China’s GDP growth forecast for 2011 falls to 8.7%

● We expect persistent inflationary pressure, softening growth and continued monetary tightening through 2H11 and well into 2012.

● Food inflation is likely to peak soon in YoY terms, but services inflation is on the rise. The nature of inflation in China is changing – it is becoming more structural. In our view, surging raw material costs, labour shortages and power supply interruptions have kept exporters operating at 80% capacity instead of their usual 105%.

● SMEs are facing severe liquidity crunch. We are increasingly concerned about this causing problems for the entire economy, leading to weaker demand or rising account receivables.

● We have revised down our 2011 GDP growth forecast to 8.7% from 8.8% for 2011, and to 8.5% from 8.9% for 2012, but we no longer foresee a hard-landing scenario as the base case.

● We do not expect the softness in growth to lead to a reversal in the monetary tightening policy. Inflation is still high, the property market remains speculative and Beijing feels comfortable with 8% to 9% growth. If a hard landing threat emerges, we would expect a fiscal stimulus rather than monetary easing.

Forecast revisions

We have revised down our 2011 GDP growth forecast to 8.7% from 8.8% for 2011, and to 8.5% from 8.9% for 2012. The weak PMI in recent months suggests declining momentum going forward. So far, the softening seems manageable, but we are cautious about the growth outlook over the next 12-18 months, as anecdotal evidence suggests export orders declined sharply and SMEs are suffering from the credit crunch. It looks increasingly likely that growth may moderate toward the 8.5%-9% level in 2H11, and soften even further into 2012.

Would slower growth lead to a reversal in monetary tightening? We do not believe this is the case. (1) CPI inflation is expected to surprise continuously on the upside; (2) the property market is still at a crossroad with risk of speculation surging again; and (3) Beijing feels reasonably comfortable with the growth rate between 8% to 9%, in our view. We would expect the government to provide stimulus should growth risk drop below 8%, though we believe the form of fiscal expansion will be the more likely route this time.

We think interest rate normalisation will continue into 2012, as the government still prefers using quantitative measures i.e., RRR hike and lending quota management to normalise liquidity conditions. We now expect an 85 bp hike in the one-year lending rate to 7.16% and 100 bp in the one-year deposit rate to 4.25% by the end of 2011, and anticipate another 50 bp hike for the lending rate to 7.66% and deposit rate to 4.75% in 2012. This is based on our view that CPI inflation would plateau around 5% in 2H11, maintaining close to a 2% negative real interest rate gap if no rate hike is done.