Rising prices versus slowing growth
When an economy overheats, the authorities have to cool it down. This is what is happening in China at present– industrial production and the manufacturing PMI have both weakened since April. Power shortages in some coastal regions may continue to disrupt production during the summer period. This, combined with inventory destocking and continuing tight policy, raises the risk of a bigger dip in activity during the summer. However, fixed asset investment (FAI) growth accelerated to 25.8% in the first five months of the year, reflecting strong investment momentum. Against the backdrop of still-strong local government investment incentives and massive public housing construction starts, we expect FAI growth to remain robust this year. As a result, we expect the moderation in industrial activity to be mild and transitory. Overall, we do not see a big risk of a hard landing, and we look for a growth momentum to recover from Q4-2011. We forecast 2011 GDP growth at 9.3% y/y, and believe there is upside risk to this forecast.
Monetary conditions remain tight
Growth in monetary aggregates has steadily slowed under quantitative loan quotas since January. We believe the People’s Bank of China (PBoC) is targeting total official new CNY-denominated loans of CNY 7.5trn for 2011 as a whole, with an allocation of 3:3:2:2 across the four quarters. Credit extension in the first five months of the year was in line with the target, and official M2 growth slowed to 15.1% y/y in May (Chart 2). In addition, the authorities have pressured firms to limit price increases, attempted to reduce food transport costs by eliminating tolls for food trucks, and increased subsidies for low-income households. After CPI inflation peaks in June-July, we expect a moderate loosening of policy, with softer credit controls in Q4. As a result, we look for CNY 8.0-8.5trn of total loans for 2011. At present, the PBoC is aggressively tightening liquidity in the interbank market. The 7-day repo rate exceeded 8% on 20 June, close to its Chinese New Year peak.
The housing market is still firm
Real-estate investment growth is still very strong, thanks to social housing investment and still-robust investment in inland provinces. Real-estate investment totalled CNY 1.874trn in the first five months of 2011, with residential building investment rising 37.8% y/y during the period (see Chart 3). Land sales are dropping but have not collapsed; large developers are still keen on buying land plots in prime locations. However, developers have slowed construction activity. Floor space, both newly started and under construction, has dropped this year amid rising inventory. This suggests that developers do not have a positive outlook on the market and are cutting supply to avoid excessive inventory build-up in H2.
Transactions nationwide appear to have rebounded in May after those in Tier 1 cities halved in Q1 from the previous quarter. Average selling prices (ASPs) are flat in many cities, with no significant price corrections. Restrictions on purchases have pushed many speculators out of the market, but credit controls imposed on developers have put more pressure on their cash flow. So far, there is no clear trend up or down in prices and transactions. We expect sales to remain at current levels (down about 5-10% from 2010), with ASPs seeing a slight correction in Tier 1 and some Tier 2 cities.
The central government’s target of starting construction of 10mn units of social housing this year has placed a heavy burden on local governments. According to a survey by the housing ministry, local governments had achieved 30% of this target by early June. This suggests that more investment may be poured into social housing in H2, which would drive up demand for commodities like steel and cement.
The biggest unknown, though, is financing: where will the estimated CNY 1.3trn of funding needed for the social housing programme come from? We expect the banks to ultimately have to provide the majority of the funds, which will leave them even more vulnerable

to local government risk. While we expect social housing construction to pick up in H2, we do not expect this to affect prices or overall demand in the commercial sector, since the desire to upgrade from social housing will remain strong. Policy outlook
So far this year, the PBoC has raised benchmark rates twice, (by 25bps each time, and hiked the reserve requirement ratio (RRR) six times, by 50bps each time. Until inflationary pressure peaks, it will not be easy to exit the tightening cycle. We still expect one more rate hike in the summer, but in previous cycles, rate hikes have stopped well before the peak in CPI inflation – so a hike is by no means certain. Tight monetary policy is currently being implemented through loan quotas and higher reserve requirements. We look for CPI inflation to fall in y/y terms after August; broader sentiment should then turn more positive.
We do not expect further property-market cooling measures in H2, although credit will remain tight for developers. Land-sale revenues, which have fed local government investment in recent years, have shrunk significantly in some areas. More favourable policies will likely be implemented to support the social housing construction plan this year.
Local government investment vehicles will also continue to face tight credit conditions. These vehicles have some CNY 10trn worth of outstanding bank debt, mostly guaranteed by land. We believe a large chunk of these loans will not be repaid. We expect a plan to resolve this issue to be formulated in 2012-13, most likely involving the Ministry of Finance taking charge of a large chunk of the loans. We believe the problem can be managed without causing a hard landing in the investment space or a banking crisis.