2013f
Nominal GDP, US$bn [1] Real GDP growth, % change y-o-y [1] Population, mn [2] GDP per capita, US$ [1] Consumer prices, % y-o-y, ave [1] Current account, % of GDP [1] Exchange rate CNY/US$, ave [3] 8,970.6 7.6 1,361.0 6,766 3.0 2.1 6.31
2014f
10,076.7 6.9 1,368.5 7,558 3.0 1.4 6.18
2015f
11,300.2 6.8 1,375.9 8,430 2.9 0.8 6.06
2016f
12,668.6 6.8 1,383.5 9,399 2.9 0.2 5.94
2017f
14,195.8 6.8 1,390.9 10,476 2.9 -0.3 5.82
2018f
15,908.3 6.8 1,398.1 11,679 2.8 -0.7 5.70
2019f
17,829 6.8 1,405.2 13,023 2.8 -1.1 5.59
2020f
19,959.1 6.8 1,412.1 14,508 2.8 -1.5 5.47
Notes: f = BMI forecasts. Sources: 1 National Bureau of Statistics, BMI; 2 World Bank/BMI calculation/BMI; 3 BMI.
31
to boost headline growth. This has come at the expense of private consumption, with the consequences likely to be a sharp slowdown in growth over the coming years as malinvestments are realised. Policy Reaction To Coming Slowdown Will Be Crucial Policies to boost consumption using subsidies, wage hikes and consumer loans, or persuading consumers to reduce their savings rate by providing a more comprehensive social security net, target the symptoms rather than the causes. Broad-based structural reforms will be needed to rebalance the economy and avoid a hard landing and, so far, these reforms have been lacking. We believe the government missed a key chance to accelerate economic reforms during the global financial crisis, with the stimulus policy of forcing banks to extend record loans to state-owned enterprises (SOEs) and local government investment vehicles representing a step backwards in terms of its long-term liberalisation drive. In doing so, these policies have ignited a property and investment bubble that is likely to burst, ushering in a sharp slowdown and undermining growth potential in the early part of this decade. It is how Beijing deals with the impending economic slowdown that will determine whether China can continue sustaining 8%-plus growth, our baseline case argues that positive economic reforms will be hard to come by. Efficiency Gains Will Be Hard To Come By Agricultural land reform and the deregulation of the hukou household registration system provide potential for gains in productivity by allowing more labour market flexibility and further freeing up labour for urban migration. There has been progress on this front, with the Chongqing government initiating a pilot scheme allowing migrant workers who have been working in the city the right to non-agricultural status, with the aim to turn 10mn farmers into urbanities by 2020. While progress has been slow, we expect this policy to continue to spread over the long term, supporting further urbanisation and growth. The idea of urbanisation as a driver of growth, however, is only valid insofar as entrepreneurs in cities can generate profits sufficient to warrant expanding their labour
force. Over the long term, this will depend on the governments willingness to allow further economic freedom. In this regard, we believe that progress over the next decade will be much slower than in the past. Financial Liberalisation Unlikely Perhaps the most important reform that the CPC could make to boost productivity would be to liberalise the banking system, allowing interest rates to reflect market forces and removing the political nature of lending, which results in excessive capital going to inefficient state-owned enterprises. The response to the 2008 crisis has made it clear that this will not be forthcoming any time soon. From a political viewpoint, the CPC would not want to give up its major lever of economic power and therefore risk losing its political strength. Closely related is the outlook for general capital market reformopening up the capital account and allowing a flexible exchange rate. We have seen some progress here, with greater currency flexibility allowed over the past year and gradual liberalisation of foreign financial investment (one of the many goals of the 12th Five-Year Plan is to make it easier for local private investors to buy into overseas markets, and in January, Wenzhou publicised a trial policy that would allow individual investors to make direct overseas speculation). We expect further gains to be made, improving capital allocation. This is by no means guaranteed, however, as the impending growth slowdown could raise the potential for a political backlash against this kind of reform among the partys elite. SOE Liberalisation Has Run Its Course As well as allowing price liberalisation and greater external trade, opening up SOEs to private competition was a major factor in boosting productivity. However, these particular reforms may have hit a brick wall. Although the CPC relinquished a great deal of power in removing itself from a large number of industries, it remains the monopoly force in several key industries. As with the banking sector, it will be difficult for the CPC to allow further private sector involvement in these sectors given the risk that this would pose to its grip on economic power.
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Minimum Wage Hikes And Social Security Will Hurt Growth Outlook In the name of boosting consumption (as well as placating the working classes), the CPC seems intent on hiking minimum wages and increasing the size of the social welfare system (for example, boosting healthcare and pension spending, and ramping up social housing construction). While these may be desirable from a social perspective, we do not believe they hold the key to raising consumption spending; rather, these policies are likely to reduce labour market flexibility and increase the already-heavy tax burden, reducing the ability of businesses to generate profits. In terms of the composition of demand in the economy, these policies will help to lower the savings ratio and, by extension, increase the share of consumption in GDPalthough they will do so at the cost of reduced growth potential.
demographic deterioration
China - Estimated Population Trends
1,600 1,400 1,200 1,000 800 600 400 200 0
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020
14 13 12 11 10 9 8 Total Population, mn Aged Dependency Ratio, % (RHS) 7 6
Source: BMI, UN
Demographic Dividend Reversing Over the past decade, the working population has risen at an average rate of 1.26% per year, providing a supportive tailwind for growth. Over the next decade, we expect this figure to fall to just 0.71% per year, acting as a direct drag compared with the previous decade, particularly towards the end of our forecast period when we see the working age population actually shrinking slightly.
33
Political outlook
Socio-economic risks on The rise
BMI View: The structure of Chinas growth model may be undermining social stability, and certain socioeconomic similarities with the backdrop of the Arab Spring have led to concerns over more widespread and organised protests against the government. While we believe the Communist Party of Chinas strong support from the middle classes will prevent a similar uprising, an economic slowdown will raise the likelihood of further protests. Meanwhile, the major risk to the economy comes from the ruling party seizing more economic power in response to perceived threats to its political interests. While the Communist Party of China (CPC) has maintained its legitimacy through fostering high rates of economic growth, the drivers of this growth are increasingly becoming the cause of growing instability. The strategy of pumping up headline real GDP growth while helping to create jobs and raising overall income may
TABLE: POLITICAL OVERVIEW
System of Government
Head of State Head of Government Last Election Composition Of Current Government Key Figures
also be contributing to the prevalence of corruption and widening of income inequality, in turn undermining social stability. Growth Drivers A Source Of Unrest Despite the opening up of the private sector, Chinas economic growth model still gives a great deal of power to local government officials, whose main aim is to generate strong headline real GDP growth in order to increase their chances of promotion. The immense control that these local administrators wield over their provincial economies increases the likelihood of corruption. The liquidity-fuelled growth boom, meanwhile, has exacerbated this long-standing problem. As an example, much of the protest activity in recent years has been the result of families being forcefully evicted from their land without fair compensation as local officials and property developers have sought to capitalise on soaring land prices. According to a senior government
Single-party socialist republic

President Hu Jintao (serving second of a maximum two five-year terms) Prime Minister Wen Jiabao (serving second of a maximum two five-year terms) Presidential and parliamentary March 2008 CPC congress October 2007 Communist Party of China The Politburo Standing Committee acts as the de facto highest decision-making body in China and comprises the top leadership of the ruling party. Its members, in order of protocol, are: Hu Jintao (concurrently general secretary of the Communist Party), Wu Bangguo, Wen Jiabao, Jia Qinglin, Li Changchun, Xi Jinping, Li Keqiang, He Guoqiang and Zhou Yongkang. Finance Minister Xie Xuren; Foreign Minister Yang Jiechi; Defence Minister General Liang Guanglie; Minister of Public Security Meng Jiangzhu; Central Bank Governor Zhou Xiaochuan Communist Party of China (CPC): The founding and ruling political party of the Peoples Republic of China, whose paramount position as the supreme political authority is guaranteed by Chinas constitution and realised through control of all state apparatus. The CPC was founded in 1921 and came to rule all of mainland China after defeating its rival, the Kuomintang (KMT), in the Chinese Civil War. Presidential and parliamentary March 2013 CPC congress Autumn 2012 Ongoing dispute over Taiwanese sovereignty and Tibetan autonomy; some minor territory disputes with Asian neighbours, including with Japan over the Senkaku Islands in the East China Sea and with Taiwan, Malaysia, the Philippines and Vietnam over the Spratly Islands in the South China Sea. Close Link With ASEAN, WTO member, permanent seat on the UN Security Council, founding member of the Shanghai Cooperation Organisation (SCO). 78.5 67.4
Other Key Posts Main Political Parties (number of seats in parliament)
Next Election Ongoing Disputes
Key Relations/ Treaties BMI Short-Term Political Risk Rating BMI Structural Political Risk Rating
Source: BMI
34
SPeCial rePorT
advisor, 2mn peasants a year have lost their land this way over the past five years. Inequality Of Privilege The Major Issue The structure of Chinas growth boom has also led to a rise in income inequality, which has risen markedly in the past three decades as the economy has opened upwhich itself has been a cause of unrest. However, we believe the main bone of contention is the rise in inequality of opportunity and privilege, rather than income itself (when comparing inequality across the region, Chinas position is not terribly bad, ranking in the middle in most measures and actually below the US, according to the CIAs Gini Coefficient Index). This is particularly manifested in the plight of migrant workers. Despite being the engine of Chinas economic growth boom, they are restricted from gaining access to benefits such as healthcare, education and pensions available to urban residents under the Hukou, which essentially maintains a strict class system. As a result, they are often seen as second-class citizens in major eastern cities where they work, and they have thus been the largest source of protests over recent years. Migrant Worker Protests Resemble MENA Troubles Chinas chengguan (municipal police, many drawn from the ranks of laid-off workers from state-owned enterprises) have developed a reputation for their harsh treatment of migrant workers. The State Council Development Research Center, a top think tank of the CPC that advises central government officials, published a recent report calling for better treatment of migrant workers by the municipal police, adding that disgruntled workers could become a serious threat to Chinas stability if the government does not address their concerns. This is particularly salient in light of the Arab Spring since the start of 2011. In early June, large-scale protests erupted among migrant workers when the police pushed a pregnant worker to the ground in Xintang, Guangdong province, to force her to move her food stand off a road. The incident bore a worrying resemblance to the trigger for the Tunisian uprising, in which a man who operated a vegetable
cart had his possessions confiscated, leading him to set himself on fire outside the provincial headquarters. Protests that followed the Tunisian incident eventually led to the ousting of long-time president Zine El Abidine Ben Ali in January. The CPC has become increasingly anxious in the aftermath of the Middle East and North Africa (MENA) protests, launching an all-out attack on civil society, stepping up the intensity of their crackdown of protesters, jailing potential dissidents and strengthening internet and media censorship. Rather than simply a knee-jerk reaction to recent protests, however, the government has been systematically boosting its domestic security apparatus in recent years. Domestic security spending overtook defence in this years budget, and the government has been reviving a Maoist system of neighbourhood surveillance by civilian volunteers since the 2008 Olympics. Middle-Class Support Remains A Strong Anchor Of Power... The strong control that Chinas central government holds over the economic levers of power, together with its tight grip on media and surveillance, are the core reasons why we do not envisage a MENA-style uprising in China any time soon. While such events are rarely predicted and can spiral out of control rapidly, particularly if economic conditions deteriorate, the strong and growing support for the CPC from the middle class should ensure that unrest remains sporadic and contained to migrant workers and rural dwellers. The current model of investment-led state corporatism has consolidated the CPCs economic power and maintained its relevance. A recent survey of university students found that political connections ranked at the top of factors needed for career success. By controlling lucrative strategic industries and the bulk of the countrys capital through state-owned banks, the CPC continues to be the major allocator and distributor of economic opportunity, ensuring its continued political support among the middle classes. Under the incoming leadership in 2012-2013, it is likely that economic power will be further consolidated, as new members of
35
the CPCs Central Committee will likely be made up of previous local government leaders with strong ties to state-owned firms. ...But Further Unrest To Be Expected As Economy Slows As mentioned above, the forces driving the current economic boom are also leading to growing unrest between the government and the populace. Not only has the inflation of money supply created a housing bubble, pitting local governments against residents for access to land, it has also driven up the price of food, putting a squeeze on the most vulnerable members of society (and those who are most prone to rebelling against the CPC). As the economy slows over the coming quarters, a rise in unemployment will hurt the most vulnerable. Workers who already have grievances with their local governments are likely to become emboldened by the relative decline in their living standards, potentially leading to more widespread violent protests and making it more difficult for the government to cover these up. The prospect for more organised protests would then heighten, making a widespread uprising a possibility, albeit a still highly remote one. To reflect the possibility of an intensification of public unrest, we have downgraded our short-term political risk rating from 79.2 to 78.5. Risk To Outlook: A Stronger Grip, Not A Looser One Perhaps the most salient economic risk, however, is not a weakened grip on power by the government but a stronger grip. In the face of rising unemployment and social unrest, maintaining the current high level of support among the middle classes could mean the government takes greater control of the means of production rather than allowing liberalisation, which would likely come at the expense of private enterprise and economic health. The countrys state-owned enterprises, which already dominate the allocation of capital in China and are highly unproductive relative to the private sector, could increase their dominance. Furthermore, should state finances continue to deteriorate, the government could be inclined to squeeze resources from the private sector by hiking taxes to pay for higher salaries for civil servants and domestic security. Meanwhile, operational
risks to the business environment could rise in the event of heightened violent protests, while a tightened grip on internal security could also create additional operational problems for businesses.
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Global implications: Case Studies

if China Sneezes, australia Catches Pneumonia
BMI View: Due to its own domestic frailties, we would argue that the lucky country faces a sharp slowdown of its own regardless of the outlook on China. A Chinese hard landing, however, would push the Australian economy over the edge, likely ushering in a recession and potentially triggering a financial crisis. The importance of Chinas economy for the growth of the region cannot be overstated. The global economic recovery beginning in mid-2009 can be traced back to Chinas massive stimulus, which generated huge demand for goods across the world. While no country is immune from a China slowdown, and the likes of Taiwan, South Korea, and Hong Kong are much more exposed than most, it is Australia that we believe has the most to lose from a Chinese hard landing. How Australia Escaped Recession... From our perspective, Australia did not avoid a financial crisis and recession of its own in 2008-2009 due to a superior starting position. The countrys property bubble and corresponding household debt situation was as overextended as any in the world, while its export sector faced a collapse in demand for raw materials. Instead, it was the policy response, both domestically and overseas, that allowed Australia to avoid a contraction in growth. Faced with a sharp collapse in domestic demand, driven partially by the sudden evaporation in homeowner equity, the Reserve Bank of Australia (RBA) slashed interest rates by a record 425 basis points (bps). This saw the interest expense to disposable income ratio fall by a massive 4.2 percentage points, boosting consumers purchasing power and helping to put a floor under property prices. The governments decision to triple the first homeowners grant was an equally stimulatory move, triggering a reversal of the property slump. Meanwhile, cash handouts as part of the nation-building and jobs plan further boosted consumer spending. Whereas stimulus packages in the US and UK focused on bailing out the banks, Australia focused on supporting the consumer, and the consumers continued demand, in turn, helped bail out the banks.
debt interest Burden Unsustainable
Australia - Debt Interest Payments, % of Disposible Income
16 14 12 10 8 6 4 2 0
1977 1978 1980 1981 1982 1983 1984 1985 1987 1988 1989 1990 1991 1992 1994 1995 1996 1997 1998 1999 2001 2002 2003 2004 2005 2006 2008 2009 2010
Source: BMI, RBA
The Chinese policy response was perhaps even more of a positive factor in Australias recovery. Beijings huge stimulus package focused on infrastructure spending, instantly boosting demand for iron ore and coking coal for steel production. Low shipping costs made Australia an ideal supplier, generating an important source of demand. Meanwhile, the US policy of quantitative easing (QE) propped up demand for risky assets including the Australian dollar, allowing demand to gain some poise and prevent a recession.
exponential Booms often lead To Busts
Australian Iron Ore Exports To China, AUDmn
4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 -500
1994 1995 1996 1996 1997 1998 1998 1999 2000 2000 2001 2002 2002 2003 2004 2004 2005 2006 2006 2007 2008 2008 2009 2010 2010 2011 2012
Source: BMI, Australian Bureau of Statistics
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...And Why Its Luck Is Running Out As things stand, Australias economic situation looks similar to 2008 but with fewer options available to policymakers at home and abroad. Firstly, Australias domestic demand is faltering under the weight of its mortgage debt burden (only this time, the property bubble is even bigger, with rental yields and house price-to-income ratios at historic lows), with recent consumer confidence and retail sales figures suggesting that private consumption could be heading for recession territory. Secondly, China is facing a sharp slowdown owing to the hangover from its stimulus measures, and further policy efforts are constrained by inflation and a weak banking sector. Thirdly, Australias reliance on hot money inflows is at an all-time high, and additional speculative demand due to US QE seems unlikely at this stage. With these factors in mind, we believe that Australia faces a sharp slowdown. Our forecast for 2012 real GDP growth of 1.6% versus consensus expectations of 4.3% clearly highlights our bearish view. A Chinese hard landing, however, would likely result in more serious economic dislocations as explained below. A Contraction In Commodity Demand Would Raise The Stakes As the worlds largest consumer of steel, China imports roughly half of its iron ore demand, and Australia is the main beneficiary. Back in late 2008, we saw Chinese demand for Australias iron ore collapse, pushing Australia into a wide trade deficit. Today, although imports have moderated since the crisis, helping Australia post
Trade Surplus on Shaky Ground
Australia - Trade Surplus, US$mn
35,000 Trade Surplus Australia Total Exports Total Imports 30,000 25,000 20,000
sustained hefty trade surpluses, a collapse in iron import demand back to the depths of late 2008 would virtually wipe out Australias entire trade surplus. Demand for coking coal (not only from China but from neighbours Japan and South Korea), Australias second largest export, would also undoubtedly take a hit, potentially leading to a sizeable trade deficit in the absence of a contraction of imports. There is little chance of a nearterm revival in the manufacturing sector picking up given the highly inflexible labour market and pervasive labour shortages. What worries us the most, however, is not the impact of a Chinese hard landing on the trade account, but rather, the impact on the financial account. While Australia has finally managed to capitalise on the mining boom to post a trade surplus in recent quarters, we find it quite alarming that even with record terms of trade, Australia is still relying on overseas capital to balance its external books. The country has posted a current account deficit for a staggering 144 consecutive quarters. It is the shaky foundation of portfolio investment that has been the dominant driver of demand for the Australian dollar over recent years as local banks have borrowed aggressively from overseas to fund the housing bubble.
Commodity Boom Fails To Yield a Surplus
Australia - Current Account, AUDmn
10,000 Current account Income Acoount Goods & Services Account 5,000 0 -5,000 -10,000 -15,000 -20,000 -25,000
Q102
Q302
Q103
Q303
Q104
Q304
Q105
Q305
Q106
Q306
Q107
Q307
Q108
Q308
Q109
Q309
Q110
15,000 10,000 5,000 0 -5,000 -10,000

1994 1995 1996 1996 1997 1998 1998 1999 2000 2000 2001 2002 2002 2003 2004 2004 2005 2006 2006 2007 2008 2008 2009 2010 2010 2011 2012
Source: BMI
The income account explains the outflows as years of portfolio inflows have flooded the Australian banking system, which has allowed banks to lend freely to the property market while keeping interest rates relatively
Source: BMI, Australian Bureau of Statistics
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low. The major risk facing the economy, then, is that foreign investors dump their Australian assets fearing that the export sector joins the domestic sector in the doldrums, putting further strain on the banking system. The export sector and investment in the mining industry have been two bright spots in recent quarters, keeping the economys growth above water. A reversal in these fortunes would likely trigger a sudden outflow of portfolio investment. Should this occur in tandem with a contraction in export revenues, domestic demand would be forced to collapse, almost certainly triggering a recession. Financial Crisis Down Under? With mortgage debt to GDP currently at 75% and the housing market possibly 50% overvalued, the bigger risk is the potential for a collapse in home prices as banks struggle to access overseas funding. Commercial banks have become excessively reliant upon foreign financing. Australias loan-to-deposit ratio stands at roughly 120%, far greater than the 85% regional average, and overseas borrowing accounts for about 40% of total liabilities. As the accompanying chart shows, all of the Big Four banks have tremendous exposure to the property market and are highly dependent on overseas financing. An outright banking crisis cannot be ruled out under a property market collapse, and we could see the government forced to step into the fray to provide some stability.
Australia - Banking Statistics For Big 4
140 Westpac 135
Loan-To-Deposit Ratio
munition. Australias net government debt stands at a negligible 6.0% of GDP, putting the government in a unique position to support demand. While the Treasury is expecting to see its fiscal deficit head back to balance in FY2012/13 (July-June), and the RBA is expected to hike interest rates next year rather than cut them, we believe these expectations are way out. We are calling for a fiscal deficit of 1.5% of GDP in FY2012/13, and at least 25bps in interest rate cuts by the RBA as Chinas economy slows. An outright Chinese recession could see the government forced to balloon its balance sheet, while the RBA could join its Western counterparts in taking funding costs down towards zero. As with other developed nations back in FY2008/09, these moves are unlikely to prevent a recession should support from China give way.
how To Play a Sharp Slowdown in China

Although our view of a material economic slowdown in China is becoming increasingly mainstream, we do not believe that regional asset markets are priced to deal with the impact of a sharp slowdown in China, let alone a full-blown recession. Below we outline some of our views on how the Chinese slowdown will impact regional financial markets.
a Sign of Things To Come For house Prices
China - Shanghai Property Index
Too leveraged, Too exposed
9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000
NAB
130 125 120 115 110 50 55 60 65 70 75 80 Housing Loans, % Of Total Loans ANZ CBA
0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Source: BMI
Source: APRA, BMI (Bubble Size Denotes Relative Size Of Housing Loans)
The one positive is that the government does have am-
Chinese Stocks: Underweight Financials, Property The Shanghai Composite Index, although cheap from a historical perspective having gone nowhere for a decade
39
in real terms, is by no means a bargain. At a book value of 2.03X and a forward P/E ratio of 11.28X, the index still trades at a significant premium to the MSCI Asia ex-Japan. Even the Shanghai Property Index, which has fallen 62% from its 2007 peak, is still trading at a 1.80X book value and a double-digit forward P/E. From our perspective, both price and earnings are likely to decline further in the event of a hard landing. A similar story holds true for the financial sector. The Hang Seng H-Financial Index trades at 1.52X book value despite the problems facing the banks in terms of non-performing loans and the risks facing investors from the potential for equity dilution should the large banks require further government assistance, which we see as likely. We see the property and real estate sectors
China - Shanghai Composite Index, Hang Seng Financials
7,000 6,000 5,000 4,000 3,000 2,000 1,000 0
Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 Sep-11 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12
continuing to underperform. Bearish Australian Dollar We have been bearish on the inflation trade in Australia for over a year, holding a bullish view on government debt and a negative view on equities, especially financials. While this view has played out well the ASX200 is back down to mid-2009 levels, the financial index is now officially in a bear market, and the 10-year bond yield has fallen to just 4.15% we believe there is more to come over the medium term.
Still Bonds over Stocks long Term
Australia - ASX200 Equity Index,10-Year Bond Index

200 7,500 6,500 ASX200 Equity Index LHS 10-Year Bond Index RHS 190 180 170 5,500 4,500 3,500 2,500 160 150 140
Financials have Further To Fall
25,000
20,000
130 120 110 100

Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11
2011
15,000 1,500 10,000

Jan-12
Source: BMI
5,000 Hang Seng Financials RHS Shanghai Composite Index LHS 0
Ratio - 10year Bond Index/ASX200

0.07 0.07 0.06 0.06
debt Beats equity
Source: BMI
Ratio Hang Seng Financials/Shanghai Composite
dont look down
0.05
8 7 6
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
0.05 0.04 0.04 0.03 0.03 0.02

2010 2012
5 4 3 2
2004 2005 2006 2007 2008 2009 2010 2011 2012
Source: BMI
Source: BMI
One market that has continued to confound us is the Australian dollar, which has remained strong despite diminished interest rate expectations and bouts of global risk aversion. Given our view that house price declines
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will gather pace in 2012, forcing the Reserve Bank of Australia (RBA) to cut interest rates, we see no reason to be long the AUD even without a major negative shock from China. A China hard landing, however, could send the Aussie back down to US$0.7500-0.8000/AUD, which we believe would represent fair value.
German Dax Versus Australian ASX200
DAX ASX200 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0
Source: BMI
Germany Better Placed
much more directly than European companies from a fall in Chinese demand, given the larger share of exports heading to China. Thirdly, lower commodity prices that would likely result from a Chinese hard landing would improve Europes terms of trade and undermine Australias, helping to support real incomes in the former, providing a tailwind to equities. With the equity risk premium on the DAX currently in excess of 10% (11.8% forward earnings yield1.9% 10-year Bund yield), versus just 4.7% for the ASX200, and the EUR/AUD exchange rate looking due for a reversal, we favour Germany over Australia from a total return perspective. Bearish Macau Casinos We initially highlighted the unsustainable nature of Macaus gaming industry boom back in July, suggesting that its main growth driverrampant liquidity growth in mainland Chinawas about to lose steam (see our online service Gambling Boom: A House Of Cards?, June 22). We also argued that casino operators with heavy exposure to this boom were extremely overvalued and faced a potential collapse. Since then, a number of gaming counters have experienced significant weakness, and further losses look highly likely as gaming revenues begin to roll over following a record surge and investor sentiment turns sour. MGM Resorts International, which we maintain could face solvency issues in the near future, is already down 20% since we initiated our bearish view, and a further fall back to the all-time low of US$1.8 from the current level of US$9.5 (80% further downside) is not out of the question. The recently launched MGM China is also suffering and looks set to test its all-time low. Wynn Macau has held up relatively well in recent weeks, but the technical chart pattern is pointing to potentially severe losses, having posted bearish divergence on the weekly relative strength index (RSI) following what appears to be a significant topping pattern. A clean break through HKD21.0 would open up a rapid move down to HKD18.0. One stock that has held up surprisingly well despite the global sell-off is Galaxy Entertainment. Trading in excess of 8x book value and with an incredibly high price-to-earnings (P/E) ratio of 82X, we believe the potential downside for Galaxy is huge. After rallying 40-fold over the past two years,
aussie outperformance wont last

RatioDax/ASX200
DAX/ASX200 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
2006
2007
2008
2009
2010
2011
Source: BMI
Bullish Dax Over ASX200 While European stocks would certainly not be immune from a Chinese sharp slowdown, and German exporters would face a significant threat to earnings, we believe that (on the whole) European stocks would hold up relatively well, particularly relative to Australian stocks. Firstly, European equities have already been beaten down severely due to domestic woes, making the index historically cheap at a forward P/E of just 8.61X. Secondly, Australian companies would suffer
2012
41
the stock has posted two key reversal weeks in quick succession, and with triple negative divergence on the weekly RSI, a major decline could be around the corner.
Galaxy Entertainment Group Equity Price
25
a major Top
to price in weakness in the spot rate over the coming months. As the accompanying chart shows, a break through support at CNY6.3650/US$ would suggest that a potential double bottom could be in the offing.
ChinaCNY 12-Month NDF

20 8.5
wedged in
15
8.0
10
7.5
7.0
0
Source: BMI
6.5
negative divergence
Weekly RSI
100 90 80 70 60 50 40 30 20 10
Oct-10
Oct-08 Oct-09
6.0
Source: BMI
Suggesting weakness
Daily RSI
100 90 80 70 60 50 40 30 20 10
Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 May-04 May-05 May-06 May-07 May-08 May-09 May-10 May-11 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 Sep-11 Jan-12
Feb-10
Feb-11
Dec-10
Oct-11
Jun-10
Jun-11
Dec-08
Dec-09
Aug-10
Aug-08
Aug-09
Aug-11
Dec-11
Jun-08
Feb-09
Jun-09
Apr-10
Apr-09
Apr-11
Source: BMI
CNY Not Immune As we have argued a number of times, we do not believe the Chinese yuan is undervalued. Rapidly rising labour and land costs are hurting international competitiveness, while the current account surplus and reserve stocks paint a misleading picture of undervaluation. The non-deliverable forward market appears to be coming around to this view. Following the CNYs steady appreciation over recent months, the six-month non-deliverable forward (NDF) is now pricing in just negligible appreciation by end-2011 despite consensus calling for significant gains. We continue to see domestic concerns weighing on this unit and would not be surprised to see the NDF begin
Source: BMI
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ratings methodology
outline of ratings
Introduction The table below provides a general guide to BMIs Country Risk ratings scores. For countries on the boundaries of two ranges, it would be advisable to consider the text for both. Brief Outline BMI Risk Ratings are a systematic gauge of the working conditions facing companies doing business in 130 countries around the world. Our ratings assess and rank the dangers to investment arising from characteristics or changes to the political, economic or business environment. In part this means an assessment of stability. Stability of politics, security, the economy and the law is critical in the decision-making process of any business planning for a remunerative future. But stability alone is not enough. Our ratings measure whether the national institutions, structures and policies, as stable as they may be, encourage competitiveness. They may be stable, but when it comes to competitiveness, they may stifle. The BMI Ratings are presented as a barometer of risk: of political risk, of the risk of a deterioration of the health of the economy, of vulnerability to financial crisis, and of the risk of a drop in the quality of the business environment. There are four ratings: a composite rating, a political rating, an economic rating, and a business environment rating. The political and economic ratings have short- and long-term components. The long-term ratings are designed to reflect structural considerations and will not change much in the short term. The shortterm ratings will change more frequently. Composite The composite rating is an unweighted geometric mean of the short-term political and short-term economic ratings, allowing a ranking of all countries in our emergingmarkets and developed-country universe.
TABLE: BMI RISK RATINGS

Score
80-100
Short term political risk Long term political risk Short term economic risk Long term economic risk
Government has no problem proposing, passing and implementing legislation. There are some minor risks to policy implementation, though the government remains firmly in control. Policy implementation challenged by strong opposition from within the government, the legislature or outside the political system. There are serious threats to governance and policy continuity and implementation cannot be guaranteed. Structurally unstable government, with crises likely to threaten its survival. Model democratic state, with very few domestic or external tensions and history of strong governance. Strong governing system set amid stable society. Strong, balanced, growth anticipated. Extremely stable economy over many years.
Business environment
World class political, legal and financial structure with excellent infrastructure. Minor weakness in at least one area infrastructure, legal, financial raises costs of investment. Country welcomes foreign trade/investment, but there are well-grounded concerns in at least one area.
70-79
Strong growth anticipated, though some indicators suggest underlying weakness.
Broadly stable economy, though some imbalances e.g. volatile growth, high unemployment cause concern. Fairly good performance. However, pronounced volatility in economic cycle due to worrying imbalances.
60-69
Solid though imperfect governing system, with some social tensions. Country has good record of consistent, pro-business policy. Weak political system with significant challenges due to poor institutions, corruption or social problems. Governmental system is inherently unstable possibly due to corruption or social problems. Substantial upheaval is likely over the medium term.
Growth well set, although significant imbalances suggest that current growth rate is not sustainable over the medium term. Reasonable economic performance cannot hide deeprooted problems. Economy is vulnerable to sudden reversal. Weaknesses outweigh strengths. Economy is extremely vulnerable to new shocks, either domestic or external.
50-59
Persistent economic imbalances due to economic structure or poor policy will retard long term prospects. Economic profile indicates ongoing vulnerability economic crises, with little prospect of solid, sustainable growth.
Serious impediments to business exist across the economy that suggest significant financial and organisational risk. Some sectors may offer good prospects, but general trading and investment environment is poor.
<49
Source: BMI
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Long Term Political Ratings Both our Long and Short Term political ratings are a guide to the political stability, which we consider to be a pre-requisite for a stable economy and business environment. The Long Term Political Rating (LTPR)
TABLE: LONG TERM POLITICAL RATINGS
Characteristics of Polity System of government Constitutional framework
considers how closely the characteristics of the political and governance system of each state adheres to an ideal type of developed western nation state. The LTPR breaks down into the following components:
Established democracies to be inherently more stable over the long term than other types of state, as unsuccessful governments can be overthrown within the existing political system. Systems based on written constitutions, which formally enshrine separation of powers and safeguard against elite/majority dominance offer better protection for civil liberties. Again, this reduces the appeal of revolutionary change. The states ability to protect its citizenry and to do so without discrimination is the cornerstone of a successful polity. Equality of income increases state legitimacy. Low poverty rates are a sign of a successful state/functioning polity. High poverty indicates that the state is unable to fulfil its functions. A high proportion of ethnic/religious minorities can be a problem, especially if there is a history of tension/ violence, as it suggests that significant numbers of citizens are not committed to the current political/ constitutional order. This is a proxy for state capacity. A low percentage indicates a weak state and vice versa. This evaluates external threats to governments sovereign power. Policy continuity is a benefit in itself for investors. More importantly, it suggests lack of polarisation within the political system.
Rule of law Characteristics of Society Income distribution Poverty Minorities
Scope of State Policy-continuity

Source: BMI
Government spending External constraints Policy-continuity
Short Term Political Ratings The Short Term Political Rating (STPR) measures prospects for short term stability as defined as the governments ability to propose, pass, implement and enforce its chosen legislation over the next two cal-
endar years. As a measure of political stability, the short-term political rating principally considers the direction of trends that are the practical manifestation of characteristics assessed in the Long Term Political Rating. The STPR breaks down into the following components:
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Long Term Economic Rating The economic ratings assess the degree to which the country approximates the ideal of non-inflationary growth with contained fiscal and external deficits and manageable debt ratios. The ratings use historical data and forecasts from BMIs country databases: as data is revised and forecasts change, so the ratings change. The Long Term Economic Rating takes into account GDP growth, unemployment, inflation, real interest rates, exchange rates, the fiscal balance, the current account balance and external debt. A number of other structural factors are also thrown into the equation inTABLE: LONG TERM ECONOMIC RATINGS
Structure of economy Primary sector, % of GDP
cluding dependence on the primary sector, reliance on commodity imports, reliance on a single export sector, and central bank independence. The long-term rating also considers a number of structural factors. The LTER breaks down into the following component: The economic indicators are averages over the period, current year minus one year, plus two calendar years of forecasts). Thus in 2007, the rated period is 2006-2008. The averages are located on a spectrum of threshold values and points are awarded on this basis.
A big primary sector leaves the economy vulnerable to commodity price volatility.
GDP per capita

GDP volatility Trade concentration Reliance on commodity imports % of exports from single sector Central bank independence Economic activity GDP growth, % Unemployment, % Monetary Indicators Inflation, %, ave Real interest rates, %, ave Fiscal Indicators Fiscal balance, % of GDP Quality of government spending External Indicators Import cover (mths goods and services) Foreign debt, % of GDP Current account, % of GDP Financial Indicators Exchange rate stability Moodys banking sector ratings Bond spread
Source: BMI
This indicator is a proxy for the states absolute economic development.

A history of volatile growth is self-evidently bad. Diversified export markets limit risks arising from a shock to key trading partners. Reliance on high level of commodity imports leaves a state vulnerable to commodity prices. Over-reliance on single sector indicates greater vulnerability to an economic shock. Government control of monetary policy increases risks that it will follow the political, not economic, cycle. Strong growth is good, poor growth bad. That said, above-trend growth is a concern, although our tolerance for it is greater for poor states than for rich ones. Sustained, high, unemployment is bad. High inflation will hit competitiveness and, most likely, exacerbate currency volatility. We also penalise very low inflation and deflation, as this tends to indicate a decline in money supply, which typically results in low growth. High real interest rates constrain investment. Very low or negative interest rates suggest inappropriate monetary policy. A surplus is good; a small deficit is okay. We have greater tolerance for moderate deficits (-1.5 to -5.0% of GDP) for developing states, as they require greater capital investment. This is a proxy for government budgetary prioritisation. The larger the better, though we are more tolerant of lower levels for states with a floating currency regime, as currencys ability to move acts as an automatic stabiliser. High levels of foreign debt leave economy vulnerable to currency fluctuations. Also, if govt. debt, it lowers spending and can crowd out private sector investment. A high current account deficit leaves the currency and thus, inflation and growth - vulnerable to capital flow volatility. Exchange rate volatility is a sign of poor balance of payments dynamics. It also impedes business planning. A weak banking sector will retard investment and increases state vulnerability to economic shocks.
Short-Term Economic Rating The economic ratings assess the degree to which the country approximates the ideal of non-inflationary growth with falling unemployment, contained fiscal and external deficits and manageable debt ratios. The ratings use as raw material quantitative historical data and forecasts fed in from BMIs country macro databases:
as historical data is revised and forecasts change, so the ratings change. The STPR breaks down into the following components: Business Environment Rating Our business environment ratings evaluate the ease of conducting business within a country. They bring together 50 different indicators in a structured matrix
45
to assess the infrastructure, institutions and market orientation of over 130 states. As the aim is to analyse the structure of each state, the ratings do not include indicators of economic conditions and do not try to examine the potential of the domestic market. And, while they give some indication of the quality of government, they do not attempt to capture the political environment. For an encompassing picture of Country Risk, therefore, our business environment ratings need to be
TABLE: SHORT-TERM ECONOMIC RATINGS
Component Economic Activity Sub-Component GDP growth, % Unemployment, % Business confidence Consumer confidence Monetary Indicators Inflation, % Real interest rates, % Fiscal Indicators External Indicators Fiscal balance, % of GDP Import cover (mths goods and services) Foreign debt, % of GDP Current account, % of GDP Financial Indicators Exchange rate stability Moodys banking sector ratings
Source: BMI
viewed alongside our economic and political ratings. The ratings are split into three major sections: infrastructure, institutions and market orientation. Each country rating is between 0 and 100 and the final score is an unweighted mean of all three sub-ratings. In the sections below, main headings are in bold, while subheadings are in normal type.
Rationale Strong growth is, generally good, but scores are weighted by economic development (proxied by GDP per capita), as developing states can have higher trend growth rates. High unemployment is bad. Fast growth is better than slow growth, especially for developing states, but overly rapid expansion may generate investment bubbles. Fast growth is better than slow growth, especially for developing states, but over rapid expansion will may lead to overheating. A small amount of inflation is good, but high inflation and deflation can cause problems. High real rates constrain investment, while very low or negative rates suggest misaligned monetary policy. However, our scoring system considers the position of the economic cycle. Excessive deficit spending can be a source of vulnerability and is penalised. However, our scoring system is more lenient if the economy is growing below trend. The larger the better, though we are more tolerant of lower levels for states with a floating currency regime, as currencys ability to move acts as an automatic stabiliser. High debt is bad, although our scoring system also considers 3-year ave. of debt, as % of exports (another distress indicator). A high deficit is bad, but our scoring system is more lenient if growth is above trend. Exchange rate volatility is a sign of poor balance of payments dynamics. It also impedes business planning. A weak banking sector, with low liquidity will retard investment and increases state vulnerability to economic shocks.
TABLE: BUSINESS ENVIRONMENT RATINGS

Infrastructure Physical Labour Financial Institutions Bureaucracy Legal Framework Corruption Market Orientation Openness Government Intervention Tax environment
Source: BMI
A dilapidated or under-developed physical infrastructure will raise business costs and hold back efficiency improvements. Firms seek out the most efficient labour those workers that produce the best output for the lowest cost. A well-developed financial system should better allow firms with profitable business opportunities to obtain the capital needed to invest. A heavy burden of rules and regulations can impose artificial restrictions on entry into and exit from a sector, and, via unnecessary administrative procedures, raise operating costs. An inefficient legal framework will both raise operating costs, as business owners spend money to protect their property, and deter individuals from investing at all, for fear of expropriation. Corruption increases transaction costs, diverting resources away from their most productive use and increases the risk of expropriating resources and profits. Freer markets will have lower costs of imports, greater access to ideas and funds from abroad, and, most likely, increased FDI. High levels of government involvement in the economy stifle private sector activity. Higher taxation levels make a business environment less attractive by lowering profitability for owners.
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SPeCial rePorT
STPR
Norway Switzerland Singapore Denmark Canada Sweden Luxembourg Brunei Darussalam Finland Australia Hong Kong United States Qatar Germany Ireland Netherlands Taiwan Turkmenistan New Zealand France Japan Laos Saudi Arabia Oman Macau Malaysia China South Korea Austria Kazakhstan Sri Lanka Vietnam United Kingdom Russia Indonesia Mongolia Brazil Spain Philippines Peru South Africa Bangladesh Mexico Thailand India Uzbekistan Cambodia Israel Bhutan Turkey Myanmar Fiji Argentina Papua New Guinea Tajikistan East Timor Pakistan Zimbabwe Kyrgyzstan Congo, Dem. Rep. 99.2 96.9 95.4 94.4 94.0 92.7 92.3 90.6 88.8 86.5 86.0 85.8 85.8 84.4 84.0 83.5 83.3 82.7 82.3 82.3 81.9 80.4 80.2 79.6 79.6 79.0 78.5 77.7 77.5 77.1 77.1 76.9 76.2 74.2 73.5 71.5 70.2 70.0 67.9 67.5 67.3 67.1 65.6 65.4 64.0 64.0 62.7 62.3 61.0 59.8 54.8 53.5 52.7 51.9 51.2 50.8 44.0 34.8 34.0 27.5
STPR RANK
1 2 3 4 5 7 8 9 10 11 13 14 14 16 17 18 19 21 23 23 27 28 30 31 31 33 35 37 38 39 39 41 43 50 52 65 72 73 82 84 86 88 94 96 102 102 108 109 114 119 131 138 142 144 146 147 156 167 169 175
LTPR
98.0 98.5 80.6 93.5 94.2 94.5 77.8 65.6 91.8 83.0 72.9 87.6 64.0 87.8 90.0 85.5 75.4 52.6 76.7 86.2 89.1 44.5 56.0 75.9 60.7 67.2 67.4 82.2 91.0 60.3 60.2 53.8 82.5 57.0 59.0 69.7 66.5 80.2 62.8 61.5 68.8 62.6 67.1 56.8 67.1 57.1 57.9 78.3 51.0 65.6 33.3 38.6 61.9 58.7 42.2 49.8 52.7 30.6 37.2 22.0
LTPR RANK
2 1 28 5 4 3 37 71 6 21 45 11 79 10 8 16 42 133 39 14 9 156 119 40 95 63 62 25 7 97 101 127 23 115 106 53 68 32 83 90 55 86 65 116 65 114 111 35 135 71 168 164 89 107 162 141 132 171 166 174 China Taiwan South Korea Hong Kong Peru Sweden Singapore Qatar Oman Saudi Arabia Luxembourg Switzerland Israel Uzbekistan Brunei Darussalam Macau Canada Kazakhstan Malaysia Austria Finland Thailand Turkmenistan Norway Myanmar Mexico Australia Netherlands Indonesia Germany Brazil Denmark Russia India Japan New Zealand Philippines Bangladesh Argentina East Timor United States Tajikistan Ireland Kyrgyzstan United Kingdom France Vietnam Sri Lanka South Africa Pakistan Laos Spain Turkey Mongolia Fiji Papua New Guinea Bhutan Zimbabwe Congo, Dem. Rep. Cambodia
STER
92.1 84.8 82.9 81.5 81.0 79.6 79.4 78.3 78.3 77.9 76.2 75.8 74.8 74.6 74.2 74.2 73.8 73.5 73.3 72.5 72.3 71.5 70.8 70.4 69.8 69.6 68.3 66.0 64.6 64.4 64.4 64.2 63.5 62.7 61.9 61.0 60.8 60.8 60.4 60.4 59.8 59.8 59.4 58.3 58.1 57.3 53.5 53.1 52.9 52.7 52.3 49.0 48.3 46.7 44.0 43.8 40.8 37.7 31.5 31.0
STER RANK
1 2 3 4 5 6 7 8 8 10 14 15 16 17 18 18 20 22 24 25 26 27 28 30 31 32 34 37 40 42 42 44 45 47 49 51 52 52 56 56 58 58 62 64 65 69 84 86 88 91 96 104 108 116 123 125 134 146 160 161
LTER
78.3 73.5 72.1 77.6 71.9 78.0 76.9 65.1 69.8 72.2 75.8 78.6 74.5 54.9 65.2 71.2 71.8 54.3 73.3 69.9 68.9 66.6 49.3 72.5 59.3 59.5 76.7 71.0 54.7 66.6 65.4 75.7 66.0 61.9 64.8 67.2 55.9 67.9 70.1 53.1 64.1 41.2 62.3 39.5 62.9 66.4 54.5 50.7 53.9 43.1 45.1 58.3 54.1 38.5 52.8 50.4 45.6 15.1 22.0 37.2
LTER RANK
2 10 14 4 15 3 5 39 21 13 7 1 9 69 38 17 16 75 11 20 23 29 100 12 54 53 6 18 72 29 36 8 33 48 40 27 63 26 19 84 42 135 47 141 45 31 73 91 79 125 117 56 76 145 86 93 115 169 167 150
Notes: STPR = Short-Term Political Risk, LTPR = Long-Term Political Risk. BMI rates 174 states worldwide. Source: BMI
Notes: STER = Short-Term Political Risk, LTER = Long-Term Political Risk. BMI rates 168 states worldwide. Source: BMI
47
BER (160)
New Zealand Denmark Singapore Ireland Norway Finland Hong Kong Sweden United States Switzerland Canada United Kingdom Australia Netherlands Austria Japan Germany France Luxembourg Israel Spain Malaysia Taiwan Thailand South Korea Saudi Arabia Qatar South Africa Turkey Oman Kazakhstan China Mexico Peru Russia Philippines Argentina Brazil Mongolia Vietnam India Fiji Sri Lanka Brunei Darussalam Indonesia Kyrgyzstan Papua New Guinea Pakistan Cambodia Tajikistan Uzbekistan Bhutan Bangladesh Laos Zimbabwe Turkmenistan Congo, Dem. Rep. Sudan Cote d`Ivoire Congo, Dem. Rep. 81.8 81.7 80.8 80.4 80.2 79.7 78.7 78.4 78.4 76.6 76.5 76.5 74.4 74.3 74.1 71.4 71.3 70.7 68.2 67.5 67.2 63.4 62.7 62.2 60.6 57.0 56.4 54.7 53.4 52.2 52.1 51.8 51.4 51.0 50.2 49.9 48.4 48.1 47.0 45.2 44.1 42.9 42.7 41.0 40.2 39.5 39.4 36.7 35.5 34.0 33.9 32.0 30.9 26.4 26.1 23.7 17.8 25.4 24.2 17.8
BER RANK
1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 8.0 10.0 11.0 11.0 14.0 15.0 16.0 17.0 18.0 19.0 20.0 22.0 24.0 29.0 31.0 33.0 35.0 43.0 45.0 48.0 53.0 56.0 57.0 58.0 59.0 60.0 61.0 63.0 71.0 72.0 75.0 78.0 80.0 88.0 89.0 95.0 98.0 100.0 101.0 112.0 116.0 119.0 120.0 127.0 131.0 144.0 146.0 153.0 160.0 146.0 153.0 160.0
COMP
75.1 81.8 82.3 76.1 83.4 80.2 79.2 83.6 75.7 83.8 81.1 72.1 77.2 75.8 76.5 73.4 74.3 72.3 76.4 70.8 65.3 69.9 73.7 64.1 72.7 66.7 67.7 58.7 55.8 68.0 61.6 70.0 60.8 64.0 60.2 57.9 57.1 60.5 53.4 54.8 57.3 45.8 54.4 62.9 55.4 41.4 47.2 44.3 43.3 43.7 53.0 43.7 53.4 45.9 28.4 50.5 23.1 29.8 32.5 22.9
COMP RANK
15.0 5.0 4.0 12.0 3.0 7.0 8.0 2.0 14.0 1.0 6.0 21.0 9.0 13.0 10.0 18.0 16.0 20.0 11.0 24.0 39.0 27.0 17.0 42.0 19.0 37.0 31.0 61.0 68.0 29.0 50.0 26.0 54.0 43.0 56.0 63.0 66.0 55.0 74.0 70.0 65.0 112.0 71.0 48.0 69.0 139.0 103.0 118.0 129.0 122.0 78.0 122.0 74.0 110.0 158.0 91.0 159.0 155 153 158
Notes: BER = Business Environment Rating. BMI rates 160 states worldwide. Comp = Overall Composite Rating. BMI rates 158 states worldwide. Source: BMI
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SPeCial rePorT
Global assumptions
Global outlook
Europe On The Edge Our global growth forecast for 2011 has been revised down to 3.1% from 3.2%; and for 2012, the projection has fallen all the way to 3.3% from 3.6%. Our core scenario sees no recession on a global basis in 2011 or 2012, though we see considerable risks of recession in the US, and - especially - the eurozone. On the whole, emerging markets will continue to outperform their developed counterparts, with 5.6% real GDP growth versus 1.6% for 2012. We have revised down our eurozone real GDP growth forecasts to 1.7% in 2011 (from 1.9%) and 1.2% in 2012 (from 1.7%), with downgrades to growth forecasts in each of the blocs major economies, including France,
TABLE: GLOBAL ASSUMPTIONS
2009
Real GDP Growth (%) US Eurozone Japan China World Consumer inflation (% ave) US Eurozone Japan China World Interest rates (% eop) Fed Funds Rate ECB Refinancing Rate Japan Overnight Call Rate Exchange rates (ave) US$/EUR JPY/US$ CNY/US$ Oil prices (US$/bbl, ave) OPEC basket Brent crude
Source: BMI
Germany, Italy and Spain. Though we retain our conviction that the eurozone will remain intact beyond the current crisis, with European policymakers developing a more closely integrated political and fiscal union, it will probably take a major crisis to spur politicians into action. Risks to our eurozone growth forecasts are predominantly to the downside. Meanwhile, our US growth forecasts have been revised down to 1.6% from 2.4% in 2012 amid political stalemate over renewed fiscal stimulus. We do not believe that the US is in, or headed into, recession, but a meltdown in the eurozone would almost certainly trigger a US downturn. For both the eurozone and the US, we have pushed back our expectations for monetary tightening, with the next rate hikes occurring in 2014.
2010
3.0 1.7 4.0 10.3 4.3 1.6 1.6 0.0 3.3 2.9 0.00 1.00 0.10 1.3 87.2 6.8 77.4 80.3
2011f
1.6 1.7 -0.7 9.2 3.1 3.0 2.2 0.2 5.6 4.0 0.00 1.50 0.10 1.4 78.5 6.5 102.0 106.0
2012f
1.6 1.2 1.8 8.1 3.3 2.1 1.9 0.4 3.2 3.6 0.00 1.50 0.10 1.4 72.5 6.4 99.0 102.0
2013f
2.5 1.9 1.2 7.5 3.7 2.0 1.9 0.8 3.0 3.5 0.00 1.50 0.10 1.3 75.0 6.3 97.0 100.0
2014f
2.6 2.1 1.2 6.9 3.8 2.0 1.9 1.3 3.0 3.5 2.50 2.50 0.10 1.3 78.8 6.2 93.0 96.0
2015f
2.5 2.1 1.2 6.8 3.7 2.2 1.8 1.8 2.9 3.4 4.00 3.50 0.10 1.3 81.3 6.1 93.0 96.0
-3.5 -4.1 -6.3 9.2 -1.9 -0.4 0.3 -0.2 -0.7 2.0 0.00 1.00 0.10 1.4 92.9 6.8 60.1 67.0
49
Developed States Our forecasts for developed states real GDP growth in 2011 and 2012 have fallen to 1.4% (down from 1.5%) and 1.6% (from 2.1%) respectively. We have downgraded our developed Europe forecasts across the board. The ongoing eurozone debt crisis is having a clear negative effect on consumer and business confidence, and the vulnerability of the banking sector is choking off credit growth. In the eurozone periphery, fiscal austerity and household retrenchment will mean continued outright recessions for the likes of Portugal and Greece. Our forecasts for the five largest eurozone economies have all been revised to the downside. Our forecast for real GDP growth in France has fallen 1.4% for 2012 from 1.7%; for Germany, the blocs biggest economy, our forecasts for 2011 and 2012 have dropped to 3.1% and 1.3% respectively (from 3.5% and 2.0%
previously). For the big Mediterranean economies, the story is the same. Our Italy forecasts have been downgraded to 0.8% for 2011 and 0.7% in 2012 (from 1.1% and 1.5% respectively), and our Spain projection for 2012 has fallen to 1.0% from 1.3%. Elsewhere, we have downgraded the Netherlands 2011 growth forecast to 1.9% from 2.2%, and Belgiums 2012 growth forecast to 1.7% from 2.1%. Outside of the eurozone, our Sweden forecasts have been downgraded to 4.5% for 2011 (from 4.8%) and to 2.0% for 2012 (from 3.5%). The US growth forecast for 2011 remains unchanged at 1.6%, but we have downgraded the 2012 outlook to 1.6% from 2.4%. Incoming data have been poor, but not recessionary. We see consumer activity (which represents 70% of the economy) continuing to grow at a
TABLE: GLOBAL & REGIONAL REAL GDP GROWTH, % CHG Y-O-Y

2010
World Developed states Emerging markets Asia ex-Japan Latin America Emerging Europe Sub-Saharan Africa Middle East & North Africa Developed Market Exchange Rates (ave) Eurozone Japan Switzerland UK Emerging Market Exchange Rates (ave) China South Korea India Brazil Mexico Russia Turkey South Africa
Source: BMI
2011f
3.1 1.4 5.7 7.5 4.1 4.6 4.7 4.6
2012f
3.3 1.6 5.6 6.9 4.2 4.3 6.4 4.4
2013f
3.7 2.1 5.6 6.7 4.1 4.7 5.8 4.6
4.3 2.7 7.0 9.1 6.1 4.5 5.1 3.9
US$/EUR JPY/US$ CHF/US$ US$/GBP
1.33 87.18 1.04 1.55
1.43 78.50 0.85 1.63
1.38 77.25 0.93 1.66
1.30 85.00 1.03 1.70
CNY/US$ KRW/US$ INR/US$ BRL/US$ MXN/US$ RUB/US$ TRY/US$e ZAR/US$
6.77 1,156.61 45.72 1.76 12.63 30.37 1.50 7.32
6.48 1,100.00 44.70 1.56 11.93 28.66 1.63 6.93
6.40 1,070.00 44.00 1.48 11.25 28.70 1.56 6.60
6.33 1,025.00 43.50 1.47 10.75 28.10 1.42 6.47
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SPeCial rePorT
weak pace, though business investment should continue to outperform. The biggest downside risks are probably for the 2013 outlook, as there is the potential for major fiscal drag from the expiry of tax cuts and the reduction in government spending. Emerging Markets Our aggregate forecast for emerging markets real GDP growth has ticked down to 5.7% for 2011 (down from 5.8%), but remains at 5.6% for 2012. Our Latin America forecasts have taken a major turn lower, with 2011 growth seen at 4.1% (down from 4.5%), owing to a downgrade in our growth outlook for Brazil. We now see Brazilian growth at 3.8% in 2011, down from 4.5% in our previous set of forecasts. However, we are maintaining our 4.8% growth forecast for 2012, as we believe that the economy is close to its cyclical
trough. Our forecast for 2011 growth in Mexico has fallen more modestly, to 3.8% from 4.0%. Alongside the crisis in the eurozone, our emerging Europe growth forecasts have been downgraded, with regional GDP growth set to come in at 4.6% in 2011 (from 4.7%) and 4.3% in 2012 (from 4.4%). We have lowered our forecasts for the Czech Republic, Hungary and Poland, and are likely to revise down our Russia projections on the release of Q211 GDP by expenditure data. For emerging Asia, our 2011 and 2012 forecasts remain steady at 7.5% and 6.9% respectively. We have been below consensus on Asian growth for the best part of a year, and have had little reason to revise down our forecasts amid the current global slowdown.
TABLE: DEVELOPED STATES REAL GDP GROWTH FORECASTS, % CHG Y-O-Y

2010
Developed states aggregate growth G7 Eurozone EU-27 Selected developed states Australia Austria Belgium Canada Denmark Finland France Germany Ireland Italy Japan Netherlands Norway Portugal Spain Sweden Switzerland United Kingdom US
Source: BMI
2011f
1.4 1.3 1.7 1.8
2012f
1.6 1.6 1.2 1.5
2013f
2.1 2.1 1.9 2.1
2.7 2.9 1.7 1.8
2.6 2.0 2.2 3.2 2.1 3.6 1.5 3.7 -1.0 1.3 4.0 1.7 0.4 1.3 -0.1 5.7 2.6 1.3 3.0
1.8 2.0 2.5 2.7 1.5 3.5 1.8 3.1 1.3 0.8 -0.7 1.9 2.5 -1.6 0.7 4.5 1.9 1.4 1.6
1.6 2.0 1.7 2.4 2.3 2.0 1.4 1.3 2.1 0.7 1.8 2.3 2.4 -1.8 1.0 2.0 2.1 2.2 1.6
2.7 1.9 2.2 2.3 2.7 2.2 1.9 2.1 2.2 1.1 1.2 2.7 2.3 2.0 2.0 2.2 2.0 2.5 2.5
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Sub-Saharan Africas 2011 forecast has fallen slightly to 4.7% from 4.8%, though it is unchanged for 2012 at 6.4%. For the Middle East and North Africa region, our 2011 forecast has risen slightly to 4.6% from 4.5%, though it has fallen slightly to 4.4% from 4.5% for 2012. We are in line with Bloomberg consensus estimates on US and eurozone growth in 2011, and for the major emerging markets, though we are below consensus on
Japanese growth. For 2012, however, we are well below consensus on US and Japanese growth.
TABLE: EMERGING MARKETS REAL GDP GROWTH FORECASTS, % CHG Y-O-Y

2010f
Emerging markets aggregate growth Latin America Argentina Brazil Mexico Middle East and North africa UAE Egypt Sub-Saharan Africa South Africa Nigeria Saudi Arabia Emerging Asia China Hong Kong India Indonesia Malaysia Singapore South Korea Taiwan Thailand Emerging Europe Russia Turkey Czech Republic Hungary Poland
Source: BMI
2011f
5.7 4.1 7.0 3.8 3.8 4.6 3.3 0.5 4.7 3.2 7.8 6.3 7.5 9.2 5.0 7.4 5.9 4.8 5.9 4.1 3.0 3.6 4.6 4.6 7.0 2.3 2.0 4.0
2012f
5.6 4.2 4.1 4.8 3.1 4.4 3.3 2.6 6.4 3.9 7.6 4.0 6.9 8.1 3.9 7.5 5.8 4.2 4.4 4.1 4.3 4.0 4.3 4.5 4.5 2.3 3.1 3.5
2013f
5.6 4.1 4.2 4.9 2.7 4.5 3.5 5.9 5.8 4.1 7.8 3.8 6.7 7.5 3.5 7.9 6.2 3.6 4.1 4.1 5.1 4.2 4.7 4.7 5.4 2.5 2.8 4.0
7.0 6.1 9.2 7.5 5.4 3.9 1.4 5.1 5.1 2.8 7.9 4.1 9.1 10.3 7.0 8.5 6.1 7.2 14.5 6.2 9.9 7.8 4.5 4.0 8.9 2.2 1.1 3.8
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TITLE: CHINA MACROECONOMIC FORECASTS

2007
3,458.5 26,307.8 2,523.2 2,617 1,909 10.5 35.6 8.2 13.3 8.3 40.1 9.0 1,321.5 4.0 4.8 3.3 7.5 7.6 10.7 20.3 0.6 1,342.2 1,034.7 307.5 8.9 371.8 10.8 1,528.2 17.7 1,946.0 18.1 8.1 368.0 6.4 3.3 245.7 4.9 2,557.7 26.4 290.8 168.7 1,290.9 1,162.8 1,581.7 1,331.5 -0.4 -1.0 -0.3 1,742.3 1,590.1 152.2 2.6 248.1 4.2 2,788.0 21.0 -18.0 -48.9 -15.9 9.3 9.9 8.8 6.9 6.8 6.8 6.5 9.1 60.3 0.9 2,004.9 1,871.7 133.3 1.9 246.4 3.5 3,100.0 19.9 5.3 5.3 5.8 6.8 3.6 3.0 2.2 2.8 5.9 -0.7 3.3 5.6 4.2 4.8 4.4 4.4 4.3 3.2 3.2 6.6 6.4 8.6 100.0 1.2 2,214.1 2,079.3 134.8 1.7 259.8 3.2 3,359.8 19.4 1,328.3 1,334.9 1,341.3 1,347.6 1,353.6 13.2 22.0 16.4 10.8 7.5 40.7 45.4 47.9 48.6 48.3 47.8 6.3 1,359.4 4.2 3.0 3.0 6.8 6.3 7.8 144.3 1.6 2,444.7 2,319.8 124.9 1.4 251.5 2.8 3,611.3 18.7 11.2 6.0 7.0 9.5 9.6 9.0 13.3 12.9 12.5 12.5 12.7 12.9 10.3 9.2 8.7 9.0 8.5 8.4 35.1 35.1 34.6 34.5 34.6 34.9 35.4 8.4 13.2 10.0 47.1 5.5 1,364.8 4.2 3.0 3.0 6.8 6.2 7.7 201.3 2.0 2,673.9 2,566.0 107.9 1.1 228.2 2.3 3,839.6 18.0 11.7 9.2 10.3 9.2 8.1 7.5 6.9 2,321 2,702 3,304 3,678 4,287 5,069 5,899 3,411 3,783 4,382 5,259 5,917 6,589 7,374 3,082.6 3,607.5 4,431.4 4,956.2 5,803.4 6,890.1 8,050.9 9,027.5 8,238 6,591 6.8 35.9 8.4 13.6 10.0 46.4 5.1 1,369.7 4.1 2.9 3.2 6.8 6.1 7.5 270.2 2.4 2,918.0 2,830.7 87.3 0.8 199.4 1.8 4,038.9 17.1 31,490.2 34,502.4 39,788.7 45,890.9 51,215.5 56,708.1 62,439.2 68,612.7 4,531.4 5,050.5 5,878.0 7,087.4 8,008.7 8,957.1 10,064.2 11,284.9
2008
2009
2010
2011f
2012f
2013f
2014f
2015f
Nominal GDP, US$bn
Nominal GDP, CNYbn
Nominal GDP, EURbn
GDP per capita, US$
GDP per capita, EUR
Real GDP growth, % change y-o-y
Private final consumption, % of Total GDP
Private final consumption, CNY real growth % y-o-y
Government final consumption, % Total GDP
Government final consumption, CNY real growth % y-o-y
Fixed capital formation, % Total GDP
Fixed capital formation, CNY real growth % y-o-y
Population, mn
Unemployment, % of labour force, eop
Consumer price index, % y-o-y, ave
Lending rate, %, ave
Central Bank policy rate, %
Exchange Rate, CNY/US$, ave
Exchange Rate CNY/EUR, ave
Budget balance, US$bn
Budget balance, % of GDP
Goods and services exports, US$bn
Goods and services imports, US$bn
Balance of goods and services, US$bn
Balance of goods and services, % of GDP
Current account balance, US$bn
Current account balance, % of GDP
Foreign reserves ex gold, US$bn
Import cover, months
SPeCial rePorT
53
f = BMI forecasts. Sources: BEA/World Bank/BLS/Congressional Budget Office/BMI
54
2007
952.6 1,138.0 694.9 45,204 32,979 4.4 55.8 5.5 17.0 3.3 28.7 10.1 21.1 4.3 2.3 8.7 6.8 1.2 1.6 17.9 1.9 182.6 198.9 -16.4 -1.7 -56.8 -6.0 24.8 1.5 1.7 30.7 -4.1 -42.2 -4.2 38.9 2.4 -0.7 -0.3 -41.0 -6.8 -3.1 217.1 195.5 210.3 192.4 261.5 246.1 15.4 1.3 -31.8 -2.6 34.1 1.7 1.1 -3.4 -4.3 11.6 -33.2 -53.3 1.8 1.8 1.4 1.4 -40.5 -2.7 304.3 274.8 29.5 2.0 -26.9 -1.8 29.0 1.3 1.2 1.3 1.1 1.0 4.3 3.8 4.8 4.8 9.0 7.6 8.4 8.4 4.4 1.8 2.8 3.3 2.4 8.2 4.5 1.1 1.5 -25.0 -1.9 273.1 243.4 29.7 2.3 -21.9 -1.7 26.1 1.3 4.6 5.5 4.9 5.3 5.4 21.5 21.9 22.3 22.6 22.9 7.9 -3.2 5.8 4.0 -2.0 3.2 23.2 5.2 2.2 8.7 5.0 1.3 1.7 -11.6 -1.0 240.2 213.4 26.8 2.3 -13.5 -1.1 28.0 1.6 29.0 28.0 27.5 28.2 27.2 27.4 3.2 1.6 3.6 3.3 2.8 2.1 17.1 18.0 18.1 18.4 18.6 18.5 1.9 1.0 2.8 2.8 1.5 2.0 2.0 18.5 3.0 27.7 4.0 23.5 5.0 2.6 8.9 5.3 1.3 1.7 -0.2 0.0 251.6 225.0 26.6 2.2 -6.6 -0.5 29.9 1.6 53.5 54.4 53.3 53.9 53.9 53.6 53.1 2.7 1.6 2.6 1.8 1.6 2.7 3.0 32,977 31,976 42,518 46,228 42,312 40,085 42,121 48,476 44,767 56,398 66,107 58,390 52,111 52,651 54,850 43,880 2.9 52.6 2.0 18.5 3.0 28.0 4.0 23.8 4.8 2.5 9.2 5.5 1.3 1.7 10.4 0.8 262.5 236.4 26.2 2.1 -4.5 -0.4 31.8 1.6 706.7 698.3 930.3 1,032.1 954.1 912.9 968.6 1,018.9 1,242.4 1,251.6 1,344.1 1,409.7 1,463.0 1,531.2 1,614.4 1,698.2 1,038.9 977.7 1,234.0 1,476.0 1,316.7 1,186.7 1,210.8 1,273.6
TITLE: AUSTRALIA MACROECONOMIC FORECASTS

2008 2009 2010 2011f 2012f 2013f 2014f 2015f
Nominal GDP, US$bn
Nominal GDP, AUDbn
Nominal GDP, EURbn
GDP per capita, US$
GDP per capita, EUR
Private final consumption, AUD real growth % y-o-y
Government final consumption, AUD real growth % y-o-y
Fixed capital formation, AUD real growth % y-o-y
Population, mn
Unemployment, % of labour force, eop
Lending rate, %, ave
Central Bank policy rate, %
Exchange Rate, AUD/US$, ave
Exchange Rate AUD/EUR, ave
f = BMI forecasts. Source: BMI/National Agencies/UN/IMF
TITLE: MACAU MACROECONOMIC FORECASTS

2007
17.7 141.9 12.9 34,952 25,499 14.7 26.7 10.3 8.8 14.5 37.7 24.0 0.5 3.1 5.6 7.8 8.0 11.0 2.9 16.6 16.4 10.1 6.3 35.9 5.6 31.8 13.2 -15.8 15.9 -17.7 28.4 5.8 43.2 49.8 7.8 37.8 18.4 -24.1 8.8 10.3 10.8 9.2 19.5 19.5 18.2 13.9 13.0 23.4 11.0 13.6 50.1 10.8 39.8 23.4 -25.5 3.7 2.9 3.5 11.8 11.2 10.6 8.0 8.0 8.0 8.0 11.4 3.6 12.4 25.7 12.1 14.0 48.7 11.0 38.5 25.4 -25.2 5.4 5.3 5.3 5.3 8.6 1.2 3.0 3.0 3.0 3.6 3.3 4.0 4.0 3.1 6.0 8.0 11.0 3.6 11.8 28.3 13.3 14.3 47.2 11.2 37.1 26.9 -24.2 0.5 0.5 0.5 0.6 0.6 -14.8 -32.3 45.9 10.0 3.8 31.1 19.3 12.6 12.8 13.0 2.3 11.5 10.9 19.2 6.5 8.5 13.0 4.4 0.6 4.0 1.9 6.3 8.0 10.4 3.6 11.2 31.1 14.6 14.6 45.7 11.3 35.5 27.9 -22.9 8.8 9.7 8.1 8.4 8.8 9.1 5.8 2.3 0.4 13.7 1.5 4.5 27.4 27.9 23.3 23.1 23.0 23.1 23.2 5.0 9.5 9.0 13.1 5.1 0.6 4.0 1.7 6.3 8.0 10.0 3.6 10.7 34.2 16.1 14.9 44.3 11.5 34.1 28.9 -21.5 2.8 1.5 26.2 16.0 2.0 4.0 4.4 26,582 27,846 37,717 36,055 38,637 42,434 45,657 39,076 38,984 50,031 51,559 53,318 55,164 57,072 13.8 14.8 20.5 20.0 21.9 24.6 26.9 28.4 59,007 47,206 4.3 23.4 5.0 9.9 9.0 13.2 5.0 0.6 4.0 1.7 6.3 8.0 10.0 3.6 10.1 37.6 17.7 15.2 42.9 11.7 32.9 29.9 -20.2 161.7 165.5 217.3 228.9 241.7 255.1 269.1 283.4 20.3 20.7 27.2 28.7 30.3 31.9 33.7 35.5
2008
2009
2010
2011f
2012f
2013f
2014f
2015f
Nominal GDP, US$bn
Nominal GDP, MOPbn
Nominal GDP, EURbn
GDP per capita, US$
GDP per capita, EUR
Private final consumption, MOP real growth % y-o-y
Government final consumption, MOP real growth % y-o-y
Fixed capital formation, MOP real growth % y-o-y
Population, mn
Unemployment, % of labour force, ave
Lending rate, %, eop
Exchange Rate, MOP/US$, ave
Exchange Rate MOP/EUR, ave
SPeCial rePorT
55
f = BMI forecasts. Source: BMI/National Agencies/UN/IMF
56
2007
56,316.3 6,535.3 8,617 4.0 3.5 13,875.4 13,552.2 15,569.9 12,096.8 14,492.7 16,779.2 17,940.7 18,900.3 20,366.6 15,812.5 12,398.7 14,858.2 17,219.7 18,307.2 19,193.6 20,573.2 5.1 2.0 2.9 4.0 3.6 3.5 3.5 2.1 -1.9 4.3 3.1 3.3 3.7 3.8 3.8 3.6 22,136.0 22,002.3 9,327 8,823 9,500 10,482 11,091 11,721 12,306 12,926 6,624.5 6,689.5 6,775.3 6,853.2 6,909.3 6,912.4 7,062.7 7,221.8 61,787.0 59,021.9 64,366.8 71,834.0 76,630.8 81,017.7 86,910.1 93,347.1
TITLE: WORLD MACROECONOMIC FORECASTS

2008 2009 2010 2011f 2012f 2013f 2014f 2015f
Nominal GDP, USS$bn
Population, mn
GDP per capita, US$
Real GDP growth, %
Inflation, %
Exports, US$bn
Imports, US$bn
f = BMI forecasts. Source: BMI/National Agencies/UN
TITLE: DEVELOPED MARKETS MACROECONOMIC FORECASTS

2007
37,624.0 891.3 42,214 2.5 2.2 7,198.8 7,951.6 -752.8 -852.8 8,792.0 7,939.2 3.0 0.2 6,192.7 6,701.2 -508.5 0.0 -4.0 43,832 41,718 908.7 906.1 39,828.4 37,800.1 39,463.8 920.9 42,851 2.7 1.4 7,122.2 7,705.7 -583.5
2008
2009
2010
2011f
42,890.6 929.9 46,123 1.3 2.2 8,164.9 8,881.9 -717.0
2012f
44,006.0 916.4 48,020 1.6 1.7 8,491.1 9,234.1 -743.0
2013f
44,610.6 922.4 48,363 2.1 1.7 8,646.5 9,437.5 -791.0
2014f
45,721.2 930.4 49,144 2.2 1.8 8,985.0 9,824.5 -839.6
2015f
47,362.9 936.2 50,590 2.2 2.0 9,487.5 10,379.5 -892.0
Nominal GDP, USS$bn
Population, mn
GDP per capita, US$
Real GDP growth, %
Inflation, %
Exports, US$bn
Imports, US$bn
Trade balance, US$bn
TITLE: EMERGING MARKETS MACROECONOMIC FORECASTS

2007
18,692.4 5,644.0 3,312 7.1 6.1 6,676.6 5,600.7 1,075.9 1,095.4 810.5 949.0 1,157.5 1,109.6 1,084.3 6,777.9 5,395.6 6,787.0 7,897.3 8,706.6 9,462.8 7,873.3 6,206.1 7,736.0 9,054.8 9,816.2 10,547.1 11,588.3 10,542.1 1,046.2 9.0 5.3 5.4 6.6 6.1 5.7 5.4 5.8 1.8 7.0 5.7 5.6 5.6 5.5 5.5 5.2 12,648.5 11,622.8 1,025.7 3,842 3,669 4,254 4,886 5,444 6,078 6,717 7,316 5,715.8 5,783.4 5,854.4 5,923.3 5,992.9 5,990.0 6,132.3 6,285.6 21,958.6 21,221.8 24,903.0 28,943.4 32,624.8 36,407.1 41,189.0 45,984.2
2008
2009
2010
2011f
2012f
2013f
2014f
2015f
Nominal GDP, USS$bn
Population, mn
GDP per capita, US$
Real GDP growth, %
Inflation, %
Exports, US$bn
Imports, US$bn
TITLE: G7 MACROECONOMIC FORECASTS

2007
30,702.4 726.4 42,264.8 2.2 2.2 5,086.5 5,709.1 -622.5 6,312.0 -732.1 5,579.9 2.8 0.1 4,323.5 4,792.8 -469.3 -0.3 -4.2 44,063.7 41,761.3 730.6 734.7 32,192.8 30,680.6 738.6 43,482.6 2.9 1.3 5,092.5 5,671.1 -578.5
2008
2009
2010
32,116.8
2011f
34,599.0 742.4 46,602.5 1.3 2.2 5,836.6 6,589.3 -752.7
2012f
35,435.1 746.1 47,493.0 1.6 1.7 6,159.4 6,948.1 -788.7
2013f
35,794.9 749.7 47,746.4 2.1 1.7 6,332.5 7,173.9 -841.4
2014f
36,706.7 753.2 48,734.9 2.2 1.8 6,604.3 7,500.1 -895.8
2015f
37,965.3 756.6 50,176.1 2.1 2.0 6,963.5 7,920.7 -957.2
Nominal GDP, USS$bn
Population, mn
GDP per capita, US$
Real GDP growth, %
Inflation, %
Exports, US$bn
Imports, US$bn
SPeCial rePorT
57
58
2007
13,224.8 3,577.7 3,696.4 6.1 2.8 4,106.3 3,656.7 449.6 264.7 244.2 291.3 194.0 166.4 113.2 50.1 4,374.5 3,588.6 4,786.4 5,540.0 6,034.5 6,553.7 7,218.3 4,639.2 3,832.8 5,077.8 5,734.1 6,200.9 6,666.9 7,268.4 4.4 1.6 2.7 4.0 3.2 3.2 3.4 4.6 1.9 7.0 4.6 5.1 5.1 5.0 5.1 3.5 7,900.8 7,927.2 -26.4 4,182.4 4,311.3 5,071.7 5,807.1 6,232.9 6,578.2 7,097.4 7,669.9 3,613.2 3,648.5 3,683.7 3,718.8 3,753.7 3,788.4 3,822.4 3,855.5 15,111.9 15,729.8 18,682.5 21,595.5 23,396.5 24,920.7 27,129.0 29,571.6
TITLE: ASIA-PACIFIC MACROECONOMIC FORECASTS

2008 2009 2010 2011f 2012f 2013f 2014f 2015f
Nominal GDP, USS$bn
Population, mn
GDP per capita, US$
Real GDP growth, %
Inflation, %
Exports, US$bn
Imports, US$bn
SPeCial rePorT
59
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BMI Special Report China 2012 From Miracle To Meltdown 2011-09-01

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IMPORTANT NOTICE:

chIna 2012: FRoM MIRacLe to MeLtdown?

Published by Business Monitor International Ltd.

China 2012: From miraCle To melTdown?

economic activity ..............................................................................................10-14

real estate outlook ..........................................................................................15-17

investment outlook .........................................................................................18-23

Business Monitor International Ltd

Banking Sector outlook ...................................................................................24-25

Consumer outlook ................................................................................................ 27

10-Year economic outlook .................................................................................... 31

Political outlook .................................................................................................... 34

Global implications: Case Studies ........................................................................ 37

Business Monitor International Ltd

China 2012: From miraCle To melTdown?

how To Play a Sharp Slowdown in China ............................................................................ 39

ratings methodology ............................................................................................ 43

Global assumptions .............................................................................................. 49

Business Monitor International Ltd

Notes: National Bureau of Statistics (NBS), BMI. f = BMI forecasts.

Business Monitor International Ltd

China 2012: From miraCle To melTdown?

4.5 3.5 2.5 1.5

Fixed Investment, % of GDP (LHS) Incremental Capital-Output Ratio (ICOR)

Business Monitor International Ltd

The Great wall of liquidity

Asia - Fixed Investment, pp contribution to real GDP growth

-10 -15 -20

Source: BMI, PBoC

US and China - Money Supply (M2), US$trn

Source: BMI, PBoC

Business Monitor International Ltd

China 2012: From miraCle To melTdown?

railway Stocks in Freefall

rebalancing will not Be easy

6 2011 2012 Long-Term

Source: BMI, IMF, Bloomberg

Business Monitor International Ltd

Banks Under Pressure

China's economic freedom score is the same now as in 1995

Source: BMI, Heritage Foundation

Business Monitor International Ltd

China 2012: From miraCle To melTdown?

7% is The new 10%

Source: BMI, NBS. f = BMI forecasts

Source: BMI, HSBC

Business Monitor International Ltd

Flying Too high

60 50 40 30 Japan (T=1984) Thailand (T=1991) Malaysia (T=1991) China (T=1990)

Source: BMI, NBS

China in a world of its own

Source: BMI, NBS

Business Monitor International Ltd

China 2012: From miraCle To melTdown?

Private Consumption GFCF Real GDP

8.7 16.4 10.3

9.0 10.8 9.2

8.5 7.5 8.1

8.4 6.3 7.5

Business Monitor International Ltd

Private Consumption GFCF Real GDP

8.7 16.4 10.3