Jim Walker Chief Economist September 2005 And then there was none…

Jim WalkerChief Economist

September 2005

And then thereAnd then therewas none…was none…And then thereAnd then therewas none…was none…

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China’s first capitalist cycleChina’s first capitalist cycle

China will have a severe cyclical downturn in the next two years

The current upswing, dating from early 2002, is Schumpeterian in nature

Business creation is destroying profits

As is natural in the late-cycle, costs are also rising

China’s cost structure is amplifying the problems


What is a Schumpeterian cycle?What is a Schumpeterian cycle?

Entrepreneurial swarming

Cause? Private property rights, WTO membership – changes to the institutional framework, not inventions or innovations

Creative destruction

Skilled and managerial labour intensive


China’s labour shortageChina’s labour shortage

Skilled and managerial workers are in increasingly short supply

Wage inflation and job turnover are both high

The Taiwanese talent pool is almost dry

Time will solve the problem but not within this cycle

Productivity growth threatened

General inflation will result


Another Austrian elementAnother Austrian element

Banks cause cyclical fluctuations in market economies

China’s banks have been a cycle-damping influence previously

This cycle will be more normal

Expect a secondary credit contraction after the downturn begins


When will it happen?When will it happen?When will it happen?When will it happen?

Variable Danger signal when: Current status: Overheating signalMay 2005:

MacroFast monetary growth relative to history YoY growth rate significantly exceeds 10-

year averageM1 below 10-year average; M2 below 10-year average

No

Rapid credit expansion relative to trend Deviation from trend on our BCR chart is greater than +1 standard deviation although real overheating present at only +2 or +3 sds

On trend No

Adjusted resource gap (the current account of the balance of payments plus net foreign direct investment inflows)

Deficit exceeds 3% of GDP Surplus of 5% of GDP estimated for 2004. CLSA estimate of 3.9% surplus in 2005

No

Accelerating general inflation CPI in excess of 5% CPI is 2.7% YoY in March. Core inflation rising from last year though

No

Rising asset prices with pressure building on most risky

Rotation from property and bonds to equities. Double-digit rises in property prices

General property inflation now in double-digits. Domestic share market the worst performer in Asia in 2004

Yes, but largely contained in the property market. Gambling

outlets growing though

Rising costs, particularly labour Wages rise faster than sales growth or nominal GDP. Raw material input costs rising fast

Official income statistics understating increases

Yes

MicroCorporate earnings Profits in general fall from previous period

(seasonally adjusted). Surprising on the downside

1Q05 'A' share corporate earnings growth in single digits

Yes

Accounts receivable Rising inexplicably in general Double digit rises but below nominal GDP growth. Not explosive yet

No

China’s overheating checklist

Source: CLSA Asia Pacific Markets


We are lowering our forecast growth range for 2006 to 5-7%

Cost pressures on Chinese companies are unrelenting. The worst of the oil price increases have yet to be felt because of controlled product prices

Money supply is plentiful but money demand is faltering

Import growth profile is not about an inventory cycle. Domestic demand growth in 2Q05 around 8% compared with 18% in 2Q04

China growth – profitless and joblessChina growth – profitless and joblessChina growth – profitless and joblessChina growth – profitless and jobless


Strains in the system are showingStrains in the system are showing

1Q04 2Q04 3Q04 4Q04 1Q05 2Q0544.2 46.2 32.6 14.7 6.6 0.9

3 8 9 14 11 15

Net profit growth (YoY)

‘A’ share PROFITS UNDER PRESSURE

Source: CLSA Asia Pacific Markets

No. of sectors showing negative YoY profit growth (out of 22)


Costs are squeezing marginsCosts are squeezing marginsCosts are squeezing marginsCosts are squeezing margins

Input Prices Index

40

45

50

55

60

65

70

75

Ap

r-04

May

-04

Jun

-04

Jul-

04

Au

g-0

4

Sep

-04

Oct

-04

No

v-04

Dec

-04

Jan

-05

Feb

-05

Mar

-05

Ap

r-05

May

-05

Jun

-05

Jul-

05

Au

g-0

5

Sep

-05

50.0 = no change on previous month, S.Adj.

Increasing rate of inf lation

Increasing rate of deflation

Output Prices Index

40

45

50

55

60

65

70

75

Ap

r-04

May

-04

Jun

-04

Jul-

04

Au

g-0

4

Sep

-04

Oct

-04

No

v-04

Dec

-04

Jan

-05

Feb

-05

Mar

-05

Ap

r-05

May

-05

Jun

-05

Jul-

05

Au

g-0

5

Sep

-05


Increasing rate of inf lation

Increasing rate of deflation


Jobless growth?Jobless growth?Jobless growth?Jobless growth?

Employment Index

45

50

55

Ap

r-0

4

Ma

y-0

4

Ju

n-0

4

Ju

l-0

4

Au

g-0

4

Se

p-0

4

Oc

t-0

4

No

v-0

4

De

c-0

4

Ja

n-0

5

Fe

b-0

5

Ma

r-0

5

Ap

r-0

5

Ma

y-0

5

Ju

n-0

5

Ju

l-0

5

Au

g-0

5

Se

p-0

5


Increasing rate of growth

Increasing rate of contraction


Manufacturing sector expansionManufacturing sector expansionManufacturing sector expansionManufacturing sector expansion

Purchasing Managers' Index

45

50

55

60

Ap

r-04

May

-04

Jun

-04

Jul-

04

Au

g-0

4

Sep

-04

Oct

-04

No

v-04

Dec

-04

Jan

-05

Feb

-05

Mar

-05

Ap

r-05

May

-05

Jun

-05

Jul-

05

Au

g-0

5

Sep

-05


Improving business conditions

Deteriorating business conditions


Above target M2 but no reaction Above target M2 but no reaction Above target M2 but no reaction Above target M2 but no reaction

China M2 growth and bank lending

0

5

10

15

20

25

30

35

Jan

-02

Ap

r-02

Jul-

02

Oct

-02

Jan

-03

Ap

r-03

Jul-

03

Oct

-03

Jan

-04

Ap

r-04

Jul-

04

Oct

-04

Jan

-05

Ap

r-05

Jul-

05

Bank Lending growth %YoY Bank Lending growth %QoQ sa 3mma

Source: CEIC

8

11

14

17

20

23

26

Jan

-99

Jul-

99

Jan

-00

Jul-

00

Jan

-01

Jul-

01

Jan

-02

Jul-

02

Jan

-03

Jul-

03

Jan

-04

Jul-

04

Jan

-05

Jul-

05

M2 growth %YoY M2 growth %QoQ sa 3mma

Source: CEIC


Import growth shows demand slowing Import growth shows demand slowing Import growth shows demand slowing Import growth shows demand slowing

China import growth

-20

0

20

40

60

80

Ja

n-9

3

Ja

n-9

4

Ja

n-9

5

Ja

n-9

6

Ja

n-9

7

Ja

n-9

8

Ja

n-9

9

Ja

n-0

0

Ja

n-0

1

Ja

n-0

2

Ja

n-0

3

Ja

n-0

4

Ja

n-0

5

(%YoY)


Mitigating forces Mitigating forces Mitigating forces Mitigating forces

A

B

a

b

c

China's growth cycle is hereA = 1998B = 2015a = 2001b = 2006/7c = 2008/9


Real GDP growth in the range 4-5% in 2007, maybe earlier

Deflation likely as credit contracts and asset markets fall

Global inflation pressures defused – commodity prices will fall temporarily

Banking sector recapitalisation will become a matter of urgency. Foreign investors will be welcomed

Profile of the downturnProfile of the downturnProfile of the downturnProfile of the downturn

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Jim Walker Chief Economist September 2005 And then there was none…

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