1. Daily Note
March 30, 2012
China’s “hard landing” to force Beijing’s hand
We suggest: Temporary +ve for A-shares; -ve for commodities
ve
China’s economy has plunged into a cyclical “hard landing”. But policymakers have taken
policymakers
their eye off the ball amid intense jockeying for positions in the run up to the leadership
change. Both those in favour of slower growth and those in favour of delaying the adjustment
are likely to be surprised by the extent of the downturn. Expect policy easing soon, but the
economic and asset price outcomes will be very different to those after the 2009 stimulus.
Economic and political forces have combined to put China in an extremely precarious
position. But while the economic story has become clearer, the politic have turned murkier.
politics
Ultimately the economics should trump the politics. The unexpected severity of the economic
downturn is likely to unsettle even those among Chinese policymakers that are vying for
Chinese
accepting slower growth and ensuring China adjusts sooner rather than later. A knee
knee-jerk
policy reaction is likely soon.
China has already plunged into a sharp cyclical downturn. The official data placed Q4 real
as
GDP growth at 2% qoq. Our own estimate, using official data, also originally showed a 2%
increase. But given the pronounced weakness in most other indictors, it seemed suspect,
leading us to conclude that growth is likely to have been already well below trend in Q4. Data
revisions since then have confirmed that we were on the right track.
right
China's real GDP as estimated by LSR, quarterly change
7%
6%
5%
4%
3%
2%
1%
0%
-1%
-2%
Q2 2004 Q1 2005 Q4 2005 Q3 2006 Q2 2007 Q1 2008 Q4 2008 Q3 2009 Q2 2010 Q1 2011 Q4 2011
www.lombardstreetresearch.com

2. The revised LSR’s estimate of real GDP showed Q4 growth was well below trend at 1.3%,
down from an average of 2.5% in Q2-Q3 2011. The change was accounted for mostly by the
downward revision of nominal growth rather than a substantial change in the GDP deflator
estimate. This suggests our worry that the official price indices could have been
underestimating the true rate of inflation in Q4 is still valid and real growth could have been
even weaker. With this piece of the puzzle falling into place, our conviction that the cyclical
“hard landing” is well underway has increased.
The data out so far for Q1 imply that the downturn is likely to have intensified even further.
China’s monetary conditions have deteriorated dramatically in 2011 and into this year. Broad
money growth, as measured by our own measure LSR M3, which is broader than the official
M2 and accounts for most of banks’ “shadow” banking activities, has slowed to its lowest rate
on record. The trade and PMI data have also worsened. With external demand faltering and
Chinese household wealth and company profitability decimated, it is no surprise that growth
has slowed down fast. Looking ahead, unless Beijing moves to ease policy more
aggressively soon there is nothing to stop the downturn spiralling further downward.
Our negative call on China’s equity market for 2011 played out well as investors were first
surprised by the extent of China’s overheating and then by the extent of the necessary policy
tightening. They held on to the hope that this will be a “soft landing” but as the data started
coming in much weaker moved to anticipate policy easing, resulting in the A-share upswing
in January and February.
We did change our call on China’s equities at the end of last year, anticipating a liquidity-
driven bear market rally lasting 6-9 months. But March saw the A-shares erase two thirds of
their early 2012 gains as policy easing was not forthcoming while Premier Wen’s rhetoric got
more hawkish. The surprise ousting of Bo Xilai and continued silence from the top political
echelon showed a bigger political rift than previously thought, increasing uncertainty and
sapping liquidity.
Intense jockeying for positions in the run up to the leadership change this autumn has led to
policy inertia. But the dire economic situation is likely to jolt policymakers into rushed action
as both the “reform” and “growth at all cost” camps are ultimately petrified by the prospect of
the cyclical “hard landing” turning into a full blown crisis. The outcomes of this stimulus,
however, are likely to be very different from those after the global financial crisis:
• The short-term liquidity boost is likely to show up in higher equity prices while
restrictions on the property sector will remain in place, causing a further correction
• This stimulus will result in faster overheating and a lower growth upturn, making
2013 a tough year for China
• Unless the Fed goes for substantial “quantitative easing” commodities will suffer
• The destruction of profitability and banks’ balance sheets will become visible
Diana Choyleva
2 Daily Note - March 30, 2012