Morgan Stanley - ‘Worse’ in 1Q09, but Not as Bad as Expected

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

Better-than-Expected Economic Performance in March and 1Q09
The Chinese economy posted stronger-than-expected real GDP growth of 6.1%Y in 1Q09, mainly reflecting the sharp sequential rebound in economic activity in March following the sharp plunge in January-February (especially in trade), which vindicated fears of economic conditions getting worse before getting better (see China Economics: Data Preview – Longing for Inflection, April 7, 2009). Indeed, as we had expected, the economy had weakened further (‘getting worse’) in 1Q09, from the 6.8%Y growth rate in 4Q08, but the dip was milder than expected. On a seasonally adjusted basis, we estimate that the economy staged a 5%Q rebound in 1Q09, after the first quarter-on-quarter contraction (-0.5%) in almost eight years in 4Q08.

We attribute the better-than-expected economic performance to the very aggressive policy response to the hard landing in 4Q08 that has served to lessen the depth of the cyclical trough. In particular, policy-driven monetary expansion drove money and loan growth to record highs in March, up 25.5% and 29.8%Y, respectively, with new loans made in 1Q09 totaling Rmb4.6 trillion, almost 3.5 times the amount in the year-ago period, or 93% of 2008’s total. Although we do not think that such rapid credit expansion is sustainable throughout the year (see China Economics: Recent Rapid Bank Credit Expansion Not Sustainable, February 2, 2009), the heavily front-loaded policy response of ‘crisis-management’ style to supporting growth has helped to effectively shore up the confidence of private investors and households and reflate the asset markets, in our view. This in turn contributed to the resilience in consumption and the rebound in real estate development investment (+7.3%Y in March versus +1% in January-February), offsetting the negative impact from job losses and slower income growth from the weak external environment.

The latest report card remains broadly consistent with our ‘getting worse (in 1H09) before getting better (in 2H09)’ call. We continue to believe that the bulk of real stimulative effect from the multi-trillion-renminbi fiscal package and expansionary monetary and credit policy is only expected to materialize in 2H09, when we should see a more genuine recovery in the economy.

External Weakness versus Domestic Demand Resilience
Although the year-on-year plunge in exports narrowed in March (-17.1%Y versus -21.1% in January-February) (see China Data Releases: Strong Rally of Exports in March on Sequential Basis, April 10, 2009), suggesting that we might have seen the worst in external demand, China did experience an unprecedented drop in trade flows in 1Q09 (exports -19.7%, imports -30.8%). The deceleration in overall GDP growth was undoubtedly milder than that suggested by the contraction in trade, as the strong fiscal policy response helped to support domestic demand.

Even though retail sales growth has been slowing in nominal terms due to rapid disinflation, consumer spending remained strong in real terms. March sales totaled Rmb932 billion, up 14.7%Y (versus our forecast of +14.5%). Although this represented further deceleration from the 15.2% gain in January-February, growth actually strengthened in real terms (deflated by retail price inflation) in March to 16.4%Y, from 15.7% in the first two months.

Meanwhile, urban fixed asset investment picked up further in March, gaining 30.3%Y (+26.5% in January-February, +23.4% in 4Q08). In particular, in reaction to the pick-up in property transactions upon stabilizing sentiment, real estate development investment rebounded, growing 7.3%Y in March, after dipping to just 1% in January-February, though still much weaker than the 20.9% expansion last year. Meanwhile, we believe that government initiatives remained a strong driver behind the pick-up in capex, with investment in the western (+46.1%Y in 1Q09) and middle (+34.3%) regions far outpacing that in the eastern region (+19.8%). Nevertheless, we again note that FAI statistics capture the value of asset acquisition transactions (e.g., land transactions before property construction), which are not genuine capital formation activities. But we do believe that the fiscal stimulus plan should bring about a meaningful boost to capex in the coming months.

No apparent further deterioration in sentiment, resilience in domestic demand and narrowing declines in trade helped to stage a noticeable bounce back in value-added industrial output, to 8.3%Y in March from 3.8% in the first two months. This beat our forecast (+3%) by a large margin. On the contrary, however, power output fell 0.7%Y in March (-2.6% in 1Q09), seemingly contradicting the trend in overall output. We believe that this could suggest a more severe slowdown in the power-intensive sectors, such as steel and other metals, as high raw material prices last year encouraged speculative production and overstocking.

Price Adjustment Continues, but Milder than Expected
Broadly in line with our expectation, consumer prices remained in deflation in March, falling 1.2%Y (we forecast -1.4%). Consumer deflation averaged 0.6%Y in 1Q09. In the upstream, nevertheless, price drops seem to be alleviating in line with the pick-up in sentiment and activity. Although producer prices (PPI, -6%Y (Morgan Stanley estimate) in March versus -4.5% in February) and raw materials purchasing prices (RMPPI, -8.9% versus -7.1%) both posted steeper year-on-year declines in March than February, the figures were less negative than our forecasts (-7% and -9.5%, respectively).

Policy Outlook
Despite the latest data for March indicating that the economy may have bottomed and even shown signs of recovery and the surge in bank lending growth, we do not expect any meaningful shift in monetary policy stance in the near term. We expect monetary policy to be kept sufficiently loose until an economic recovery is firmly underway, which we expect to materialize by mid-year (see China Economics: US Fed’s QE Points to More Monetary Easing in China, March 25, 2009). In view of the persistence of deflation, we expect one 27bp interest rate cut in 2Q09 and further RRR cuts if warranted by liquidity need. We expect rapid new loan creation to moderate in the coming months, as the authorities’ monetary policymaking shifts from the ‘crisis management’ mode to a ‘conventional monetary easing’ one over the course of the year. The total new loan creation could reach Rmb6-7 trillion for the year, in our view. We expect loan growth to moderate to the 18-20%Y range toward the latter part of the year. Despite the likely moderation in loan growth, the share of medium- and long-term loans in total new loan creation should increase as the investment projects under the stimulus plan are being carried out.

Meanwhile, upon realizing the better-than-expected performance in 1Q09, we believe that there is no need for additional fiscal policy stimulus in the near term. The maintenance of the status quo of fiscal and monetary policy stances should lead the economy further up its recovery path, in our view.

Upside Risk to Growth Forecasts
In view of this better-than-expected performance in 1Q09, we think there is now considerable upside risk to our current forecast for 5.5% real GDP growth in 2009. In particular, we believe that the very aggressive policy response – as in part reflected in the surge in bank lending – has helped to contain the deterioration in sentiment and confidence and reflate asset prices, preventing a too rapid slowdown in private consumption and investment.

While we still believe that a meaningful recovery in real economic activity will not take place until mid-year, as the bulk of the effect of policy stimulus kicks in and a tepid recovery in G3 demand starts to set in towards year-end, it appears that a rosy ‘goldilocks recovery scenario’, which we had previously thought of as a low probability event, is playing out (see China Strategy and Economics: 2009 GDP Recovery Unlikely to Boost Profits or Equities, February 23, 2009).

Regular readers of our reports may recall that under this ideal recovery scenario, we envisage the Chinese authorities taking a rather unorthodox approach in managing the economic downturn: boosting the real economy through reflating the stock market first. The goldilocks recovery scenario would therefore feature a series of positive catalysts, such: 1) a technical rebound in growth as destocking runs its course and trade finance normalizes somewhat in 1Q09; 2) on the back of a policy-induced, liquidity-driven stock market rally (despite weakening fundamentals), the confidence of consumers and private investors is boosted despite job loss and slower sales/income growth, thus preventing too rapid a slowdown in consumption and private investment in late 1Q and 2Q09; 3) the effect of fiscal stimulus starts to show in a major pick-up in public investment growth in late 2Q or early 3Q09; and 4) the G3 economies bottom and stage a tepid recovery in 4Q09, improving external demand and further boosting confidence.

Although we had attached a low probability to this ‘everything-goes-exactly-right’ scenario at the time, it is looking increasingly probable that this scenario is playing out. In particular, it has become evident that the Chinese authorities, who still have a powerful and pervasive influence over the business community (including in particular the banking sector), are determined to leverage the ‘strong balance sheet’ of the economy for a ‘decent-looking income statement’ of the economy in the next couple of years.

If this scenario were to materialize, we believe that the ‘getting-worse’ leg under our baseline recovery scenario would not be as deep as we envisage, and thus the average GDP growth rate in 2009 could be higher than 5.5%. We will likely revisit our forecasts after we take comprehensive stock of the developments based on a full set of data that will be made available in the coming days.

Implications: China to Be Among First to Recover
In our view, the aggressive policy stimulus should bring about further recovery in GDP growth in 2H09, making China among the first countries to emerge from the global downturn. Nevertheless, while the policy stimulus can help to bring about a rebound in the headline GDP growth rate and may even prevent a sharp rise in the unemployment rate, we believe that it is unlikely to be able to deliver corporate earnings growth nearly as strong as when the same level of headline GDP growth is fueled by buoyant private sector spending. This would be a relatively ‘job-rich’ but ‘profit-deficient’ macroeconomic environment, especially in 1H09, with sectors/companies exposed to government-supported capex programs most likely being able to benefit most, in our view.