China: The recovery may come earlier than expected

China’s GDP growth has declined for six consecutive quarters, from 13.8% y-o-y in Q2 2007 to only 6.8% in Q4 2008. While the decline was partly driven by softer growth in aggregate final demand, the steeper drops over the last two quarters were exaggerated by temporary factors such as inventory de-stocking. Since we expect these temporary factors to fade in Q2 and the government’s massive stimulus package to kick in, we have been forecasting V-shaped growth in 2009, rebounding from a bottom in Q1.

However, over the past few weeks, data flow and policy responses suggest to us that the trough may have been reached in Q4 2008. In other words, the recovery in GDP growth may have come earlier than we originally expected. First, inventory adjustment has moved faster than our expectations. Our survey of 500 Chinese firms in 60 cities conducted between December and early January shows that 60% of surveyed firms have cut inventories – for both raw materials and finished goods – to only one to two months of usage or sales, which was already below their reported normal inventory level of three to four months. Even if we factor in an unexpected slowdown in final sales that may prolong the usage of inventories, the need for massive inventory de-stocking is now quite low. In other words, while inventory de-stocking continues in Q1 2009, the magnitude of the de-stocking should be much smaller than that seen in Q4 2008. In fact, our survey suggests a high likelihood of re-stocking activity in late Q1, which may give an unexpected boost to demand for, and production of, raw materials. Recent rises in the domestic steel price – which is up 15-25% from the trough – may, in our opinion, be partly driven by such re-stocking activity.

Second, the government’s stimulus package may kick in earlier than expected. According to our conversations with local government officials and state-owned enterprises (SOEs), the central government in December already allocated RMB100bn – of the RMB4.0trn stimulus package – to designated industrial and social projects as seed money to gear up a total of RMB400bn spending by local governments and SOEs. The money is required to be used for new investment only, and must not be used to repay bank loans. The deadline for using these funds is March 31, 2009. Because of the time constraint, this RMB400bn package – equivalent to 10% of quarterly FAI – will most likely boost investment growth in Q1 2009 rather than in Q4 2008.

Third, the banks have also increased their lending ahead of expectations. In early November, the PBC removed bank lending quotas and changed its monetary policy stance from restrictive to accommodative. In December, bank lending growth surged, adding RMB772bn in a single month. We judge that this increased lending is also likely to boost economic activity much more in Q1 2009 than in Q4 2008.

Finally, anticipated reforms to the VAT regime may well have encouraged firms to postpone some of their fixed- asset investment (FAI) from Q4 2008 to Q1 2009. The government announced in November that, as of January 1, firms no longer need to pay 17% VAT on their machinery and equipment purchases. As a result, many firms may have postponed equipment investment into 2009, causing temporary weakness in FAI and industrial sales/production data in November and December 2008, but adding more strength to growth in Q1 2009. All these factors suggest economic activity will likely be stronger in Q1 than in Q4. We expect real GDP growth to rebound to 7.0% y-o-y in Q1, followed by 7.5% in Q2, 8.2% in Q3 and 9.2% in Q4, as the impact of the government’s stimulus package increases. We keep our full-year growth forecast at 8.0%, with risks to the upside.

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