India
SOE Divestment Policy: Missing the Big Picture?
July 17, 2009

By Chetan Ahya | Singapore & Tanvee Gupta | India

Summary

Since India first initiated the divestment of government holdings in state-owned enterprises (SOEs) in 1991-92, the process has been very slow. The total amount collected through SOE divestments is just US$14.4 billion over 18 years - US$800 million per annum - and an annual average of just 0.17% of GDP. SOE divestment remains a highly debated and politicized topic. The key concern presented by those against divestment is that it results in job losses, adding to social pressure. In our view, however, the right application of the funds raised from SOE divestments could actually help to create jobs and be in the long-term interest of a rising working age population.

What Is the Size of Government Assets in PSUs?

Our very broad estimate indicates that the total market value of government companies (including unlisted companies) is US$406 billion. The market value of 55 listed public sector companies is US$281 billion. The average government stake in these companies (listed) is 80%, and hence the government's stake in these listed companies is worth US$224 billion. Note that our estimates are based on secondary market-based valuation tools. We believe that the government could realize a much higher amount if it were to make strategic stake sales with a transfer of management control to the private sector. The basket of unlisted companies is also large. Some of the large, quality, profit-making public sector entities include Life Insurance Corporation of India (the largest life insurance company in India with an asset base of US$193 billion as of F2008), Bharat Sanchar Nigam (the second-largest telecom company in India with a subscriber base of 82.5 million), and Coal India (the largest coal company in India with annual coal production of 404 million tons as of F2009). Our overall estimate excludes central government assets in the form of infrastructure facilities (such as Indian railways) and other operations that are not yet corporatized.

SOE Divestments Trend So Far Has Been Uninspiring

SOE divestment in India has so far been on a slow track. About 87% of the receipts are from divestments of stakes without transferring management to the private sector. Although the BJP-led coalition government started the sale of strategic stakes in public sector units by transferring control to the private sector, the Congress Party-led government appears to be against this option. The pre-election manifesto of the Congress Party allows for divestment of SOEs. The Union Budget F2010, which was the first key policy announcement from the new government, also did not fully elaborate on its divestment plan. However, in his interview to the media after the budget, the Finance Secretary clarified that the government will announce a divestment plan in three months' time. We expect the government to collect proceeds of about US$4-5 billion by March 2010, which will be much larger than the amount collected in recent years. However, even this larger amount will still be small relative to what we think is needed.

Is Divestment Really Against the Welfare of Labor?

Opponents of SOE divestment claim that it is against the welfare of the labor force. The common concern is that divestment will result in job losses in the public sector units privatized. In our view, this argument misses the bigger picture and focuses on a very narrow section of the population. The total workforce employed in quasi-government entities (including public sector undertakings) of the central government (excluding those working directly in administrative machinery) is 5.9 million, just 1.4% of the total workforce. Hence, only a very small portion is being protected.  Moreover, while the government continues to own these entities, market forces are nevertheless forcing it to pursue labor rationalization. Many entities resisting market forces have become unviable, in our view, questioning the sustainability of this protective policy.

Transparent and Right Application of Divestment Funds Critical

Thus far, the government has not been able to demonstrate to the populace any visible gain from divestment, in our view. The small amounts that have been collected from divestment have been used for consumption purposes. Indeed, since F1991 governments have cut capital expenditure as a percentage of GDP to 5.6% (in F2009) from 9%, which has been reflected in overall growth constraints due to infrastructure deficiency. We believe that the government should direct funds collected from divestment through a special purpose vehicle directed to productive areas, demonstrating clearly to the country the benefits of divestment. Note that the government currently has an arrangement to transfer divestment proceeds into a separate fund that is managed professionally. However, we believe that a clear allocation to infrastructure would be ideal.

In our view, the government should allocate divestment proceeds directly to fresh investments in rural and urban infrastructure and/or other development expenditure, both of which we believe are critical for accelerating growth and would help to create jobs for a semi-skilled, less-educated workforce. Indeed, we believe that potential job creation from investment in infrastructure could more than offset the job losses due to divestment. It would be hard to argue against a government move to transparently allocate funds for productive purposes for the development of the poor sections of the population.

US$15-20 Billion per Annum from Divestment for Infrastructure

To address unemployment, we believe that the most important macro focus for the government should be to increase spending on infrastructure. We believe that the key policymakers in the new government appreciate the urgent need for investment in infrastructure but are strapped for funds, with the current national fiscal deficit of about 11.8% of GDP as of F2009. We believe that the government could easily provide for additional infrastructure funding of at least US$15-20 billion (1.2-1.6% of GDP) per annum for the next three to four years through divestment. Indeed, we believe that the private sector (including foreign investors) would be likely to invest a matching amount in manufacturing in response to these infrastructure investments.

In 2008, we estimate India's infrastructure spending at just US$68 billion compared with US$390 billion for China. In the current environment, with capacity utilization at low levels, private sector business investment is likely to remain weak.  To re-accelerate GDP growth to a sustainable level of 8%+, we believe there is a need to invest an additional amount of at least US$20 billion per annum.  The government has been waiting for the private sector to play a more active role in infrastructure spending.  However, few countries in the world enjoy major infrastructure spending support from the private sector.  While we believe that the government should continue its efforts to attract private sector investment, in our view it will have to lead the way in increasing the ratio of infrastructure spending to GDP.

We believe that increases in infrastructure, particularly in the rural areas, could also help to improve employment elasticity. Low government spending on infrastructure hurts the high employment-generating, labour-intensive small enterprises the most. While large companies can draw from their own resources for basic infrastructure services, such as a captive electricity plant or a diesel generator set, the small enterprises suffer when public infrastructure support is lacking. In many cases, it is not cost but the lack of infrastructure per se that holds back small enterprises. We believe that improved infrastructure will also attract foreign direct investment in manufacturing and augment a sustainable recovery in the investment cycle and growth.

Young Workforce Needs Flexibility

The median age of the Indian population is currently 23.7 years, one of the lowest among large nations. India is likely to add 141 million to its current working age population of 750 million by 2018, according to estimates by the United Nations. However, existing restrictive labor laws have been a deterrent to employers, forcing them to prefer capital-intensive options for production, even if they would have otherwise preferred labor-intensive options. Government efforts to protect public sector labor add to inflexibility in the overall labor market, in our view, as in practice they work against labor. Most entrepreneurs prefer casual laborers as opposed to having workers formally on the company's payrolls. In our view, SOE divestment is one of the practical solutions under current economic conditions to augment the resources that will kick-start this virtuous loop of creating productive jobs for an expanding workforce, which, in turn, should translate into higher savings, investment and economic growth.

Important Disclosure Information at the end of this Forum

China
Policy-Driven Decoupling: Upgrading Our 2009-10 Outlook
July 17, 2009

By Qing Wang, Denise Yam, CFA & Steven Zhang | Hong Kong

Another Stronger-than-Expected GDP Report for 2Q09

The Chinese economy staged a stronger-than-expected rebound in 2Q09, with real growth reaching 7.9%Y, up from the trough of 6.1% in 1Q09. On a seasonally adjusted basis, we estimate that the economy grew by a strong 4.5%Q (+19% annualized), accelerating from 1.5% in 1Q09 and the trough of 0.4% in 4Q08. We attribute the better-than-expected economic performance to the maintenance of the growth-boosting policy stance, which made possible a much-accelerated realization of the real stimulative effect from the multi-trillion renminbi fiscal package and expansionary monetary and credit policy, which we originally expected to materialize only in 2H09. In particular, policy-driven monetary and credit expansion, which has been consistently surprising on the upside, has enabled the significant pick-up in domestic investment. The Rmb1.53 trillion new loans made in June sent money and loan growth to new record-highs of 28.5%Y (M2) and 34.4%Y, respectively. Credit creation in 1H09 totaled Rmb7.37 trillion, three times the amount in the year-ago period, and exceeding the 2008 total (Rmb4.91 trillion) by 50%, helping to finance the 35.7%Y growth in fixed asset investment (nationwide) in 2Q09, up from 28.8% in 1Q (33.5% in 1H).

Taking stock of the achievements already realized in 1H09, and standing by our view that the Chinese economy will continue to stage a gradual and steady recovery in the remainder of the year, we are yet again raising our growth forecasts. Our latest upgrade is underpinned by the following four main arguments:

• Much stronger-than-expected policy responses have successfully prevented a potentially sharper slowdown triggered by external shock and helped an early recovery in investment;

• The strong recovery in the property sector bodes well for further recovery in real estate investment in the remainder of this year and 2010;

• Domestic consumption remains resilient as confidence holds up well;

• Policy stance will remain broadly supportive through 2010.

We raise our real GDP growth forecasts to 9% from 7% for 2009 and to 10% from 8% for 2010.

Domestic Strength Offsets External Weakness

Although the decline in exports continued into 2Q09 and turned out to be worse than our earlier expectation (see China Data Release: Trade Recovery Still Short of Expectations, July 10, 2009), this had been adequately offset by the aggressive growth-supporting policies. Continued large-scale credit creation (see China Data Release: Acceleration of Monetary Expansion; Meaningful Tightening Unlikely, July 15, 2009) continued to fuel domestic economic activity, starting from infrastructure investment.

Urban fixed-asset investment growth remained strong in June, rising 35.3%Y (+32.9% in Jan-May), bringing year-to-date (1H09) growth to 33.6%, although this was a tad slower than the 38.6% jump in May alone. In particular, the pick-up in real estate development investment (+18.1%Y in June versus +12% in May, +9.9% in 1H09) remained encouraging (although still weaker than the 20.9% expansion last year). Needless to say, policy-driven capex, as evidenced in infrastructure investment, remained the driver. Investment in the Western (+42.1%Y in 1H versus +46.1% in 1Q) and Central (+38.1% versus +34.3%) regions continued to outpace that in the Eastern region (+26.7% versus +19.8%), also suggesting the policy-driven nature of the latest projects.

Domestic consumer demand growth, as evidenced by retail sales, also remained strong. June sales totaled Rmb994 billion, up 15%Y (versus our forecast of +15.2% and market forecasts of +15.3%). In real terms (deflated by retail price inflation, -2.3%Y in June), sales growth powered ahead further, to 17.7%Y in June, from 17.4% in May.

The pick-up in domestic demand and restocking in the manufacturing sector have led value-added industrial output on a firmer recovery track. Output growth reached 10.7%Y in June, beating our and market (both +9.5%) forecasts by a wide margin, up from 8.9% in May (+6.3% in Jan-May). Electricity generation also, finally, returned to positive growth in June, up 3.6%Y, after remaining negative since October 2008 (except in February 2009 because of the Lunar New Year effect), suggesting a recovery in production in the power-intensive sectors, such as steel and other metals, which suffered relatively a more severe contraction and destocking earlier on following speculative production and overstocking during the up-cycle. We attribute much of the strength in industrial production to domestic demand and would like to highlight the apparent decoupling from the weakness in exports.

Consumer prices (CPI) remained in deflationary territory in June, falling 1.7%Y, slightly more negative than our and market forecasts (both at -1.3%), resulting in average consumer deflation of 1.1%Y in 1H09. We believe that the downside surprise mainly stems from the fall in food prices (-0.3% in 1H, which implies more than a 1%Y drop in June). Indeed, we observe that CPI is still being dragged down on a sequential basis by food prices (-1.4%M in June by our estimate), although the non-food component is likely rebounding on the retail fuel price hikes.

In the upstream, producer prices (PPI) fell 7.8%Y in June (-7.2% in May), while raw materials purchasing prices (RMPPI) fell 11.2% (-10.4% in May). The declines for both indices exceeded our (PPI: -7.5%, RMPPI: -11%) and market (PPI: -7.4%) expectations. Nevertheless, we are confident that prices, both upstream and downstream, are riding out the bottom, in line with the pick-up in sentiment and activity. Sequential price drops are certainly alleviating, although year-on-year declines could persist - because of base effects - until late this year.

A Policy-Driven Decoupling

When turmoil of such a global scale hit, the initial negative effect of the shock was felt indiscriminately strongly by every economy that is deeply integrated into the global economy. The strength and speed of policy responses in the immediate aftermath of the crisis were, however, quite uneven among the countries, resulting in different patterns of post-crisis recovery.

China is a case in point. The aggressive policy response by the Chinese authorities helped translate China's ‘strong balance sheet' into a ‘decent-looking income statement', which distinguishes China from those countries that either suffer from a paralyzed financial system or are unable to launch strong pro-growth fiscal or monetary policy responses because of weak fiscal and/or external balance-of-payments positions. This makes China the first major economy to recover from the turmoil with strong momentum, effecting a policy-induced economic decoupling between China and the rest of the world.

In our previous research, we highlighted a potential ‘goldilocks recovery scenario', wherein the government's growth-supporting policies enable asset reflation, which underpins consumer and investor confidence and prevents the harsh adjustment in domestic consumption and private investment in 1H09 (see "Mapping the Recovery in 2009-10", China Strategy and Economics: 2009 GDP Recovery Unlikely to Boost Profits or Equities, February 23, 2009). The shallower trough in the economic cycle is then followed by recovery in activity, initially spearheaded by fiscal stimulus (3Q09), and then by a tepid recovery in external demand (4Q09 and 2010). Although the timing of these series of events is not exactly as we had envisaged, this ideal scenario appears to be playing out.

Specifically, sustained and stronger-than-expected credit growth in recent months has continued to buoy sentiment and helped to deliver: a) an accelerated rollout of public infrastructure projects; b) more resilience in private consumption and private manufacturing sector capex despite weak exports; and c) an increasingly convincing recovery in property investment. These positive developments, together with the steady asset price reflation, are serving to compensate for the prolonged weakness in external demand.

Growth Outlook Upgrade for 2009-10

We upgrade our forecasts for GDP growth to 9% for 2009 and 10% for 2010. The latest 2Q09 data confirmed that 1Q09 was the trough of the V-shaped trajectory we had envisioned, but the recovery track is proving to be even steeper than we had earlier expected.

The aggressive policy responses - as reflected in the rapid expansion of bank lending - so far this year will likely continue to fuel rapid investment growth in the remainder of 2009. Moreover, we expect property investment to accelerate significantly in 2010, partly offsetting the slowdown in infrastructure investment expected to materialize because of the high base in 2009. Private consumption will likely continue to improve steadily through 2010, as consumer confidence and employment improve. We expect export expansion to resume in 2010 following a sharp contraction in 2009, which, together with a recovery in profits, should help to underpin non-property-related private investment. Despite strong headline GDP growth, inflation pressures are unlikely to emerge until mid-2010, in our view. In terms of trajectory, we expect GDP growth to peak in 1Q10 before starting to moderate thereafter.

Specifically, in our updated forecasts, we have revised consumption growth (in real terms) to 8.5% for 2009 and 9.8% for 2010, stronger than that in 2008 (+8.3%), though weaker in nominal terms because of lower inflation. Consumption has certainly demonstrated its resilience in 1Q09 with a bottoming-out of retail sales and consumer confidence. Consumption-boosting measures introduced by the government appear to have worked well to make up for the shortfall in the near term. Moreover, broadly stable employment since 1Q09, together with the Chinese authorities' pledge to further strengthen the social security system and other social service reform in the coming years, will likely underpin consumer confidence, preventing a sharp rise in precautionary savings despite a substantial economic downturn. Of particular note, housing-related consumption (e.g., furniture, decoration materials) will likely grow remarkably amid a strong recovery in the property sector.

On the investment front, our last upgrade was primarily driven by an upward revision in real estate investment. This time round, it is the resilience in manufacturing sector investment despite weak exports, as well as real estate investment, that has prompted our revisions. We now expect 9% growth in manufacturing investment in 2009, versus 0% previously, and a further acceleration to 12% growth in 2010, as we expect profit growth to recover backed by improving exports (as discussed below).

In line with our expectation, real estate investment has shown increasingly convincing signs of recovery, as reflected in the remarkable rebound in property sales in recent months (see China Economics: Property Sector Recovery Is for Real, May 15, 2009). We believe that this trend is sustainable, pointing to considerable upside to real estate investment in the remainder of this year and next. We therefore are again lifting our forecast for real estate investment to 10% in 2009 and 15% in 2010. On the other hand, we expect infrastructure investment to see explosive 50% growth this year but pass on its role as the key growth driver in 2010. We now expect overall fixed investment to grow 15.1% in 2009 and 12.2% in 2010 in real terms. While policy-driven capex will likely prove to be the key growth driver this year, we expect a steady revival in private investment to reduce the reliance on public investment for growth in 2010.

Export Recovery Expected by 4Q09

Much attention has focused on the unprecedentedly sharp contraction in China's exports in the past several months. We had admitted, on several occasions, that the declines have far exceeded and sustained for longer than our expectations. Meanwhile, overall GDP growth and other economic indicators (output value for export delivery and trade data reported by Hong Kong) have shown far milder downturns than consistent with this export plunge, raising our skepticism yet again towards the reliability of the data.

We suspect that strong exports data in 2007 and 2008 (up to 3Q08) could have encompassed some hidden hot money inflows. Driven by expectations of rapid renminbi appreciation, exporters (domestic as well as foreign-invested producers) may have overstated their shipments to obtain more renminbi. With the stalling of the renminbi appreciation since 2H08 and intensified de-risking amid the financial turmoil, the cutback or discontinuation of this over-invoicing practice could have contributed to the exaggerated sharp declines in the export data. The year-on-year export numbers may be somewhat misleading - as they are being distorted downwards by the reduction in hot money inflows - and help solve the anomaly of the milder-than-expected effect of the export decline on the real economy in 1H09. It follows that we should not expect exports to return to pre-crisis levels any time soon, given the structural reduction in hot money inflows, and that weak year-on-year export numbers would sustain for up to one year. Nevertheless, it also means that as this one-off normalization wears out, exports can promptly resume positive growth.

Moreover, we believe that the current exchange rate policy, i.e., a quasi-hard peg to the USD (see China Economics: An Exit Strategy for the Renminbi? June 9, 2009), combined with recent and expected USD weakness, helps Chinese exports reclaim external competitiveness, and strengthens our optimism towards export recovery. In fact, while the year-on-year export decline averaged 21.8% in 1H09, shipments have been showing sequential improvement in the past few months. We continue to forecast narrowing trade declines in 2H09, and expect export growth to return to close to zero by year-end, and average -16% in 2009, followed by a 9% rebound in 2010. We expect imports to contract by 13% this year (-25.4% in 1H09) and increase by 10% in 2010. We expect the trade surplus to contract this year, for the first time since 2003, to just under US$220 billion, down from US$297 billion in 2008.

Quarterly Growth Profile

We have also updated the quarterly growth trajectory. The 2Q09 rebound (+4.5%Q) represents a strong bounce from the cyclical trough, so we do not expect this sequential growth rate to continue in the upcoming quarters, but return to a more sustainable 2.0-2.5% in the quarters ahead. Nevertheless, the year-on-year growth rate is set to accelerate further in the next few quarters, surging to double-digit rates by 4Q09 and peaking in 1Q10, before tapering off - on the base effect - toward a more sustainable high-single-digit level. The deceleration in growth rate over the course of 2010 would reflect acceleration in private consumption and investment (e.g., property investment) and recovery in exports being partly offset by a smaller dose of policy stimulus.

The Risks: Bull and Bear Cases

The key risk to this outlook lies in external demand. While strong policy responses could help to achieve a meaningful decoupling between China and the rest of the world for several years, there is no absolute decoupling as long as China remains deeply integrated into the global economy, in our view.

There is considerable uncertainty about the outlook for 2010 for the global economy. As it stands now, our global economics team expects that both the US and Eurozone will start to show positive sequential growth by 4Q09 before embarking on a sustained, albeit tepid, recovery through 2010 (see Global Forecast Snapshots: The Global Economy in One Place, June 18, 2009). However, at the current juncture, it is still uncertain whether the G3 economies can successfully maintain such a strong recovery through 2010. Our US economists, Richard Berner and David Greenlaw, expect US GDP growth to be around 2.2% in 2010, but think it could swing between 1.2% under a bear case and 3.8% under a bull case. Similarly, our European economist, Elga Bartsch, expects Eurozone GDP growth to be around 0.5% in 2010, but thinks it could swing between -0.9% under a bear case and 2.2% under a bull case.

In this context, we also revise our two alternative scenarios - bear and bull cases - to highlight both downside and upside risks to the 2010 outlook under our new baseline scenario. We believe that the key risk to our new forecasts stems from the external demand outlook and its attendant effect on private investment in the manufacturing sector. The GDP growth rates under the bull and bear scenarios are 12% and 8%, respectively. We assign 70%, 20% and 10% subjective probabilities to the base, bear and bull cases, respectively.

Under the bull scenario, a faster and stronger recovery in the US and Eurozone economies implies that China's export growth turns positive sooner than expected and private investment in the manufacturing sector registers higher growth. Under the bear scenario, the economy will likely register a sharp double-dip after 1Q10. Persistently weak exports will offset the effect of policy stimulus and hurt sentiment again such that neither private investment in the manufacturing sector nor private consumption will pick up significantly.

Inflation Not a Concern in the Next 12 Months

The rapid expansion of bank lending and money supply (M2) growth have caused considerable concern about the risk of inflation. However, we argue that these concerns are unwarranted at least in the next 12 months. When the economic system is subject to as large a negative external shock as the one China is experiencing now, the dominant contributing factor to headline CPI inflation is export growth instead of money growth, in our view. Here is why:

First, China's past experiences suggest that a sharp decline in export growth should have a strong disinflationary/deflationary effect on the economy. Export growth in this context can be treated as a proxy of the output gap in China: the lower the export growth rate, the larger the potential negative output gap and thus disinflationary/deflationary pressures. Note, however, that it is very difficult to estimate the output gap for China, an economy of which the structure evolves rapidly. China has suffered three episodes of deflation in the past 12 years: the first during the Asian Financial Crisis, the second in the aftermath of the NASDAQ stock bubble burst, and the third being the current one. All three episodes of deflation either coincided with, or occurred in the immediate aftermath of, a collapse in export growth. Although we do expect the decline in export growth to narrow substantially in the remainder of the year and exports to resume positive growth in 2010, we do not expect the recovery in export growth to be sufficiently vigorous as to generate meaningful inflationary pressures (e.g., 3.0+% inflation) in the next 12 months.

Second, the relationship between money and inflation tends to become quite unstable amid a serious economic downturn because the velocity of money declines markedly. This makes gauging inflation risk simply based on money supply growth particularly tricky, especially when there is no robust and stable causal relationship between the two in the first place.

Third, from the supply side, the bursting of the international commodity price bubble caused prices of raw materials (e.g., crude oil, iron ore, metals) imported by China to decline sharply, representing a powerful positive terms-of-trade shock, as in part reflected in the sharp decline in PPI inflation.

Looking ahead, our global commodity research team believes that "ultimately, commodities should perform strongly through this cycle", although in the near term, "fundamentals remain mixed with agriculture balances arguably most constructive, with energy and metals less so..." (see The Commodity Call: Commodities Rally on Greenback & Green Shoots, June 4, 2009). This implies that the upside to commodity prices is unlikely to be large in the next few months, suggesting that PPI inflation is unlikely to rebound strongly any time soon from its recent low of -7.2%Y in June. Furthermore, the low PPI inflation will likely put downward pressures on ex-food CPI inflation.

In this context, the inflation outlook through 2010 will likely again be largely shaped by changes in food prices, in our view. The relevant inflationary pressures could stem from two sources: i) the government's decision to hike the minimum purchase prices of grains by 15%, which would bring about grain price increases in 2010; and ii) the classical ‘hog cycle' that will likely lead to an increase in pork and other meat prices in 2010. In particular, regarding the latter, pork prices have been sliding sharply from the peak since 1Q08 and have fallen below the break-even level (i.e., 6-to-1 pork-to-grain price ratio) recently. Discouraged by poor profit prospects, hog farmers have reportedly started to cut back breeding scale by slaughtering sows. According to our agricultural research team, the destocking of live hogs should extend to 4Q09 to complete the supply adjustment, which could cause substantial pork price increases (e.g., mid-teens) over 2010.

We forecast CPI inflation at -0.6% in 2009 and 2.5% in 2010. We expect the headline CPI inflation to remain negative through October 2009 and creep into positive territory from November 2009. Food price inflation will likely turn positive three months earlier than headline inflation, while we expect ex-food CPI inflation to remain in negative territory through 2009. Entering into 2010, while CPI inflation will likely stay on a steady uptrend with food prices starting to edge up in part due to the base effect, we expect overall headline CPI inflation to remain relatively low through 1H10 (i.e., below 2.5%Y). We expect CPI inflation to climb slightly faster in 2H, as the recovery in export growth gains momentum, reaching 3%Y in 4Q10. We forecast average food price and ex-food price inflation at 4.2% and 1.6%, respectively.

End of Profitless Growth

Latest data (through May) indicate that the decline in industrial profit growth narrowed substantially from about -30%Y in Jan-Feb to -16%Y in Mar-May. The improvement is particularly strong for downstream manufacturing sectors (from -40%Y to -3.5%Y) (see China Economics: Green Shoots in Profits, June 29, 2009).

The strong recovery and acceleration in headline GDP growth in the remainder of the year and through 2010 will likely bring an end to the profitless growth in 2010. In particular, the favorable mix of potential growth drivers in 2010 bodes well for an eventual recovery in profit growth, in our view. Industrial profits are a function of genuine strength of the economy instead of policy stimulus, as the latter may help to produce decent top-line figures but not necessarily be able to deliver bottom-line earnings performance, in our view. In 2H09 and over the course of 2010, we expect the headline GDP growth to be increasingly driven by such autonomous demand as private consumption, property investment and exports instead of public spending carried out under the stimulus plan.

In addition to better overall economic conditions, the low cost pressures stemming from the still relatively low raw material prices will likely contribute to improved profits.

First, despite the sharp improvement in their terms of trade in late 2008 and 1H09, producers were unable to realize the potential gains back then because activities such as production and sales dropped to very low levels at the height of the financial turmoil.

Second, as activity starts to pick up, the low cost benefits should show accordingly, especially for the producers who have seized the opportunity of very low international commodity prices to build up their inventory of raw materials.

Third, the recent developments in international commodity price markets have largely reflected normalization of the relative prices between commodities and manufactured goods - the structure of which had been compressed to unsustainable levels at the height of the turmoil - instead of inflationary pressures due to broad-based recovery in global demand, in our view. Commodity price increases due to relative price normalization are consistent with the competitiveness of China's manufacturing sector and are thus unlikely to have much negative implications for corporate profitability, in our view.

Fourth, the Morgan Stanley Commodity Research team does not believe that the rise in demand due to an early economic recovery in China alone will be able to substantially drive up international commodity prices. This makes China a potential beneficiary from relatively low commodities prices for a considerable period of time until the economies of its competitors for the same fixed amount of supply of commodities recover.

Policy Calls

As economic recovery gains traction, concerns about potential policy change that could derail the recovery are also on the rise. However, we do not expect any meaningful policy change through 2009. Since the strong recovery has been largely policy stimulus-driven, it makes little sense to us for the authorities to make a major policy shift towards outright tightening in the absence of robust autonomous organic growth, especially when inflation does not pose a risk. Any meaningful policy tightening will be endogenous, i.e., contingent on sufficient evidence of sustainable, autonomous demand, in our view.

We therefore expect the status quo of the current accommodative policy stance to be maintained for the remainder of the year. We continue to expect further normalization in loan creation each month, but this should not be interpreted as policy tightening. In this context, total new loans could reach over Rmb9 trillion this year. We also expect the base lending and deposit rates to remain unchanged through 2009. Meanwhile, we do not expect additional fiscal policy stimulus of any meaningful size in the remainder of the year. We believe that the current exchange rate arrangement - featuring a quasi-hard peg of the renminbi to the US dollar - will remain unchanged through 2009 and most probably through the next 12 months and even beyond.

If the outlook that we envisage for 2009 materializes, normalization of the policy stance becomes a distinct possibility for 2010, in our view. The Central Economic Work Conference that traditionally takes place in late November and early December and sets the broad policy parameters for the coming year should be an occasion for such a policy shift. While some normalization of the policy stance in 2010 is entirely possible, we caution against interpreting these potential changes as outright tightening. By the end of 2009, export growth - despite perhaps having rebounded substantially from the lows - will likely remain slightly negative and headline inflation will likely barely creep into positive territory. In this context, the Chinese authorities are unlikely to consider the Chinese economy to be completely out of the woods, and a major policy shift cannot be justified, despite potential double-digit GDP growth by 4Q09, in our view.

However, a more meaningful policy shift by mid-2010 is quite possible. By mid-2010, we expect year-on-year export growth to have reached close to the high single-digit level and the headline CPI inflation to have reached 2.5%Y. The developments of these two key variables on the back of a peak GDP growth rate potentially at about 12%Y in 1Q10 (as per our forecast) will make the authorities feel sufficiently comfortable with turning on the tightening bias in the policy stance for the remainder of the year, in our view.

Specifically, we expect the following: a) new bank lending to moderate considerably from the extraordinarily high levels so far this year such that the overall size of the loan book may increase by 15-17% in 2010, down from nearly 30% in 2009; b) more proactive open market operations by the PBoC in 1H10 likely to be aided by RRR hikes in 2H10 to help achieve the loan growth target; c) hikes of the base interest rates by 25-50bp in 2H10, signaling the beginning of a rate hike cycle that is broadly in sync with that of the US. Incidentally, our US economists, Richard Berner and David Greenlaw, expect that "a hike in the (US Fed) target rate will not occur until mid-2010" (see US Economics: US Economic and Interest Rate Forecast: Does the Economy Need More Stimulus? July 7, 2009); and d) the implementation of the second half of the Rmb4 trillion spending package will be unaffected.

We do not expect any major policy change vis-à-vis the property sector either. The strong recovery in this sector in general and recent property prices increase in particular have made many worry whether the Chinese authorities will intervene in the property market heavy handedly again, as they did in late 2007 and 1H08. Indeed, the memory is still fresh, and many market participants have been traumatized. However, we dismiss this concern. The property sector is the most important source of organic growth in China, and lessons from the past few years have made it clear that a stable policy environment is critical for healthy, sustainable development of the property sector in China. Looking ahead, we expect the authorities' current policy stance vis-à-vis the property sector to remain unchanged. In fact, we should view the policy change since October 2008 as policy normalization, rather than discretionary, counter-cyclical policy easing, which tends to be temporary.

The authorities' current policy approach features two tracks: 1) encouraging market-based commercial housing by removing unduly austere policy measures that artificially depress its development; and 2) addressing the housing issue for low-income households by developing the low-cost, low-rent, affordable housing program financed by public funds. This is an effective and sustainable policy approach, as a viable affordable housing program is predicated on a buoyant commercial housing program, in our view. In view of the property sector's importance in supporting an economic recovery and sustainable growth, any concern that the policy shift might potentially hurt this sector is unwarranted, in our view.

That said, we think it justified if the government chooses to strictly enforce existing rules to prevent abuse by speculators. These moves will not change the broad trend of the property sector - the fundamentals of which, as we have consistently argued, remain sound - and will instead contribute to a sustainable, healthy development in the long run, in our view (see again China Economics: Property Sector Recovery Is For Real, May 15, 2009 and China Economics: Can the Property Sector Be Counted on as the Engine of Growth? September 2, 2008).

Investment Implications

The next 6-12 months will likely feature a mix of growth acceleration and low inflation against the backdrop of a relatively stable policy stance, a macroeconomic environment that is conducive to asset price reflation, in our view. However, we think that as inflation pressures start to emerge by mid-year, concern about potential policy tightening will likely weigh on market sentiment. On the other hand, bottom-line corporate earnings will likely improve in 2010, as autonomous organic growth gains traction over time.

For further details, please see Policy-Driven Decoupling: Upgrade 2009-10 Outlook, July 16, 2009.

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