China ’ s economic t ransition & inflation shock

1. China’s economic transition & inflation shock Xu Sitao Chief Representative, China, The Economist Group Director, Global Forecasting, China,, Economist Intelligence Unit

2. Key points China’s inflation scare Asset bubbles: causes, policy measures and implications Policies to improve social welfare Risk scenarios & Investment implications

3. Diagnosing inflation • Short term concerns focused mostly on food. Supply shocks could send prices higher; PBOC’s target (4%) looking hard to achieve • The impact of food prices is over-estimated but the effect of services is under-estimated; the net-effect is under-estimation of inflation • Factor price normalisation will put upward pressure on prices for electricity, water, other utilities, wages and cost of capital etc. 3 Source: EIU & CITI

4. China’s exit strategy is being executed

5. Discussion on inflation, labor market & demographic dividend • Inflation, if mainly caused by food, would benefit farmers, but urban poor would be worse off , • Is inflation caused by demand or supply?

6. Factor price normalisation is underway • What are factor prices? • Why is normalisation good for China? • Will normalisation result in inflation? • Examples: fuel prices, Hukou system, interest rate deregulation • Sequencing • Will inflation scare affect normalisation?

7. Housing market remains robust despite repeated anti-speculation policies • Strong housing market is being underpinned by lack of other investment choices & liquidity • Recent policies in Beijing tighten scope for non-residents to enter market • Other policies aim to reduce leverage • Shanghai and Chongqing are experimenting with property taxes • Beijing – the only city to pledge price reductions of properties

8. “China is Dubai times 1,000, if not a million.” --- James S. Chanos Erdos, Inner Mongolia Is this the end of the Chinese economic miracle?

9. Why short China… (according to James Chanos) • Land prices surged faster than property prices in some Tier 2 cities. This is backed up by Ministry of Land & Resources data for recent years. • Therefore, we expect margin pressure for developers that entered such Tier 2 cities in recent years. • Oversupply approaching; Tightening measures extended to Tier 2 cities. • Consequences of bubble bursting (banking sector, related industries, consumers, external impact…)

10. China’s 12th Five-Year Plan: • Shift: from quantity of growth to quality of growth and sustainable development • 1/3 of PM Wen’s Govt work report speech focused on livelihood of common people • Pledge to significantly increase stock of low income housing • Reiterate inflation target of 4%

11. Prepare for Currency appreciation • RMB appreciation occurring in both real and nominal terms • Real appreciation (China’s tolerance of inflation) will take center stage the next a few years • A rise in the value of the RMB is consistent with factor price normalisation

12. RMB Revaluation – Ongoing debate (in the wake of shocks from oil and quake) • Pros • Trade surplus shrinks but is still significant in absolute terms • Foreign reserves rise despite promotion of outbound investment • Politicization of issue in US: House of Reps Currency Reform for Fair Trade Act; Krugman’s “Taking on China”; Samuelsson’s “Stand up to China” • Growing international pressure on China to implement “exit strategy” and support global rebalancing (especially after the quake in Japan) • Without exchange rate adjustment, asset bubbles may grow • Cons • Revaluation hampers recovery of export industry • RMB is already appreciating against the Euro on trade-weighted basis due to sovereign risk • Widening inflation differentials between China and the US will result in a stronger RMB in real terms • Labor shortages and price reforms will increase pressure on thin export profit margins • China should not have to “pay” (by revaluation) for global imbalances arising from irresponsible monetary policies in other countries

13. A Chinese Prescription: A more open capital account while a relative stable RMB • RMB’s is likely to appreciate less than the market has discounted • China will come up various creative ways of exporting her vast savings • Interest rate reregulation is imminent

14. Discussion & debate on fiscal reform • Is China a high-tax country? • Likely changes on personal income tax (why so much attention?) • Discussion on property taxes • The link between fiscal reform and financial deregulation • Goalpost of public finance reform • Political and social factors affecting tax cut

15. Risks, policy responses & Unintended consequences • Risks of stagflation in the developed countries and heightened inflation in the emerging world; • Contradiction between housing-for-the-people and local governments’ dependence on revenues from property; • Forced appreciation of the RMB, triggered by QE3 (Japan’s experience in the ’80s) when China is facing persistent upward pressure on labour wage rate