Daily note

15 July 2010

China’s Q2 boom ⇒ growth slump soon

WE SUGGEST: No respite for plunging Shanghai Composite

SUMMARY: Our estimates show real GDP grew at an above-trend rate of 22.4% on a
quarterly annualised basis in Q2 after a 6.4% rise in Q1. China’s sustained overheating
makes the economy much more unstable. The longer it continues the worse the growth
correction is set to be.

China’s Q2 GDP data make for uncomfortable reading. On the face of it, our estimates of real
output paint a more positive story of the economy powering ahead in contrast to the slowdown
that the official annual growth number is meant to convey. China does not produce quarterly
data for the level of real GDP. Most commentary and analysis focuses on the official annual
growth figure, which came in at 10.3% in Q2, down from 11.9% in Q1. But according to this data
China abolished the business cycle. The impact of the “Great Recession” on China’s economy
was for real growth to slow to 6.2% in Q1 2009. If that had been the case, why did the authorities
feel the pressure and urgency to engineer an unprecedented monetary and fiscal boost?

China's real GDP (LSR estimate), QoQ growth

10%
8%
6%
4%
2%
0%

-2%
-4%
-6%
-8%
2005 Q1 2005 Q4 2006 Q3 2007 Q2 2008 Q1 2008 Q4 2009 Q3 2010 Q2

GDP Domestic demand

Our estimates of the quarterly level of real GDP paint a much more plausible story. China
plunged in recession at the end of 2008, with the cumulative fall in output at 7.6%, more than
enough to cause panic in Beijing. But the economy’s response to the huge policy stimulus has
also been impressive. The rebound to Q2 2010 has resulted in a cumulative growth of 25.5%.
No mean feat, but such a development is inherently unstable. Real quarterly output growth
slowed down progressively to a below-trend rate of 1.6% in Q1 this year from the 6.9% surge in
Q3 2009. But in the second quarter the economy more than made up for that, returning to
above-trend growth at 5.2%. Above-trend growth would have been desirable if there was slack in

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the economy. But this is far from being the case. On our estimates, China’s output gap, the
difference between the actual level of output and potential output, was significantly positive at
9.3% of GDP in Q2 2010. Estimating the output gap is fraught with problems, even more so for
China. But the message of our estimates is corroborated by the huge monetary expansion in
2009 and the first half of this year, both amounting to 40% of GDP.

China's output gap, % of GDP

12%
10%
annual data quarterly data, LSR estimates
8%
6%
4%
2%
0%
-2%
-4%
-6%
-8%
1987 1991 1995 1999 2003 2004 2005 2006 2007 2008 2009 2010
Q2 Q2 Q2 Q2 Q2 Q2 Q2

The longer the economy is booming in the face of large cyclical constraints, the worse the
necessary growth correction to curb the overheating is going to be. China’s Statistics Bureau
also published today the data for June consumer price inflation. As rumoured, inflation slowed to
2.9% from 3.1% in the previous month. With overheating the main policy challenge at present,
the authorities are all too likely to attempt managing inflation expectations by “massaging” the
official data. If the official figure for consumer price inflation is indeed a true reflection of the
reality then the official annual real growth number is not and vice versa. The official output
growth data shows that the GDP deflator grew by 6.2% in Q2, more than twice the rate of CPI
inflation (2.9% in Q2). Even our estimates of real output cannot avoid the inherent conflict of
China’s data.

In an attempt to put all the pieces of the puzzle together what crystallises as our main conviction
is that China’s spectacular recovery is set to end in tears. If our estimate of real growth is close
to the truth, further inflationary pressures are in the pipeline, set to sap growth. If our estimate
overstates real growth because of inflation being higher than the slump in output growth is set to
come sooner rather than later. In any case, at some point over the next four quarters China’s
expansion is highly likely to be cut short, restrained by the economy’s cyclical barriers amid a
sizable relapse of global growth.

Diana Choyleva
diana.choyleva@lombardstreetresearch.com

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