Recent volatility in the LEI components underlines growing economic uncertainty

Interpretive Comments on The Conference Board Leading Economic Index (LEI) and The Conference Board Coincident Economic Index (CEI) for China
April 1, 2012 (February 2012 data) The Leading Economic Index for China increased 0.8 percent in February, down from Januarys 1.5 percent increase. The upward movement was led by consumer sentiment and credit growth; however, growth in both components was markedly weaker compared to previous months. The six-month growth rate stood at 5.0 percent, down from 5.7 percent in the previous six months. The more widespread weakness among the indicators, and the moderation in the six-month growth rate of the LEI, suggest that a pick up in the rate of economic growth is unlikely in the coming months. The most important insight for this month is that the underlying leading indicators have become somewhat more volatile which suggests that structural changes may be at work. This leads one to speculate that Chinas growth rate is slowing, not just from a cyclical perspective but also more structurally as demographic changes begin to take hold and changes in policy direction may set in as well. Official statements and commentary within the policy community seem to be indicating several important dynamics as regards the Chinese economy: real estate and monetary policy will remain tight to contain over-investment; slower growth will be tolerated; and the reform debate is heating up as regards how to change Chinas pattern of growth. 2012 portends to be a challenging year for opining the direction of Chinese economy, as various market and regulatory forces counteract each other, a situation that will likely intensify in the run up to the political transition that begins later in the year. Still, as of yet, our 2012 growth forecast is unchanged at 8 percent, down from 9.2 percent in 2011. The global environment has recently offered some tentative signs of stabilization with the Eurozone crisis gaining a short respite and U.S. growth surprising to the upside. Export markets in China will remain sluggish, but for now a sudden deterioration in the already-fragile real estate sector is the top risk to our China forecast.

What the Numbers Tell Us The LEI increased 0.8 percent in January, while its six-month growth rate fell to 5.0 percent for the August-toFebruary period down from 5.7 percent in the previous six months. The slowdown in the six-month growth rate in particular confirms the moderating growth trend now underway. Four of the six components provided positive contributions to the index, but each only slightly. The two largest contributors were credit growth and consumer sentiment, as measured by Total Loans by Financial Institutions and the Consumer Expectations Index, respectively. However, both of these components continue to show weak overall growth, as consumer expectations matched their August level and new loan growth has been decidedly weaker than last year. Meanwhile, growth in the PBoCs 5000 Industrial Enterprise Survey: Raw Materials Supply and PMI: New Export Orders were flat, adding only marginally to the advance in the index. This suggests continued weakness in the manufacturing sector, both from domestic and foreign demand perspectives. Preliminary data for Floor Space Started (estimated) placed a small drag on the index after an uptick in January, and PMI: Supplier Delivery also detracted from growth in the headline index. The CEI showed a strong increase, up 4.1 percent from the month before after Januarys revised 2.0 percent decline. The strong monthly uptick was most likely due to the resumption of industrial activity after the Chinese New Year holiday in January. Preliminary data for Value Added of Industrial Production showed a particularly strong rebound after the January slowdown. All the indicators added positively to the CEI index in February, which offered a stark reminder that even while most China watchers are focusing on the slowdown in the top line growth rate, the data suggests that current economic activity is pretty robust.

Our Interpretation of the Numbers While the distortions from Chinese New Year continue to make data interpretations difficult, particularly due to the need for preliminary data estimations, the overall trend seems to be toward broad-based moderation in growth, which may weaken further in coming months. While the headline China LEI increased 0.8 percent from January, the slower rise in individual indicators in February may be early signals of weakening. Over recent months, headline LEI growth has generally been checked by at least one indicators strong negative movement, offsetting other positive contributions. In February, however, four components showed only a slight positive gain, while two detracted from the index somewhat suggesting that weakness has continued to diffuse across the indicators. Additionally, the sixmonth growth rate of 5.0 percent remains subdued compared to the beginning of last year. Recent statements from the government seem to acknowledge the overall slowing trend, and increased volatility within the underlying LEI components gives some reason to suspect a more structural easing of growth. Overall the Data look weak Loan growth remained subdued in February. Although overall credit, as measured by Total Loans by Financial Institutions made the largest positive contribution to the index in February (along with consumer expectations), new loans in February registered a relatively weak 711 billion RMB, down from Januarys 738 billion RMB. Monetary policy has remained relatively tight in the first part of 2012 even in the face of unusual financial pressures, such as low deposit growth, slower capital inflows and high loan-to-deposit ratios which are acting to further constrain lending. Savings deposits did expand by 1.6 trillion RMB in February, but over half of this growth came as a result of increased corporate deposits (companies tend to reduce their cash on hand after the Chinese New Year holiday). Demand was also weak across the board. PMI: New Export Orders was just barely above the positive threshold after seasonal adjustment. This is particularly striking as PMI data by nature reflect the perceived change from the previous month, and since the holiday season fell in January, one would expect somewhat of a bounce back the next month. In addition, the headline trade data was particularly weak in February, as the trade balance registered a deficit of $31.5 billion USD. Due to the seasonality issue, January-February data together give a more reasonable picture of

Comments on The Conference Board Leading Economic Index (LEI) for China February 2012 (January 2010 data)

trade dynamics. For the two month period, the deficit stood at 4.2 billion USD. This outcome is quite weak, and underlines the continued weakness in the U.S. and Europe even as signs of stabilization have begun to surface in both economies. Domestic conditions were weak throughout the manufacturing sector. PMI Supplier Deliveries detracted slightly from the index while preliminary data for the PBoCs 5000 Industrial Enterprise Survey: Raw Materials Supply provided a very minimal positive contribution. Additionally, according to the NBS official release, gross industrial output registered only an 11.4 percent y-o-y gain in the January-February period, down significantly from the average of 12.8 percent in the fourth quarter of 2011. Fixed asset investment also fell to 21.5 percent y-o-y for the two month period, down from 23.8 for all of 2011. Finally, the flash HSBC PMI reading came in at 48.1 recently, its fifth month in contractionary territory, and the lowest reading since November. These data all point to a broad slowdown in the domestic industrial and manufacturing sectors. Along with the weakening data from the real economy, inflation eased to 3.2 percent y-o-y in February, sharply down from Januarys 4.5 percent. While some analysts see this as an indication that the PBoC now has greater room to use monetary policy to support the economy, the central bank seems to be committed to staying relatively tight for a host of reasons. First, the average inflation figure for January-February is 3.9 percent, not substantially below the 4.2 percent average for November-December. Thus, to anchor inflation expectations, the PBoC will likely want to see inflation stabilize more firmly below 4 percent before it is truly comfortable loosening in any significant way. Moreover, tight monetary policy seems to be in place for more reasons than containing inflation. Indeed, preventing continued poor investment and over-investment seems to be the primary target. In addition, overall monetary policy is becoming more complicated. As funds continue to be placed outside of the banking system in wealth management products, company balance sheets and off-the-books loans the actual transmission of monetary policy has arguably weakened somewhat (as we detailed in our previous LEI commentary). Capital flows remain volatile, and it seems that money may once again be flowing out of the country (in March). Recent weak data has revived depreciation pressure on the yuan, and the position of FX purchase slowed sharply in February even after accounting for the trade deficit. Both of these factors indicate that demand for RMB has dropped significantly in recent days. Whats more, the incubation of the offshore RMB market may be exacerbating these flows, as we asserted in a recent chart of the week. These developments have made tracking the size of cross border flows more difficult. As such, the PBoC may be waiting to see how capital flows evolve over the next weeks and months before committing to any further easing. If it becomes more probable that strong outflows will continue, the central bank will likely cut reserve requirements as a liquidity response, while raising the daily fixing of the onshore yuan as a scheme to attract capital back into the mainland. In short, the PBoCs three key mandates: (1) to fight inflation, (2) regulate capital flows, and (3) maintain a tightly managed exchange rate, have begun to conflict more than usual in recent months. The central government acknowledges slower growth Early in March the government held the National Peoples Congress (NPC), widely understood to be a rubber stamp session that lays out the agenda of the leaders on the standing committee. The opening speech by Premier Wen Jiabao garnered much media attention for the announcement of a 7.5 percent growth target for 2012. While the government regularly beats its stated growth targets, announcing a number below 8 percent seems like a clear effort to manage expectations as the slowdown proceeds. In his closing press conference the Prime Minister addressed a broader range of issues including real estate, local government debt and the reform agenda. In regard to real estate the Premier emphasized that prices still have further to fall in order to reach a reasonable level. The central government appears highly committed to sustaining administrative property transaction controls, even as many companies in the sector continue to believe that Beijing will be forced to loosen policy soon to avoid a sharp downturn. Prices in the 70 cities that the government tracks seem to be falling only slightly, with the largest year-over-year drop for February coming in Wenzhou, at 8 percent; but less than half of the cities (a total of 27) saw price declines from a year before. A fallout in the real estate market remains the largest material domestic risk to the economy in 2012, but allowing the bubble to re-inflate may further destabilize longer-term economic growth. Ultimately, the government acknowledges that it must transition from the short-term fixes currently in place to a

Comments on The Conference Board Leading Economic Index (LEI) for China February 2012 (January 2010 data)

more fundamental restructuring of the sector that instills healthier incentives for market participants, especially local governments. At his press conference, Premier Wen also mentioned that net local government debt expanded by a mere 300 million RMB in 2011, which would add only marginally to the stock of 10.7 billion RMB estimated by the CBRC at the end of 2010. While the long-term fiscal position of local governments remains a constraint on growth and a potential risk for the banking sector, the government seems highly focused on addressing the issue. In recent weeks Beijing further addressed the details of how and when banks should roll over local government loans that are soon to come due. And while this kind of strategy may ultimately only push the burden off to the future, it greatly diminishes the risk that local government debt will cause a shock to the economy in 2012. Finally, Wen also made calls for continued economic reform in his final session presiding over the NPC. While calls for accelerated reform have increased both inside and outside of government since the beginning of the year, the top leaderships orientation and policy position remains unknown. Some have read the removal of Bo Xilai, the former Chongqing Communist Party chief, as evidence that more reform is on the way, as Bo was more a champion of a state-led style of development loosely categorized as the Chongqing model. While there seems to be a growing bias toward economic reform based on increased marketization, overcoming vested interests the aristocratic clans and parasite companies that cling to and channel State resources remains a serious obstacle, as evidenced by the degree of autonomy Bo apparently wielded over the economy (and society) in Chongqing. Will slower grow lead to higher-quality growth? We expect headline policy to remain tight for much of this year longer than many observers expect and see this as a prerequisite for gradually rebalancing the countrys growth model. Whether the slowdown has been truly engineered by policy or it is naturally occurring doesnt really matter. The critical issue is that authorities do not resort to artificially boosting growth through wasteful capital expenditure, exacerbating the increased volatility weve begun to see in the underlying indicators to our LEI. We continue to emphasize that a sustained, stable slowdown in Chinas growth rate should be the most desirable development path both for the country and for MNCs operating in China. In the short-term it may cause order books to compress and spur consolidation in some industries, especially for domestic companies that relied on cheap financing to extend away from their core businesses into real estate and other speculative markets. Looking forward though, slower growth may well lead to a more favorable regulatory environment, as FDI funding increases in importance, and as authorities seek to draw on foreign knowhow in order to increase domestic innovation and stabilize the growth rate. In this regard, The Conference Boards Chief Economist, Bart van Ark, was in Beijing last week discussing the recent release of our annual CEO challenge a hallmark survey which examines the top concerns of CEOs worldwide. Perhaps unsurprisingly, the top two issues on the minds of CEOs in China were Innovation and Human Capital. Dr. van Ark emphasized that the relatively easy productivity gains China has enjoyed from its many years of catch up growth have arguably come to an end, and the imperative now is to shift to frontier-level innovation as the means of driving productivity growth. This is naturally a very difficult transition, and one that is very human capital dependent. Survey results suggest that CEOs in China understand the imperative and the connectedness of innovation to talented workers. These longer-term growth trends notwithstanding, we continue to expect the economy to grow at a robust 8 percent in 2012 unless volatility increases, particularly within the real estate and export sectors. Our outlook assumes continued, but relatively stable, weakness in export markets and a commitment to tight real estate and monetary policy in order to address the over-investment and over-quick credit growth that continue to linger as a result of the 2009-2010 stimulus. Some targeted loosening should act as a stopgap to stabilize growth in the second half of the year.

Comments on The Conference Board Leading Economic Index (LEI) for China February 2012 (January 2010 data)

Summary of The Conference Board Leading Economic Index (LEI) and The Conference Board Coincident Economic Index (CEI) for China The LEI increased by 0.8 percent in February from January, following a 1.5 percent increase in January. The LEI increased on average by 5.0 percent in the period between August and February, down from the 5.7 percent increase for the previous 6 months. Four of the six LEI components increased over the past 6 months. The CEI increased by 4.1 percent in February over the previous month, following a revised 2.0 percent decrease in January. The CEI grew on average by 4.8 percent from August to February, down from the 4.9 percent increase in the previous 6 month period. All of the CEI components increased over the past 6 months.

Chart 1: The Conference Board Leading Economic Index (LEI) for China continued to increase in February
Peak: 1988:07 Trough: 1989:10 400
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The Conference Board Leading Economic Index (LEI) for China, LHS The Conference Board Coincident Economic Index (CEI) for China, RHS 200

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Index, 2004=100

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Feb '12
20

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2012

86

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00

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Source: The Conference Board

Comments on The Conference Board Leading Economic Index (LEI) for China February 2012 (January 2010 data)

Chart 2: LEI and CEI growth rates suggest continued economic expansion through 2012, albeit at a slower rate than 2011
30 25 20 15 10 5 0 -5 -10 -15 -20 Feb '12
86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
6 month percent change (annual rate)

China CEI China LEI

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Note: Shaded areas represent growth cycles in China determined by The Conference Board CEI for China Source: The Conference Board

Comments on The Conference Board Leading Economic Index (LEI) for China February 2012 (January 2010 data)

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