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November 22, 2010 china economics 2011: a year of reflation

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    November 22, 2010 china economics 2011: a year of reflation November 22, 2010 china economics 2011: a year of reflation Document Transcript

    • MORGAN STANLEY RESEARCH ASIA/PACIFIC Morgan Stanley Asia Limited Qing Wang Qing.Wang@morganstanley.com +852 2848 5220 Steven Zhang Steven.Zhang@morganstanley.com Ernest Ho Ernest.Ho@morganstanley.com November 22, 2010 China Economics 2011: A Year of Reflation China’s Super Cycle in A Globalized Economy Chinese economy in 2010 has featured a Goldilocks scenario, as a mix of normalized policy environment and a tepid G3 recovery has helped deliver relatively 2008: strong growth and modest inflation so far this year. 20011: “Imported Soft “A Year of Landing” However, the recent flaring in inflation suggests the Reflation” Goldilocks scenario is close to running its course. It will be a Year of Reflation for Chinese economy in Great 2011, as the post-crisis economic normalization and Recession in 2008-09 rebalancing carry on. Specifically, the lagged effect of massive monetary expansion in 2009-10 is expected to 2009: continue to provide strong tailwinds for inflation in the 2010: “Policy-driven Decoupling” near term, while the headwinds stemming from weak “Goldilocks Scenario” external demand are letting up. Beyond the near term, China’s economic rebalancing that features a shift in growth drivers from tradable to non-tradable sectors also points to a higher future secular inflation rate. We forecast 9.0% GDP growth and 4.5% CPI China: A Year of Reflation inflation for 2011, with consumption and investment envisaged to be equally important in terms of 15 12 contribution to growth. CPI inflation is expected to rise in Deviationof M1 from the trend (%, 2-quarter lead) CPI (%, rhs) 10 1H11 and peak at 5.5% YoY by mid year and then start 10 to decelerate to the tune of 4.0% YoY by year end. 8 5 6 Tackling inflation will be an overarching policy priority, especially in 1H11. The M2 growth target and 0 4 quota for new bank lending for 2011 will likely be set at 2 15% and Rmb7tn, respectively. And the monetary -5 tightening will be frontloaded. We expect three 25bps 0 interest rate hikes through mid year and maintain the -10 -2 target for US$/CNY rate at 6.20 by end-2011. -15 -4 Mar-97 Mar-98 Mar-99 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 The primary risk to this outlook stems from potential policy missteps. If Chinese authorities were to mainly rely on administrative controls over monetary aggregates instead of allowing price-based policy Source: CEIC, Morgan Stanley Research: instruments such as rate hikes and appreciation of the Renminbi to control inflation, the risk of policy-induced boom (in 2010) and bust (2011) cycle would be on the rise. Continued tepid recovery in G3 economies would make it easier to manage inflation pressures and reduces the policy risk. For important disclosures, refer to the Disclosures Section, located at the end of this report.
    • MORGAN STANLEY RESEARCH November 22, 2010 China Economics 2011: A Year of Reflation It has been a Goldilocks Scenario… We therefore are vigilant on any signs of developments A key thesis of our outlook for Chinese economy in 2010 is that that can help to determine whether the Goldilocks the macro economy will demonstrate a Goldilocks scenario scenario is on track or close to running its course. featuring relatively strong growth and modest inflation. We made the call on November 22, 2009, exactly one year from The global financial and economic crisis in 2008-09 should publication of this report (see China Economics: A Goldilocks be treated as part of the correction of global imbalances Scenario in '10, November 22, 2009). This call hinges on two forced upon the global economy by market forces. The key assumptions: a) a tepid G3 recovery; which provides crisis also serves a catalyst for a more profound global headwinds for inflation; and b) normalization of rebalancing for years to come, in our view. macroeconomic policy stance, which underpins robust domestic demand. Exchange rate adjustment is bound to be part of the solution to addressing global imbalances. Chinese With the benefit of hindsight, we think that Chinese economy Renminbi exchange rate must appreciate in real terms. has indeed demonstrated a Goldilocks scenario, with the Barring adequate nominal appreciation of the Renminbi, average year-to-date GDP growth of 10.6%yoy and CPI inflation will sooner or later emerge in a meaningful way in inflation of 3%yoy. Specifically, the rather benign inflation print China, in our view. squarely contradicts the prediction by some market commentators of an overheating economy in general and a In this context, we take any signs of meaningful inflation surge in inflation in particular in 2010, a concern that escalated seriously. The latest developments on this front lead us to to its highest level upon release of the data pack for 1Q10. believe the Goldilocks scenario is close to running its Moreover, the robust growth has also suggested that the fear course and, going forward, the economy will likely start of a potential hard landing of the economy, which intensified embarking on a more profound rebalancing, with greatly in early 2Q10 when Chinese authorities launched structurally higher inflation featured prominently in this austere measures against property speculation, has been process. indeed unwarranted. A Year of Reflation in 2011: The Cyclical Conditions …Which Is Close to Running Its Course The cyclical conditions of the economy suggest that it will likely The recent flaring in inflation suggests the Goldilocks scenario be a year of reflation in 2011. is close to running its course, in our view. The tailwinds for inflation stemming from the To be sure, we do no think that Goldilocks is a new norm extraordinarily strong monetary expansion in 2009, as for the Chinese economy in the first place, but rather a shown in the surge in M1 growth from 9%YoY in Dec 2008 special macro scenario under a particular circumstance: to 32%YoY in Dec 2009, which, however, did not result in the immediate aftermath of the great recession in 2008-09. significant inflation (Exhibit 1). Goldilocks is therefore best suited to describe a transitional instead of permanent state of the economy. This is in part because the post-crisis tepid recovery in G3 economies has indeed constituted strong headwinds for China’s inflation, despite the tail winds from the strong monetary expansion in 2009. This is highlighted in the To be sure, we do not think that Goldilocks is a new huge swing in China’s export growth rates from +23%YoY norm for Chinese economy…but rather a special in 3Q08 to -23%YoY in 2Q09 (Exhibit 1). macro scenario under a particular circumstance: the The development in 2010 was that the M1 growth slowed immediate aftermath of great recession in 2008-09 on the back of strong growth in 2009, while export growth rebounded sharply (Exhibit 1). However, the former did not appear to have any dampening impact on headline CPI, the latter did not appear to have any boosting impact on headline CPI either. 2
    • MORGAN STANLEY RESEARCH November 22, 2010 China Economics This is because despite the deceleration in M1 growth in relationships—which are based on the YoY changes of 2010, M1 is still well above its long-term trend growth key variables—unstable. In this light and looking ahead, (Exhibit 2). In the same vein but opposite situation, despite both monetary and export factors continue to work toward strong rebound in export growth in 2010, exports are only adding to inflationary pressures (Exhibit 2). about to close the negative gap with its long-term trend. In 2011, the lag effect of expansionary monetary Exhibit 1 expansion in 2009-10 is expected to continue to constitute China: Benign Inflation in 2010 strong tailwinds for inflation, while headwinds stemming from external demand are receding (Exhibit 2). Inflation has been benign, despite tailwinds from extraordinarily strong monetary expansion… Exhibit 2 12 36 China: Inflation to Accelerate in 2011 CPI (%YoY) 33 9 30 Until monetary growth starts to return to its long-term trend, M1 (%YoY, 2Q-lead, rhs) inflationary pressures are likely to persist… 27 6 24 15 12 Deviationof M1 from the trend 21 (%, 2-quarter lead) 10 10 CPI (%, rhs) 3 18 8 15 5 0 12 6 9 0 4 -3 6 2 Mar-97 Dec-97 Sep-98 Jun-99 Mar-00 Dec-00 Sep-01 Jun-02 Mar-03 Dec-03 Sep-04 Jun-05 Mar-06 Dec-06 Sep-07 Jun-08 Mar-09 Dec-09 Sep-10 Jun-11 Mar-12 -5 0 -10 -2 …reflecting strong headwinds from a tepid G3 recovery. -15 -4 12 70 Mar-97 Mar-98 Mar-99 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 CPI, %YoY 10 56 Exports (%YoY, rhs) 8 …especially when headwinds from external demand start to 42 6 become less strong. 28 30 12 4 14 Deviationof Export from the trend (%) 10 2 20 CPI (%, rhs) 0 8 0 10 -14 6 -2 External Shocks 0 4 -4 -28 Jun-00 Jun-03 Jun-06 Jun-09 Mar-98 Dec-98 Sep-99 Mar-01 Dec-01 Sep-02 Mar-04 Dec-04 Sep-05 Mar-07 Dec-07 Sep-08 Mar-10 Dec-10 Sep-11 2 -10 0 -20 Source: CEIC, Morgan Stanley Research -2 -30 -4 In year 2011 that features normalization, a more suitable Mar-97 Mar-98 Mar-99 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 approach to gauge inflationary pressures is to examine how monetary aggregates and exports deviate from and converge to their long-term trends. This is because the Source: CEIC, Morgan Stanley Research wild and large swings of key macro variables during the crisis (i.e., 2H08-09) and in its immediate aftermath (i.e., 2010) have rendered the original functional 3
    • MORGAN STANLEY RESEARCH November 22, 2010 China Economics A Year of Reflation in 2011: The Secular Forces In terms of secular trend, the Chinese economy is now at an The potential reflation in 2011 reflects not only post crisis inflection point similar to that of the Japanese economy 40 normalization in terms of cyclical conditions but also medium- years ago and the Korean economy 20 years ago, in our view and long-term structural rebalancing of Chinese economy. (Exhibit 3). After this inflection point is crossed and if history is a guide, the overall GDP growth tends to decelerate and inflation China’s economic rebalancing that features a shift in growth to accelerate (see China Economics: Chinese Economy drivers from tradable to non-tradable sectors would lead to through 2020: Not Whether but How Growth Will Decelerate, slower overall productivity growth and thus a higher future September 20, 2010). secular inflation, in our view. From the historical perspective, the reflation that we envisage First, in general, productivity growth in non-tradable sectors to happen in 2011 should be viewed as part of secular trend of (e.g., lodging, dining) tends to be slower than tradable sectors rising inflation that started as early as 2007. And with the (e.g., IT). Second, it takes time and great effort to adapt benefit of hindsight, this secular trend appears to have been production factors (e.g., labor) that are suitable for tradable temporarily disrupted by the Great Recession in 2008-09 but sector activity to the need of non-tradable sectors. In this will likely be reasserting itself in 2011 and beyond. transition, productivity growth tends to slow, creating upward pressures on inflation. Exhibit 3 … the reflation that we envisage to happen in 2011 Chinese Economy at an Inflection Point should be viewed as part of secular trend of rising inflation that started as early as 2007 15 GDP Growth China (2007) 12 Korea (1988) A Year of Reflation in 2011: The Political Economy Factor Japan (1969) In gauging China’s economic outlook for 2011, one must not 9 lose sight of the big picture of political economy in China, in our view. The political cycle in China points to, ceteris paribus, 6 upside risk to fixed asset investment (FAI) growth over the next couple of years, adding to reflationary pressures. And China’s economic growth cycle has been largely dictated by the FAI %, 3-yr MA 3 cycle. Oil crisis Asia financial crisis 0 China’s FAI cycle tends to be influenced by China’s political T-20 T-15 T-10 T-5 T T+5 T+10 T+15 T+20 T+25 T+30 cycle, as FAI tends to accelerate in the run to change of government (Exhibit 4). Experiences since early 1990s 25 suggest that China’s investment cycle tends to coincide with %, 3-yr MA CPI Inflation Oil crisis China (2007) the cycle of change of governments – at both central and local 20 Japan (1969) levels – which takes place very five years. If this pattern 15 Korea (1988) persists, FAI growth in China appears poised to enter an upturn phase in the next two years through early 2013, when the next 10 change of government is due to take place. 5 Another pattern in this regard is that FAI growth tends not show meaningful slowdown in the first year of a new five-year plan, 0 because many new projects that are planned and approved by the relevant authorities are expected to kick off in the first year -5 of the implementation of the 5-year plan. Year 2011 would be T-20 T-15 T-10 T-5 T T+5 T+10 T+15 T+20 T+25 T+30 the first year of the 12th 5-year plan. Source: CEIC, Morgan Stanley Research. 4
    • MORGAN STANLEY RESEARCH November 22, 2010 China Economics Exhibit 4 By helping stabilize expectations of property price inflation China: Political Cycle-driven FAI Cycle and improve housing affordability, the ambitious social housing program represents a large scale transfer of 50 % Year of change of government wealth from the public to house sector, greatly helping 45 Beginning Year of A New 5-yr Plan Impact of boost the latter’s purchasing power, in our view. Real FAI Growth Great Recession 40 The sustained strong consumption growth in 2011 will 35 prove to be part of a secular consumption boom over the 30 medium- and long-run in China, in our view (see China 25 Economics: Chinese Economy through 2020 (Part 3): A Golden Age for Consumption, October 31, 2010) 20 15 Exhibit 5 China: Forecasts of Key Macroeconomic Indicators 10 5 2008 2009 2010E 2011E Growth Rate (YoY, %) 0 GDP 9.6 9.1 10.2 9.0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Consumption 8.6 8.4 9.8 10.0 GCF 11.0 20.5 12.0 10.0 Source: CEIC, Morgan Stanley. Mining 15.4 7.7 7.3 6.0 Manufacturing 14.8 16.7 13.1 15.0 Real estate 8.3 13.2 21.0 16.0 Infrastructure 8.6 30.5 7.3 2.7 Other 11.6 26.5 5.0 3.6 The political cycle in China points to, ceteris Net exports (Cont, ppt) 0.8 -3.7 -0.2 -0.6 paribus, upside risk to fixed asset investment (FAI) Contribution to growth (ppt) GDP 9.6 9.1 10.2 9.0 growth over the next couple of years, adding to Consumption 4.2 4.1 4.7 4.8 reflationary pressures. GCF 4.6 8.7 5.6 4.7 Mining 0.3 0.2 0.1 0.1 Manufacturing 1.9 2.2 1.9 2.2 Real estate 0.9 1.4 2.3 1.9 Forecasts: Growth Outlook Infrastructure 1.1 4.0 1.1 0.4 We forecast 9.0% GDP growth and 4.5% CPI inflation for 2011, Other 0.4 1.0 0.2 0.1 with consumption and investment envisaged to be equally Net exports 0.8 -3.7 -0.2 -0.6 important in terms of contribution to growth. Forecasts of a full set of macro indicators including FAI, retail sales, IP and so on Exports (%, US$) 17.3 -15.9 29.5 15.0 Imports (%, US$) 18.4 -11.3 36.0 18.0 can be found in Exhibit 13. Trade balance (in US$bn) 297 198 191 179 % of GDP 6.5 3.9 3.2 2.4 First, consumption is expected to register modest CPI (%) 5.9 -0.7 3.2 4.5 acceleration: Source: CEIC, Morgan Stanley Research. We forecast consumption growth to accelerate from 9.8% Second, investment growth is expected to register only in 2010 to 10% in 2011, reflecting sustained strong income modest deceleration in 2011, in part reflecting the political growth as a result of a tight labor market (Exhibit 5). economy factor (Exhibit 4). More specifically, Consumer confidence will likely remain buoyant, aided in We forecast a moderation in investment growth from 12% part by a favorable policy environment that features an in 2010 to 10% in 2011. The deceleration primarily reflects ambitious social housing program (see below for Special slowdown in infrastructure investment, as the massive Topic I: Even Stronger Push for Social Housing Program). spending program launched as anti-crisis policy package in 2009-10 runs its course in 2011. 5
    • MORGAN STANLEY RESEARCH November 22, 2010 China Economics While real estate investment is also expected to China’s export growth in 2011 will continue to outperform decelerate from 21% in 2010 to 16% in 2011, the global trade, as China’s external competitiveness remains slowdown will unlikely be as deep as the heavy-handed strong, which allows Chinese exporters to continue to gain austere policy measures against property speculation their market shares in both DM and EM economies. would suggest, in our view. This is because a substantial acceleration of construction of social housing should be A mid-teen export growth for China is sustainable over the able to provide an adequate cushion for the downside, in next 2-3 years, unless there is a substantial appreciation our view (see below for Special Topic I: Even Stronger of the Renminbi exchange rate in a short period of time or Push for Social Housing Program). a sudden jump in labor costs. The impact of slowdown in real estate investment can be Import growth will likely continue to outpace export growth, largely offset by acceleration in manufacturing investment a pattern established since 2008, given still resilience in 2011, in our view. Indeed, potential pickup in investment domestic demand. However, since the import component in manufacturing sector will likely be one of the most of exports is large, the gap in the growth between exports interesting developments in 2011, in our view. Three and imports will likely remain modest such that trade considerations underpin this rather optimistic outlook for surplus will be broadly stable in absolute terms and narrow manufacturing investment: a) the industrial capacity gradually in percent of GDP. utilization has already recovered back to pre-crisis peak level; b) a key finding of a proprietary survey conducted Fourth, the quarterly growth trajectory will be characterized recently by Morgan Stanley China AlphaWise Evidence by moderation in 1H, stabilization in 3Q11, and acceleration in team is that ‘private capex growth is likely to halt its 4Q11 (Exhibit 6). deceleration and approach an inflection point’ (see AlphaWise Evidence Series: China Macro: Private Capex We envisage that the seasonally-adjusted QoQ Is Likely to Accelerate, November 8, 2010); and c) the annualized sequential GDP growth will accelerate further financing conditions facing investors in manufacturing to 10.4% in 4Q10 (from 9.8% in 3Q10) but start to sector will likely improve in 2011, as the crowding-out moderate in 1Q11 and reach a trough rate of around 8.0% effect stemming from massive public investment in in 2Q11, as the effect of anti-inflation policy tightening 2009-10 is expected to diminish. kicks in (to be discussed below). Exhibit 6 China: Quarterly Trajectory of GDP Growth Potential pickup in investment in manufacturing sector 20 20 will likely be one of the most interesting developments in 2011 15 15 10 10 Third, both export and import growth is expected to decline significantly to a more sustainable level in 2011 after a sharp rebound in 2010: 5 5 R a G P (Y Y % el D o, ) Proj. The performance of G3 economies in 2010 will likely R a G P (Q Q % S A ) el D o , , AR continue to be best characterized as a ‘BBB recovery’, a 0 0 long-standing made call by Morgan Stanley global M 3 Se -0 M 4 Se -0 M 5 Se -0 M 6 Se -0 M 7 Se -0 M 8 Se -0 M 9 Se -0 M 0 Se -1 M 1 Se -1 ar-0 ar-0 ar-0 ar-0 ar-0 ar-0 ar-0 ar-1 ar-1 p 3 p 4 p 5 p 6 p 7 p 8 p 9 p 0 p 1 economics team co-headed by Richard Berner and Fels Joachim, namely ‘recovery in domestic demand remains bumpy, the rate of expansion below par, and the domestic Source: CEIC, Morgan Stanley Research demand recovery brittle (see Global Forecast Snapshots 2010 Outlook: from Exit to Exit, December 9, 2009). We envisage that the sequential growth rate will bottom out in 3Q11 and pick up again in 4Q11 to around 9.5%, as 6
    • MORGAN STANLEY RESEARCH November 22, 2010 China Economics inflation peaks by mid year, when a shift toward a neutral Exhibit 7 policy stance would be warranted, in our view. China: CPI Inflation Forecasts 25 This will translate into a sustained moderation in the YoY CPI YoY, % GDP growth through 2011 from 9.6% in 3Q10 to 8.7% in 20 Non-food CPI 4Q11 such that the average GDP growth for the year will Food CPI Proj. be 9.0%. 15 10 Forecasts: Inflation Outlook Inflation is ultimately a monetary phenomenon. Inflation in 5 China is no exception, in our view. Even when inflation 0 pressures tend to initially stem from and concentrate in food price increase as is often the case in China, food price increase -5 is more likely symptomatic of demand pressures than due to Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 supply shocks, in our view (see below for Special Topic II: Why Food Price-driven Inflation May Not Be Due To Supply Shock). 170 160 CPI Price Level (Jan 2005=100) Non-food CPI …food price increase is more likely symptomatic of 150 Food CPI 140 Proj demand pressures than due to supply shocks 130 120 We expect that the recent policy shift toward tackling 110 inflationary pressures will bring about a further deceleration in 100 M1 growth to high teens such that the positive gap between M1 90 growth and its long-term trend start to narrow in 2011 (Exhibit 1 80 & 2). This would suggest that the tailwinds for inflation would Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 start to let up by mid-year 2011, as there is roughly two-quarter lag between the change in M1 and its impact on CPI inflation. Source: CEIC, Morgan Stanley Research. We forecast that CPI inflation will rise in 1H11 and peak at 5.5%YoY by mid year and then start to decelerate to the tune of Exhibit 8 4.0%YoY by year end (Exhibit 7). Besides the evolution of China’s Inflation: The Carry-over Effect in 2011 carry-over effect (Exhibit 8), forecast of such a trajectory of inflation also hinges on three key assumptions: 7 New Price Increase 6 %YoY Carryover Effect 1) Monetary tightening that is being initiated at the current juncture will effectively moderate the sequential growth 5 momentum for CPI in 2H11, a situation similar to the inflation episode during 2006-08 (Exhibit 9). 4 3 2) Average 15% increase of pork prices in 2011 according to the forecast made by our colleague Lillian Lou, Morgan 2 Stanley Agriculture and Food Industries analyst. 1 3) Average $100 per barrel crude oil prices in 2011, or some 0 Jun-11 Jul-11 Nov-11 Jan-11 May-11 Aug-11 Dec-11 Feb-11 Apr-11 Oct-11 Sep-11 Mar-11 over 20% increase from the level in 2010, according to the forecasts made by our colleague Hussein Allidina, Morgan Stanley Lead Commodity Analyst (see The Commodity Call: Crude Oil To $90/bbl and Higher, November 5, 2010). Source: CEIC, Morgan Stanley Research. 7
    • MORGAN STANLEY RESEARCH November 22, 2010 China Economics Exhibit 9 data pack, in our view (Exhibit 6). At the same time, we believe China: A Tale of Two Episodes of Inflation that the authorities also recognize the implications of structural rebalancing of the economy to secular inflation, which would 3 3 Actual call for tolerance of relatively high inflation going forward. CPI (MoM, %) 2 2006-08 2 We therefore believe the policy objective at the current juncture 2009-11 (rhs) is to prevent an overshoot of inflation beyond a reasonable Forecast 1 1 level that is consistent with the need to accommodate for structural rebalancing. To this end, we expect: a) a change in characterization of monetary policy stance from “appropriately 0 0 loose’ in 2010 to “prudent” in 2011; and b) the target average CPI inflation rate will be at 4% for 2011, higher than the target -1 -1 of 3% for 2010. Onset of Great Recession We expect monetary policy tightening will be front-loaded. -2 -2 Inflation is a monetary phenomenon, and in some sense, Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov tackling inflation is all about managing expectations. Of note, Source: CEIC, Morgan Stanley Research. inflation expectations could become self-fulfilling more easily in China, because there has been an overhang of money in the Policy Outlook: Front-loaded Policy Tightening system, due in part to massive cumulative monetary expansion Tackling inflation has become Chinese authorities’ overarching in 2009-10. Inflation expectations tend to lead to increase in policy priority. Of note, the current inflation situation is broadly velocity of money and therefore effective money supply. similar to late 2007/1H08, in our view. However, compared to late 2007/1H08, there are several key differences in terms of initial conditions: …it is possible that the authorities would While in late 2007/1H08 there was a surge in global soft deliberately announce a rather low quota for new and hard commodity prices, this is not yet the case at bank lending…and/or a low M2 growth target…with present. a view to crushing inflation expectations… While in late 2007/1H08 there was considerable concern about economic overheating and asset price bubble, this is not the case at present, especially in view of the muted We therefore expect China’s anti-inflation monetary policy property transactions after austerity measures were would be front-loaded. Specifically, we make the following calls imposed. on monetary policy: While in late 2007/1H08, there was a major supply shock The M2 growth target and quota for new bank lending for (i.e., blue ear disease that killed a large portion of the hog 2011 will likely be15% and Rmb7tn, respectively. population); the supply shock, if any, is mainly related to vegetables this time around. Three 25bps base interest rate hikes through mid year. The possibility of asymmetric rate hikes will increase after However, there is currently a large overhang of money in the first 1-2 hikes, in our view. the system as a result of massive cumulative monetary expansion over 2009-10. It was not the case back in late Multiple RRR hikes to help liquidity management and 2007 and 1H08. achieve the target for new bank lending. The exact number of RRR hikes hinges on the excess liquidity It is the last point that makes Chinese authorities conditions which are influenced by China’s balance of uncomfortable with the current situation and explains why they payment situation (e.g., trade surpluses, .capital inflows). have taken action rather decisively, as soon as the downside risk to growth outlook diminishes, as indicated by the 3Q10 8
    • MORGAN STANLEY RESEARCH November 22, 2010 China Economics We maintain the target for US$/CNY rate at 6.20 by end Natural resource tax is expected to be implemented, but 2011, but consider the risk to this forecast is tilted to the the exact timing appears to be complicated once again by downside (more discussion below). the current policy priority of controlling inflation. To achieve the effect of front-loading policy, it is possible that Value-added tax will likely be implemented in the service the authorities would deliberately announce a rather low quota sector to replace the current transaction-based tax for new bank lending (e.g., around Rmb6tn or below) and/or a categories, which is the usual practice in this sector. This low M2 growth target (e.g. 14% or below) with a view to change should have the effect of boosting investment in crushing inflation expectations early on, despite that these service sector. The initial implementation will likely start targets may sound too low to be realistic/credible from the with services that have more direct link to manufacturing perspective of maintaining a “sound and fast” growth, which is production (e.g., transportation). the official party line objective. Alternatively, authorities may choose not to announce a concrete target for new bank lending at all but instead talk The absolute amount of fiscal deficit will likely be hawkish to generate fear of aggressive tightening. The purpose broadly stable at the same level in 2010, but some is to scare the market so that the excess liquidity will return modest cut likely related to central governments- back to the banking system. Put differently, to force the "tiger back into its cage", because the overhang of money has been sponsored infrastructure projects. traditionally treated as "a tiger in the cage" which is dangerous but under control. The minimum threshold of personal income tax will likely Besides monetary policy measures, the authorities will take be raised, while the margin tax rate for high-income some additional actions to manage inflation expectations, brackets will likely be raised. These potential policy some of which have already been announced, including: measures are believed to help address income inequality. Direct control over the prices of items that have direct Special real estate tax will be implemented in a small impact on the headline CPI, which was announced last number of cities on residential property that meet certain week and similar to the practice in late 2007/1H08. criteria, as a means to curb property speculation. Further tightening controls over FX inflows, including the With regards to Renminbi exchange rate policy, we expect introduction of a special tax on short-term capital inflows, the following to take place over the course of 2011: also known as a "Tobin tax," as Brazil did. This should help ease the liquidity pressures. At some point and likely in the early part of the year, Chinese authorities may start to publish the nominal Deregulation of controls overseas direct investment (ODI) effective exchange rate (NEER) index for Renminbi, which by Chinese companies, as a means to induce capital will likely represent the beginning of adopting Renminbi outflows, which also help ease domestic liquidity NEER as the operating target instead of the current pressures. practice of using US$/CNY as the operating target for exchange rate policy. The authorities may start to target an On fiscal policy front, the official characterization of fiscal appreciation path of the NEER instead of US$/CNY rate. stance will likely remain unchanged as “proactive fiscal policy”. And we expect the following potential policy moves: While Renminbi appreciation against US$ will remain broadly gradual, we expect its pace will accelerate— The absolute amount of fiscal deficit will likely be broadly especially during 1H11—compared to that in 2H10, as stable at the same level in 2010, but some modest cut warranted by the need to contain inflationary pressures likely related to central governments-sponsored stemming from rising international prices of key infrastructure projects. The overall fiscal deficit in terms of commodities. GDP will likely be 2.5-2.8% for 2011. In the months immediately ahead, there could be another round of relatively fast Renminbi appreciation against the 9
    • MORGAN STANLEY RESEARCH November 22, 2010 China Economics US$ in the run-up to the state visit by Chinese President condition for the economy, even tighter than that in the Hu Jintao to the USA that is reportedly scheduled to take 1H08 during which period the overall credit expanded by place in mid January 2011. 14%YoY. Under this scenario, we expect a sharp slowdown in FAI growth that would result in 7.5% GDP Risks: Potential Policy Missteps growth and 3.5% CPI inflation, or an effective hard landing The primary risk to this outlook stems primarily from potential of the economy. policy missteps. If Chinese authorities were to mainly rely on administrative controls over monetary aggregates instead of Under the bull case, to which we assign 10% probability, allowing price-based policy instruments such as rate hikes and we envisage no meaningful policy tightening in that the appreciation of the Renminbi to control inflation, the risk of new bank lending quota is assumed to be set at Rmb8tn in policy-induced boom (in 2010) and bust (2011) cycle would be 2011, higher than the Rmb7.5tn target in 2010. This on the rise. Although direct credit controls has been seemingly implies about 17% growth of the outstanding amount of quite effective in controlling inflation in the short run, they are loan in 2011, down only slightly from 18-19% in 2010. also very blunt and tend to inflict substantial damage to the real Under this scenario, the economy will likely demonstrate economy and market sentiment. high growth (10.5%) and high inflation (5.5%), or an effective overheating scenario. We construct two illustrative alternative scenarios to highlight only the policy risks, both downside and upside, to our base Besides policy risks, potential developments in G3 economies case scenario. also represent important risks. Exhibit 10 If the recovery in G3 economies were to be even weaker China: Illustrative Alternative Scenarios than expected, it would provide sufficiently strong 2010E 2011E headwinds for China’s inflation and thus make it easier for Base Bull Bear Chinese authorities to manage inflation pressures, Subjective probability (%) 70 10 20 reducing the risk of policy missteps that could result in a hard landing of the economy. Real GDP growth (%) 10.2 9.0 10.5 7.5 Consumption 9.9 10.0 11.4 8.3 If the recovery in G3 economies were to be much stronger GCF 12.0 10.0 12.6 7.3 than expected, it would definitely add to inflationary Net Exports -0.2 -0.6 -1.0 0 pressures in China. Under this scenario, while China’s Contribution to Grwoth (ppt) policy tightening may be appropriately aggressive and Consumption 4.8 4.8 5.5 4.0 contribute to a substantial slowdown of FAI, the overall GCF 5.6 4.7 6.0 3.5 economic activity may prove to be resilient, as strong Net Exports -0.2 -0.6 -1.0 0.0 exports would provide an important offset to the policy tightening effect. CPI (%) 3.2 4.5 5.5 3.5 While there are of course other idiosyncratic risks that could Trade balance (in US$bn) 191 179 152 220 destabilize the economy, we choose not to address them in this Exports (%, US$) 30 15 15 15 note but instead delegate the relevant discussion to our regular Imports (%, US$) 36 18 20 15 publication China Macro Risk Radar (see China Economics: Source: Morgan Stanley Research China Macro Risk Radar, October 18, 2010) Investment Implications: Do Not Fight the State Council Under the bear case to which we assign 20% probability, The experiences since 2008 teach many of us one useful we envisage that the policy tightening will be rather lesson: do not fight the State Council! It is by now clear that the draconian in that the new bank lending quota is assumed State Council has made controlling inflation a top policy priority, to be set at Rmb6tn in 2011, down substantially from in which case there typically is a concerted effort by all relevant Rmb7.5tn in 2010. This implies less than 13% growth of government agencies to address the same problem the outstanding amount of loan in 2011, down markedly simultaneously. The risk of compound policy effects and thus from 18-19% in 2010. If this target amount of new loan overreaction is not trivial, in our view. were to be executed, it would indicate a very tight credit 10
    • MORGAN STANLEY RESEARCH November 22, 2010 China Economics While we are of the view that macroeconomic and policy through 2020 (Part 3): A Golden Age for Consumption, dated uncertainties will eventually diminish especially in 2H11, the October 31, 2010), the aggressive social housing program is potential macroeconomic policy environment calls for one of the integral parts of this “mechanism” that help reduce exercising great caution for market participants over the next precautionary savings, especially for low-income households. 3-6 months, in our view. That said, we believe China’s inflation A declining household saving ratio would in turn boost risk is still quite manageable, and the early and resolute policy consumption growth. responses by the authorities so far suggest that the situation will be more likely than not turn out to be rather benign beyond The successful implementation of the social housing program, the next 3-6 months, in our view. in particular, the focus on public rental housing, would not only break this cycle of inter-generational precautionary savings for Special Topic I: property acquisitions, but also indirectly facilitate wealth Strong Push for Social Housing Program in 2011 redistribution – the high land premium, which originally would have ended up as government revenue and would flow through Review: Sticking with Our (Once) Out-of-Consensus Call to high property prices borne by the household sector, is now We had been optimistic about the social housing program ever retained in the household’s pocket. since it began in earnest in April earlier this year. It certainly was an out-of-consensus call at the time. In particular, we The implication is immense, as it helps lower precautionary dismiss simplistic comparison with its lackluster track record, savings, unleash the consumption power of the low- to but instead resort to robust analyses of construction activities, middle-income household and in turn contribute positively to political will and financing incentives which helped us reach the the transition from the investment- and export-led to conclusion that the aggressive social housing program would consumption-driven growth model. not only help offset a potential slowdown in market-based residential property construction, but also contribute to a soft Looking Ahead: Building 15 million units in the next 2 landing in overall fixed asset investment (FAI) growth. (see years China Economics: Social Housing: Lackluster Growth or We had originally expected social housing construction to be 5 Quantum Jump? dated August 12, 2010 and China to 6 million units for the next two years, allowing MoHURD to Economics: Can Social Housing Program Help Secure a Soft deliver its pledge to “solve the housing problem for 15.4 million Landing? dated June 17, 2010). With Urban FAI growing at an low-income households by end of 2012”. However, the latest astonishing rate of 24.5% YoY YTD, we can rest assured that information we managed to collect suggest that the strong the fear of a hard landing in FAI was indeed unwarranted. momentum in construction activities will very likely continue and strengthen heading into year 2011. Specifically, the Robust Progress: It Is For Real This Time Around potential plan is to build 6.8 million and 6.2 million units for year By end of September 2010, 5.2 million units, or 90% of the 2011 and 2012, respectively. Taking into account the 2.3 annual target of 5.8 million units of social housing construction million units brought forward from year 2010 (given 60% had been started, with at least 60% to be basically completed completion of the 5.8 million units construction target as guided by the end of this year. On the funding side, the Rmb79.2 billion by government officials), for year 2011 alone the construction central government subsidies had all been disbursed. More volume could add up to 9.1 million units, equivalent to about than Rmb470 billion (vs. our estimate of Rmb370 billion) had 491 million sqm, compared to the total residential floor space already been invested. In addition, more supportive measures completed of 821 million in year 2009 (Exhibit 11). are in the pipeline, including tax breaks and exemption of social housing construction projects from Local Government Exhibit 11 Financing Platform (LGFP) “clean-up” campaign. Aggressive Construction Targets 2011 2012 Floor Floor avg. # of units Space # of units Space More importantly, the social housing program is sqm (mn) (sqm, mn) (mn) (sqm, mn) imperative to the pressing needs for economic Non-Commodity 7.3 365 5.0 250 rebalancing: In the 12th Five Year Plan, the Chinese Public Rental 50 5.5 275 3.8 190 Low-Rent Housing 50 1.8 90 1.2 60 government is committed to rebalance the economy by Commodity - Economic Housing 70 1.8 126 1.2 84 establishing a “sustainable mechanism” to boost consumption TOTAL 9.1 491 6.2 334 in order to achieve balanced growth drivers between Source: Morgan Stanley Research consumption, investment and exports. In this context, as we argue in one of our recent report (see Chinese Economy 11
    • MORGAN STANLEY RESEARCH November 22, 2010 China Economics It is worth noting that this is an upward revision to the original Exhibit 12 plan to “solve the housing problem for 15.4 million low-income Pricing of Clothing vs. Pricing of Food households by end of 2012”, with the new target is to build a total of 18.8 million units (5.8 + 6.8 + 6.2 million units) by end of 2012. We believe that it will be instrumental in cushioning the potential slowdown in the commodity residential building construction activities. Special Topic II: Why Food Price-driven Inflation May Not Be Due To Supply Shock? The headline CPI inflation jumped to 4.4% on the back of escalated food inflation (10.1% YoY) in October 2010. The heightened food inflation is symptomatic of general demand-side pressure instead of being due to supply-side shocks, in our view. This argument can be illustrated with a simple example. Assume that Country A only consumes two kinds of goods, food and clothing, each accounting for a 50% weight in the consumption basket. Moreover, Country A has a large pool of surplus labor and tends to overinvest in the clothing-producing industry, so that it always produces more clothing than it can consume and thus exports the rest. In this context, firms in the clothing-producing Source: Morgan Stanley Research industry have little pricing power. Based on the above analysis, food items are the most sensitive If Country A’s policy authorities run a loose monetary policy to to change in underlying monetary conditions among the CPI stimulate domestic demand, the resulting inflationary basket components, in our view. In other words, inflationary pressures will manifest first and foremost in the increase in pressure stemming from loose monetary conditions tends to be food prices rather than in clothing prices. In a demand-supply reflected in food price inflation first. In China’s context, framework, because the supply curve for clothing shifts to the attributing food inflation merely to supply-side factors – as is right (driven by overinvestment) much more readily than that the usual case in many other countries – tends to for clothing, the price increase in response to a positive underestimate the inflationary consequences of loose demand shock would be much more pronounced in food than monetary policy. in clothing. 12
    • MORGAN STANLEY RESEARCH November 22, 2010 China Economics Exhibit 13 China: Summery of Key Macroeconomic Indicators 2005 2006 2007 2008 2009 2010(F) 2011(F) GDP (Normial, RMB, bn) 18,713 22,224 26,583 31,490 34,502 39,988 46,115 Real GDP Growth (%) 11.3 12.7 14.2 9.6 9.1 10.2 9.0 Consumption 8.1 9.8 11.1 8.6 8.4 9.8 10.0 GCF 10.6 13.5 14.6 11.0 20.5 12.0 10.0 Contribution to Growth (ppt) Consumption 4.3 5.1 5.6 4.2 4.1 4.7 4.8 GCF 4.4 5.6 6.1 4.6 8.7 5.6 4.7 Net Exports 2.6 2.0 2.5 0.8 -3.7 -0.2 -0.6 Nominal GDP Growth (%) GDP 16.4 18.8 19.6 18.5 9.6 15.9 15.3 Consumption 13.1 13.7 16.8 15.8 8.7 14.8 15.6 GCF 12.6 19.4 19.4 24.7 18.9 18.7 16.7 Contribution to Growth (ppt) GDP 16.4 18.8 19.6 18.5 9.6 15.9 15.3 Consumption 7.2 7.3 8.5 7.8 4.2 7.1 7.4 GCF 5.4 8.1 8.1 10.3 8.3 8.9 8.2 Net Exports 3.8 3.4 3.0 0.3 -2.9 -0.1 -0.3 Structure of Economy (%) GDP 100 100 100 100 100 100 100 Consumption 52.9 50.7 49.5 48.4 48.0 47.5 47.6 GCF 41.6 41.8 41.7 43.9 47.7 48.8 49.4 Net Exports 5.5 7.5 8.8 7.7 4.4 3.7 2.9 Current Account as % of GDP 7.0 9.1 10.6 9.6 5.9 4.6 3.6 Key Pricing Data (YoY, %) CPI 1.8 1.5 4.8 5.9 -0.7 3.2 4.5 PPI 4.9 3.0 3.1 6.9 -5.4 5.5 6.0 GDP Deflator 4.6 5.4 4.7 8.1 0.4 5.2 5.8 Key Economic Activity Data (%) Industrial Production 16.4 16.6 18.0 12.6 11.6 15.5 13.0 Fixed Asset Investments 28.1 24.5 25.6 26.2 31.0 24.0 20.0 Retail Sales 12.9 13.7 16.8 21.6 15.5 18.2 19.0 Exports 28.4 27.2 25.7 17.3 -15.9 29.5 15.0 Imports 17.7 19.9 20.8 18.4 -11.3 36.0 18.0 Trade Balance (USD bn) 102 178 262 297 198 191 179 Key Policy Variables %) Policy Interest Rate 5.58 6.12 7.47 5.31 5.31 5.56 6.31 USD/CNY Exchange Rate (eop) 8.19 7.97 7.60 6.95 6.83 6.60 6.20 Source: Morgan Stanley Research 13
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