BMI Special Report China 2012 From Miracle to Meltdown 2011-09-01

7/31/2019 BMI Special Report China 2012 From Miracle to Meltdown 2011-09-01

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2011

Publi by Bui Mir Iril L.

.buimir.m

sPecIaL RePoRt

chIna 2012:

FRoM MIRacLe to MeLtdown?


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2 Business Monitor International Ltd

China 2012: From miraCle To melTdown?

Cttsexcutv Suy.................................................................................................. 5

TABLE: CHINAECONOMIC ACTIVITY ................................................................................................................................................5

ituct ..........................................................................................................6-9

Cu 2012 B T Y of T Cs h lg?.......................................................6

CHArT: AN INCrEAsINgLY INEffICIENT grOwTH sTOrY ...........................................................................................................6

China - Investment, Output & Returns

CHArT: DIMINIsHINg rETurNs

China - GDP Growth And Equity Market Returns

CHArT: THE grEAT wALL Of LIquIDITY .........................................................................................................................................7

China - Money Supply (M2), CNYtrn

CHArT: PrINTINg PrEssEs gOINg fuLL TILT ...............................................................................................................................7

US and China - Money Supply (M2), US$trn

CHArT: INVEsTMENT BOOMs DONT END wELL ...........................................................................................................................7

Asia - Fixed Investment, pp contribution to real GDP growth

CHArT: rEBALANCINg wILL NOT BE EAsY ....................................................................................................................................8

China - Real GDP Growth Forecasts, %

CHArT: rAILwAY sTOCks IN frEEfALL..........................................................................................................................................8

China - China Railway Group, CNY

CHArT: BANks uNDEr PrEssurE ..................................................................................................................................................9

China - 3-Month Shanghai Interbank Offered Rates (SHIBOR), %

CHArT: NO rEfOrM HErE ................................................................................................................................................................9

China - Index Of Economic Freedom

ecc actvty ..............................................................................................10-14

T Scs F Gt .................................................................................................10

CHArT: 7% Is THE NEw 10% .........................................................................................................................................................10

China - Real GDP Growth, % chg

CHArT: sErVICE PMI JOINs MANufACTurINg IN THE DOLDruMs ........................................................................................10

China - HSBC Services Purchasing Managers Index

CHArT: CHINA IN A wOrLD Of ITs OwN .....................................................................................................................................11

Gross Fixed Capital Formation, Percentage Point Contribution To Growth

CHArT: fLYINg TOO HIgH ...............................................................................................................................................................11

Gross Fixed Capital Formation, % of GDP

TABLE: COrE sCENArIO .................................................................................................................................................................12

CHINAECONOMIC ACTIVITY ..........................................................................................................................................................13

TABLE: sCENArIO 2 .........................................................................................................................................................................13

TABLE: sCENArIO 3 .........................................................................................................................................................................14

r estt outk ..........................................................................................15-17

Ppty mkt: a T hks of a Tp .....................................................................15TABLE: CHINAMONETArY POLICY ...............................................................................................................................................15

CHArT: ExPECT A suB-ZErO PrINT .............................................................................................................................................16

China - Ofcial House Price Index, % chg y-o-y

CHArT: A wOrrYINg COMBINATION ...........................................................................................................................................16

China - M2 Money Supply Growth And CPI (% chg y-o-y)

CHArT: CHEAP BuT sET TO gO CHEAPEr....................................................................................................................................17

China - Shanghai Composite Index

ivstt outk .........................................................................................18-23

C Bubb: Cs Stuy T rs & F of hg-Sp r ........................................18CHArT: HIgH sPEED ECONOMY ....................................................................................................................................................18

Chinas High Speed Railways


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3Business Monitor International Ltd

SPeCial rePorT

C Bubb: Cs Stuy 2 luck rug out F mcu Css .................................. 19CHArT: uNCErTAINTY grOws OVEr HIgH sPEED sPENDINg ................................................................................................19

China Railway Infrastructure Industry Value Forecasts

CHArT: sIgN Of THINgs TO COME? .............................................................................................................................................19

China - China Railway Group, CNY

CHArT: THE HOusE HAs BEEN wINNINg ....................................................................................................................................20

Macau - Gross Gaming Revenue, MOPmnCHArT: wOrLDs fAsTEsT grOwINg ECONOMY ......................................................................................................................20

Macau - Real GDP Growth, %

CHArT: CHINEsE gAMBLErs PuNCHINg ABOVE THEIr wEIgHT ............................................................................................ 21

Macau - Average Tourist Spending Per Visit

CHArT: TurNINg Off THE TAPs ..................................................................................................................................................21

China - M2 Money Supply Growth, % chg y-o-y

CHArT: ANOTHEr ruN AT THE LOws ...........................................................................................................................................22

MGM Resorts International Equity Price

MGM China Equity Price

CHArT: wYNNINg sTrEAk OVEr ..................................................................................................................................................22

Wynn Macau Equity Price & RSI

CHArT: TrIPLE NEgATIVE DIVErgENCE wArNs Of MAJOr TOP ............................................................................................23

Galaxy Entertainment Group Equity Price & RSI

Bkg Sct outk ...................................................................................24-25

Bkg Sct istbty Pybk ....................................................................................24

TABLE: CHINA - BANkINg sECTOr OVErVIEw ............................................................................................................................24

Csu outk ................................................................................................ 27

dt Cut o T Csu .............................................................................................27TABLE: CHINAgDP BY ExPENDITurE, % Of gDP .....................................................................................................................27

CHArT: ExPOrTs & rETAIL sALEs COrrELATED ......................................................................................................................27

China Retail Sales & Exports

CHArT: CONsuMErs CONfIDENCE NOT IMMuNE TO AN ExPOrT sLOwDOwN ...................................................................27

Consumer Condence IndicatorTABLE: CHINAgDP CONTrIBuTION TO grOwTH ......................................................................................................................28

CHArT: A TEMPOrArY BOOsT ......................................................................................................................................................28

China - Passenger Car Sales, 000s

CHArT: PrIVATE CONsuMPTION sMALLEr THAN INVEsTMENT ..............................................................................................29

Nominal GDP of Selected Countries, US$trn

Chinese Private Consumption, % Of GDP

10-Y ecc outk .................................................................................... 31

7.0% is T n 10.0% ........................................................................................................31

TABLE: CHINA LONg-TErM MACrOECONOMIC fOrECAsTs ..................................................................................................... 31

CHArT: A MOrE suBDuED grOwTH OuTLOOk .........................................................................................................................31

China - Real GDP Growth, % chg

CHArT: DEMOgrAPHIC DETErIOrATION ....................................................................................................................................33China - Estimated Population Trends

Ptc outk .................................................................................................... 34

Sc-ecc rsks o T rs .......................................................................................34TABLE: POLITICAL OVErVIEw ........................................................................................................................................................34

Gb ipcts: Cs Stus ........................................................................ 37

if C Szs, aust Ctcs Pu .................................................................37

CHArT: DEBT INTErEsT BurDEN uNsusTAINABLE ...................................................................................................................37

Australia - Debt Interest Payments, % of Disposible Income

CHArT: ExPONENTIAL BOOMs OfTEN LEAD TO BusTs ............................................................................................................37

Australian Iron Ore Exports To China, AUDmnCHArT: TrADE surPLus ON sHAkY grOuND ...........................................................................................................................38


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Australia - Trade Surplus, US$mn

CHArT: COMMODITY BOOM fAILs TO YIELD A surPLus .........................................................................................................38

Australia - Current Account, AUDmn

h T Py a Sp S i C ............................................................................39CHArT: TOO LEVErAgED, TOO ExPOsED.....................................................................................................................................39

Australia - Banking Statistics For Big 4

CHArT: A sIgN Of THINgs TO COME fOr HOusE PrICEs........................................................................................................39

China - Shanghai Property Index

CHArT: fINANCIALs HAVE furTHEr TO fALL .............................................................................................................................40

China - Shanghai Composite Index, Hang Seng Financials

CHArT: DONT LOOk DOwN ...........................................................................................................................................................40

Ratio Hang Seng Financials/Shanghai Composite

CHArT: sTILL BONDs OVEr sTOCks LONg TErM ......................................................................................................................40

Australia - ASX200 Equity Index,10-Year Bond Index

CHArT: DEBT BEATs EquITY ..........................................................................................................................................................40

Ratio - 10year Bond Index/ASX200

CHArT: gErMANY BETTEr PLACED .............................................................................................................................................41

German Dax Versus Australian ASX200

CHArT: AussIE OuTPErfOrMANCE wONT LAsT ......................................................................................................................41

RatioDax/ASX200CHArT: A MAJOr TOP .....................................................................................................................................................................42

Galaxy Entertainment Group Equity Price

CHArT: NEgATIVE DIVErgENCE ....................................................................................................................................................42

Weekly RSI

CHArT: wEDgED IN .........................................................................................................................................................................42

ChinaCNY 12-Month NDF

CHArT: suggEsTINg wEAkNEss .................................................................................................................................................42

Daily RSI

rtgs mtgy ............................................................................................ 43

out of rtgs ................................................................................................................43

TABLE: BMI rIsk rATINgs .............................................................................................................................................................43

TABLE: LONg TErM POLITICAL rATINgs .....................................................................................................................................44

TABLE: LONg TErM ECONOMIC rATINgs ....................................................................................................................................45

TABLE: sHOrT-TErM ECONOMIC rATINgs ..................................................................................................................................46

Gb assupts .............................................................................................. 49

Gb outk .....................................................................................................................49

TABLE: gLOBAL AssuMPTIONs .....................................................................................................................................................49

TABLE: gLOBAL & rEgIONAL rEAL gDP grOwTH, % CHg Y-O-Y ............................................................................................50

TABLE: DEVELOPED sTATEs rEAL gDP grOwTH fOrECAsTs, % CHg Y-O-Y ........................................................................51

TABLE: EMErgINg MArkETs rEAL gDP grOwTH fOrECAsTs, % CHg Y-O-Y .....................................................................52

TITLE: CHINA MACrOECONOMIC fOrECAsTs .............................................................................................................................53

TITLE: AusTrALIA MACrOECONOMIC fOrECAsTs ....................................................................................................................54

TITLE: MACAu MACrOECONOMIC fOrECAsTs ...........................................................................................................................55

TITLE: wOrLD MACrOECONOMIC fOrECAsTs ..........................................................................................................................56

TITLE: DEVELOPED MArkETs MACrOECONOMIC fOrECAsTs ................................................................................................56

TITLE: EMErgINg MArkETs MACrOECONOMIC fOrECAsTs ..................................................................................................57


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SPeCial rePorT

excutv Suy

C 2012: F mc T

mt?In this report we outline the likelihood and the con-sequences of Chinas multi-decade investment boom

coming to an abrupt end. With the global economy

slowing and the housing market showing increasing

signs of fragility, the clock is ticking on Chinas stellar

growth run.

Although we do not forecast an outright collapse, our

forecast of sub-8.0% growth by 2012 puts us more in

the hard landing than the soft landing camp. We believethe risks to our forecasts are tilted to the downside,

with the probability of an outright recession running

at around 30%.

Chinas housing market is exhibiting signs typically

seen at the end of a bubble. The next phase of the cycle

will likely see prices begin to fall as developers ofoad

inventory. We estimate house prices need to fall by 30%

nationwide before price excesses are unwound.

Tangible evidence of Chinese malinvestment is starting

to surface. After cautioning that the massive build-up

of high-speed rail should be regarded as a red ag, the

Macau casino boom, dependent upon cheap liquidity,

could be the next sign of Chinas bubble bursting.

As the repayment capacity of loans extended to local

government investment vehicles comes under threat,

we continue to expect instability in Chinas banking

system and a surge in non-performing loans.

In the event of a pronounced correction in investment

spending, a slump in exports and potential banking sector

instability, we nd it highly unlikely that the Chinese

consumer will be able to shoulder the burden of growth.

An economic slowdown will raise the likelihood of

further protests. The major political risk to the economycomes from the ruling party seizing more economic

power in response to perceived threats to its political

interests.

While no country would be immune from a Chinese hard

landing, we would argue that Australia is most precari-

ously positioned. A Chinese hard landing would push

the Australian economy over the edge, likely ushering in

a recession and potentially triggering a nancial crisis.

Regional asset markets do not appear priced for a sharp

slowdown in China. H-nancials (Chinese nancial

companies listed in Hong Kong) are set to underperform,

while disinationary forces will weigh on Australian

risk assets and support bonds. Consensus expectations

of continued yuan strength are not likely to be met.

CHINAECONOMIC ACTIVITY

2008 2009 2010 2011f 2012f 2013f 2014f 2015f

Nominal GDP, CNYbn 31,490.2 34,502.4 39,788.7 45,890.9 51,215.5 56,708.2 62,439.2 68,612.7

Nominal GDP, US$bn 4,531.4 5,050.5 5,878.0 7,087.4 8,008.7 8,957.6 10,064.2 11,284.9

Real GDP growth, % change y-o-y 11.7 9.2 10.3 9.2 8.1 7.5 6.9 6.8

GDP per capita, US$ 3,411 3,783 4,382 5,259 5,917 6,590 7,374 8,239

Population, mn 1,328.3 1,334.9 1,341.3 1,347.6 1,353.6 1,359.4 1,364.8 1,369.7

Industrial production index, % y-o-y, ave 12.9 11.1 14.4 10.8 7.8 8.2 8.5 8.0

Unemployment, % of labour force, eop 4.2 4.8 4.4 4.4 4.3 4.2 4.2 4.1

Notes: National Bureau of Statistics (NBS), BMI. f = BMI forecasts.


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ituct

Cu 2012 B T Y of TCs h lg?BMI View: Chinas economic growth story has rapidly

turned from one underpinned by productivity gains to

one engineered by inationary monetary and scal poli-

cies, and the quality of growth has suffered considerably

as a result. Several years of poor capital allocation will

have to be unwound eventually, leading to much slower

headline expansion, and with the global economy stut-

tering in H211, we caution that 2012 could be the year

of the Chinese hard landing.

At face value, Chinas economy remains a picture of

strength. Real GDP growth clocked a forceful 9.5% y-o-y

in the second quarter of 2011. Retail sales and xed asset

investment, meanwhile, were running at a healthy clip of17.0% y-o-y and 25.0% y-o-y, respectively, in August.

These numbers paint a picture of a rapidly expanding,

albeit gradually moderating, economy. Nonetheless,the

robust headline numbers mask a worrying deterio-

ration in the quality of Chinese economic growth.

The countrys incremental capital output ratio (ICOR),

a metric that assesses the marginal amount of capital

required to generate an extra unit of output, is at a 10-

year high. What this tells us is that with record levels

of capital spending (xed investment is on course to ac-count for a whopping 48.6% of nominal GDP in 2011),

China is getting less bang for its buck. This increasingly

inefcient growth story is echoed at the micro level.

Despite strong and rising nominal GDP growth, total

returns on the MSCI China Index are slumping (see

chart below). Clearly, then, not everything is quite as

rosy as it seems.

We believe that this disconnect between the quantity and

quality of growth can be largely attributed to the poli-

cies implemented by Beijing following the onset of the

global nancial crisis back in 2008. Faced with massive

demand destruction across key export markets in the

EU and US, China unleashed unprecedented monetary

and scal expansion, which saw credit growth skyrocket

virtually overnight. As the chart on page 6 shows, it has

taken China just two years to add the same amount of

new money at roughly CNY2trn that had been cre-ated in the six years previously. This has, in turn, seen

Chinas existing monetary stock (M2) overtake and far

exceed that of the US (US$12.0trn versus US$9.3trn)

despite its economy being less than half the size.

The scale of money and credit creation has been truly

remarkable, and is a major reason why we have seen

Chinas investment boom take off since 2008. History

suggests that investment bubbles do not end well (think

back to the Soviet Union in the 1960s, Japans 1980sboom, or South East Asia in the 1990s). With so much

a icsgy iffct Gt StyChina - Investment, Output & Returns

*ICOR is a metric that assesses the marginal amount of investment capital necessary to

generate the next time periods unit of production. Source: BMI, NBS. f=BMI forecasts.

0

10

20

30

40

50

60

70

1991

1996

2001

2006

2011f

1.5

2.5

3.5

4.5

5.5

6.5

Fixed Investment, % of GDP (LHS)

Incremental Capital-Output Ratio (ICOR)

China Joins WTO Investment has not only

become increasingly vital

to growth but also

increasingly inefficient

dsg rtusChina - GDP Growth And Equity Market Returns

Suc: Bmi, Bbg

5

10

15

20

25

Jan-03

Jan-05

Jan-07

Jan-09

Jan-11

-100

-50

0

50

100

150

200

Nominal GDP, % chg y-o-y (LHS)

MSCI China Gross Total Return, % chg y-o-y

A view supported

by the declining

returns on Chinese

equities


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SPeCial rePorT

capital allocated on the basis of state-led directives

rather than sound prot-driven decision making, it

appears to us only a matter of time before we see a

material unwinding of Chinas investment bubble,

which would in turn drag overall economic growth

much lower.

Havent We Heard All This Before?

None of this should come as a major surprise given the

vast array of bearish China-focused literature that hashit the headlines in recent months and quarters. Many

doomsayers have been wrong in the past and timing is,

of course, everything. For our part, while we are well

below consensus on Chinas 2012 growth prospects

(8.1% versus a Bloomberg median of 8.8%) and more

so over the long-term (average expansion of 7.6% per

annum between 2011 and 2016 against the IMFs 9.5%),

our baseline scenario is for a signicant correction

and not an imminent crash. Nevertheless, we nd the

case for a severe growth collapse much more credible

now than 12 months ago (or indeed anytime in recent

history). Below, we outline the factors why 2012 could

yet be the year of the Chinese hard landing.

Signs That Poor Investment Is Starting To Unravel:

Tangible evidence of Chinese malinvestment is start-

ing to surface. Back in February 2011, for instance, weindentied the massive build-up of high-speed rail as

a classic example of the overinvestment taking place

across the country, cautioning that huge debt levels at

the Ministry of Railways (MoR) and poor economic

viability of major projects should be regarded as red

ags. Since then, the sectors fall from grace has been

astonishing. Aside from a tragic train crash (which the

government has conceded was due to poor safety stand-

ards), the MoR announced record losses of CNY3.8bn

in the rst quarter, new investment has been shelved,and the two companies we earmarked for share price

downside China Railway Group and China Rail-

way Construction Company have sunk over 40%

respectively. With so much money channelled into other

areas of infrastructure which are likely to yield poor

rates of return (not least the real estate segment), the

next example of malinvestment does not appear far off.

Banking Sector Awash With Bad Debt:The Big Four

of Chinas banking sectorIndustrial and Commercial

ivstt Bs dt e wAsia - Fixed Investment, pp contribution to real GDP growth

Source: BMI

-20

-15

-10

-5

0

5

10

15

T

T+1

T+2

T+3

T+4

T+5

T+6

T+7

T+8

T+9

T+10

T+11

T+12

T+13

T+14

T+15

T+16

T+17

T+18

T+19

T+20

T+21

Japan (T=1984)Thailand (T=1991)Malaysia (T=1991)Korea (T=1990)China (T=1990)

T Gt w of lqutyChina - Money Supply (M2), CNYtrn

Source: BMI, PBoC

0

20

40

60

80

Jan-01

Jan-03

Jan-05

Jan-07

Jan-09

Jan-11

Six years worth of money

creation has taken place over

the past two years...

Ptg Psss Gg Fu TtUS and China - Money Supply (M2), US$trn

Source: BMI, PBoC

0

2

4

6

8

10

12

14

Jan-01

Jan-03

Jan-05

Jan-07

Jan-09

Jan-11

US Money Supp ly (M2), US$trn

Chin a Money Supply (M2), US$trn

...whic h has seenCh ina's nominal monetary stockexceed that of the US


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Bank of China, China Construction Bank, Agricul-

tural Bank of ChinaandBank of Chinacontinue to post

healthy bottom line numbers. However, their exposure

to local government investment vehicles (LGIVs) is a

major concern amid tightening monetary conditions.

Bank lending to local governments could be as much

as CNY14.2trn according to some estimates, equivalent

to 37.5% of 2010 GDP and 28.6% of total loans in the

banking system. Even under a moderate default scenario,

non-performing loans are set to spike signicantly (in

a sign of things to come Yunnan Highway Develop-

ment Investment informed its creditor banks back in

April that it would repay interest but not principal on

its debt obligations). Given the primary role of credit

in the recent investment boom, should banks be forcedto write down losses, this would bode ill for economic

growth. Adding to our concerns is the lack of concrete

data on bank exposure. We have to look no further than

the US subprime crisis of 2007-2008 to see the deleteri-

ous impact of poor information ow on credit markets

and, worryingly, Chinese interbank rates have risen by

25% already this year.

Global Backdrop Has Soured:An enduring bright spot

in 2011 has been the performance of Chinese exports,

which have continued to soar to new heights in the likes

of the US, Germany and the UK. Going forward, however,

we are now less optimistic on the state of developed world

demand than we were 12 months ago. A double dip in

the housing market and anaemic job creation are both

symptomatic of a lacklustre US economy. While further

stimulus measures proposed by US President Barack

Obama may provide some comfort at the margin, US

domestic demand growth will not return to its long-term

trend anytime soon. Across the Atlantic, the eurozonecontinues to battle with a protracted and painful debt

crisis. The end-game will not be conducive to economic

recovery, with purchasing managers indices across the

continent signalling that the rebound is already losing

steam. For 2012, we are pencilling in sober real GDP

growth forecasts of 1.6% and 1.2% in the US and euro-

zone, respectively, suggesting that demand for Chinese

goods could eventually start to falter.We believe that a

US recessionary scenario, which cannot be ruled out

at this stage, would almost certainly tip the balancein favour of a Chinese hard landing.

Political Risk Can No Longer Be Ignored: The

march of revolution across the Middle East and North

Africa has sent shockwaves through Beijing. Labour

unrest and social disharmony in China have becomeincreasingly commonplace, forcing the government

into a hardline response. In June, for instance, violence

broke out in the coastal Zhejiang province, as villag-

ers fought with riot police over compensation of land

seized for development. We would argue that many of

these problems have been long in the making. While

Chinas growth at all costs model has undoubtedly

created jobs, it has also seen a widening of income

disparities, a rise in corruption, and greater levels

of state interference in the economy. Data from the

rbcg w nt B esy

China - Real GDP Growth Forecasts, %

Source: BMI, IMF, Bloomberg

6

7

8

9

10

2011 2012 Long-Term

Consensus BMI

Bloomberg Consensus

IMF

ry Stcks i FfChina - China Railway Group, CNY

Source: BMI

2

3

4

5

6

7

8

Jan-09

Mar-09

May-09

Jul-09

Sep-09

Nov-09

Jan-10

Mar-10

May-10

Jul-10

Sep-10

Nov-10

Jan-11

Mar-11

May-11

Jul-11

Sep-11

Nov-11

BMIGo es Bearish Railway Stocks


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SPeCial rePorT

Heritage Foundations Index of Economic Freedom

shows that Chinas economy is as tightly controlled

today as it was in 1995 (see bottom chart). With this in

mind, we are wary that a material economic slowdown

may be self reinforcing. As the economy loses steamover the coming quarters, a rise in unemployment could

persuade workers already aggrieved with their local

governments to take more aggressive action.

Global Implications Of A Worst Case Scenario

A major collapse in China would have serious reper-cussions for the rest of the world, such has been the

enormity of the countrys appetite to consume raw

materials and capital goods. To be sure, China has

become the number one export destination for a

plethora of countries in recent years, including Japan,

Germany, Brazil and South Korea. Hence, a collapse

in demand in the Asian giant would undoubtedly be

felt across the globe.

One economy that looks particularly vulnerable toa Chinese slump is Australia. Despite record terms

of trade in 2011, buoyed by high commodity prices,

Australia has run a persistent current account decit

nanced primarily via hot money and short-term over-

seas commercial borrowings. The country is already

facing domestic frailties, with home prices grinding

lower, consumer sentiment falling precipitously, and

business credit contracting in year-on-year terms for 26

consecutive months. Should Chinese demand for raw

materials dry up, Australia could be in line to face a triple

whammy of weaker mining sector growth, a declining

trade surplus and a reversal in portfolio inows. Such

a scenario would be sufcient, in our view, to tip the

economy into recessionary territory, and potentially a

nancial crisis.

On the ipside, we believe that India could actually

benet (at least in relative terms) from a Chinese

hard landing. To be sure, the South Asian country is

not without its own problems, with the rising cost of

capital, vulnerability to high oil prices, poor projectexecution and a series of damaging corruption scandals

all choking growth in 2011 to date. Nevertheless, Indias

economy is primarily driven by internal demand and

is, as such, less exposed than most to China. Structur-

ally, too, lower wages and an ambitious infrastructure

drive could tempt multinationals to shift manufacturing

hubs southwards. Indias favourable demographics,

lower levels of leverage, and more stable economic

make-up (the consumer accounts for around 60% of

the economy versus 35% in China) suggest to us thatIndia will outperform China over the medium term. A

Chinese collapse in 2012 could see this process play

out sooner rather than later.

Bks U PssuChina - 3-Month Shanghai Interbank Offered Rates (SHIBOR), %

Source: BMI

0

1

2

3

4

5

6

7

Oct-06

Jan-07

Apr-07

Jul-07

Oct-07

Jan-08

Apr-08

Jul-08

Oct-08

Jan-09

Apr-09

Jul-09

Oct-09

Jan-10

Apr-10

Jul-10

Oct-10

Jan-11

Apr-11

Jul-11

n rf hChina - Index Of Economic Freedom

Source: BMI, Heritage Foundation

50

51

52

53

54

55

56

57

1995

1997

1999

2001

2003

2005

2007

2009

2011

China's

economic

freedom score

is the same

now as in

1995


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ecc actvty

T Scs F GtBMI View: Chinas economy is clearly entering a slow

patch as both the manufacturing and services sectors

feel the strain of higher interest rates and tightening

money supply conditions. The big question is whether

this will prove temporary or whether it will continue

and intensify. Our core view on Chinas growth rate is

that we are past the boom phase and we are entering a

period of much weaker expansion, with headline real

GDP growth set to fall to 7.5% by 2013. Despite being

below consensus, we believe the risks to our forecasts

are tilted to the downside.

Two years ago we highlighted three potential scenarios

for Chinas economic growth trajectory over the coming

years. Under our core scenario we argued that growth

would be strong in 2010, but delayed action on with-

drawing the 2009 stimulus measures would underminegrowth in 2011. While we have started to see signs of a

slowdown, and our below-consensus view is now gain-

ing credence, our forecasts were too bearish at the time

as we believed that the government would take more

action to cool money supply growth. As things stand

now, having failed to use the past two years to rein in the

credit excesses, the government faces a similar dilemma,

but with the stakes raised and the payoffs skewed to the

downside. Our core view is that a signicant slowdown

now appears unavoidable and that healthy growth

will not return until the property market excesses

are unwound. Any further stimulus measures would

likely seriously undermine the economys ability to

grow strongly over the medium term.

A Landing Underway

Data coming out of China at present is consistent with

our view that the economy is experiencing a slowdown,

and we maintain our below-consensus real GDP growth

forecast for 2011 and 2012 of 9.2% and 8.1% respec-

tively. Indeed, purchasing managers indices (PMI)

point to negative growth in the manufacturing sectorover July and August, while the HSBC services PMI

also shows the service sector teetering on the edge of

contraction. While industrial production data remains

strong, vehicle sales growth, which is highly sensitive

to economic conditions, came in at just 2.5% y-o-y in

August, and looks set to fall sharply negative in the

coming months. Cement production, electricity pro-

duction, and freight trafc, all point to a moderation

in growth in the coming quarters.

Exports Holding Up, For Now

One area that is not showing any signs of slowing is

exports, which continue to post gains despite the on-

going economic difculties in Chinas major export

markets. Export growth picked up to 24.5% y-o-y in

August, from 20.4% in July, as outbound shipments

7% is T n 10%China - Real GDP Growth, % chg

Source: BMI, NBS. f = BMI forecasts

0

2

4

6

8

10

12

14

16

2005

2006

2007

2008

2009

2010

2011f

2012f

2013f

Svc Pmi Js mufctug i T dusChina - HSBC Services Purchasing Managers Index

Source: BMI, HSBC

46

48

50

52

54

56

58

60

Ju

ly

August

September

Octob

er

Novemb

er

December

Janua

ry

February

Marc

h

Ap

ril

Ma

y

June

Ju

ly

August


12/61


SPeCial rePorT

posted their second highest level ever. Exports to the

US, meanwhile, hit a new all-time high, despite the USs

renewed economic slowdown. Despite the sustained

strong performance of Chinas exports, we continue

to believe that a slowdown is inevitable as the savingsrates in the developed world increase.

At present, then, the Chinese economy is clearly enter-

ing a soft patch. The big question is whether this will

prove temporary before lower ination allows looser

policy to reignite growth, or whether it will continue

and intensify. Below we outline our core scenario and

some alternative scenarios for Chinas growth over the

coming years.

Core Scenario: Prolonged Sharp Slowdown 70%

Our core view on Chinas growth rate is that we are past

the boom phase and we are entering a period of much

weaker expansion, with headline real GDP growth set

to fall to 7.5% by 2013. In this regard, although we do

not forecast an outright collapse, our call for sub-

8.0% growth puts us more in the hard landing than

the soft landing camp.

The main reason we are anticipating a sharp slowdown

is our belief that the countrys investment boom has

gone on far too long, resulting in serious misallocation

of capital, which is nally set to be unwound in the

near term. As the accompanying chart shows, Chinas

investment boom has gone on longer and has been far

larger than any that have preceded it, and we believe

that the command nature of the economy has meant that

much of this investment has been unproductive. The

recent examples we have seen with the boom and bust

of high-speed rail, the nancing problems facing localgovernments, sharply declining money supply growth

and the loss of momentum in the housing market, all

suggest to us that now is the time for the boom to end.

The housing market is a perfect example of this un-

productive investment, and it our belief that propertyprices are set to experience serious downside, which

will drag down the entire economy. As we explain in

the next section (pages 15-17), we believe that a 30%

correction in home prices nationwide is possible, and

that this will have a seriously negative impact on the

economy as a whole. We are forecasting gross xed

capital formation growth to fall to 8.7% and 6.3% in

2012 and 2013. This compares with a projected 10.8%

in 2011 and a whopping 16.4% in 2010.

Leverage Will Be Felt By Governments

It is often argued, either to reject the idea of a bubble

or to suggest that the fall-out from its bursting will be

contained, that there is very little leverage associated

with the housing boom. We do not share this view.

While it may be true that mortgages represent less than

30% of total bank credit, the growth rate has soared in

recent years. Furthermore, anecdotal evidence suggests

to us the housing loan-to-value ratios are also higher

than are widely reported, with banks routinely skirting

C i a w of its o

Gross Fixed Capital Formation, Percentage Point Contribu-tion To Growth

Source: BMI, NBS

-20

-15

-10

-5

0

5

10

15

T

T+1

T+2

T+3

T+4

T+5

T+6

T+7

T+8

T+9

T+10

T+11

T+12

T+13

T+14

T+15

T+16

T+17

T+18

T+19

T+20

T+21

Japan (T=1984)

Thailand (T=1991)Malaysia (T=1991)

China (T=1990)

Fyg T hgGross Fixed Capital Formation, % of GDP

Source: BMI, NBS

0

10

20

30

40

50

60

T

T+2

T+4

T+6

T+8

T+10

T+12

T+14

T+16

T+18

T+20

Japan (T=1984)

Thailand (T=1991)

Malaysia (T=1991)

China (T=1990)


13/61



ofcial restrictions. Even if consumer leverage is low, it

is the debt of property developers and local government

investment vehicles that are the source of the bulk of the

leverage, as they have taken on huge amounts of debt

backed by rising property prices. Indeed, governments

rely on land sales for roughly 30% of total revenues, and

local government debt is estimated to be as high as 40%

of GDP. Once property prices fall, local governments

will have an extremely tough time nancing projects,

and overall investment growth will slow sharply.

Upstream Industries Will Be Hit Hard

Construction directly accounts for 54% of Chinese steel

usage, and once autos and durable goods are added in

the share rises to over 60%. We estimate that it could

rise to two thirds once property-related infrastructurespending and the investment in new steel capacity are

factored in. Chinas steel industry is a mainstay of the

economy, accounting for around 45% of global steel

production, up from just 15% a decade ago. Cement

production, construction equipment, and power genera-

tion machinery are just a few examples of industries

heavily at the mercy of a property slump and likely to

nd themselves in a tough operating environment once

the housing bubble bursts. Although perhaps of lesser

impact on the overall economy, downstream industriessuch as real estate broking, retail, autos, etc. will also

be hit from a downturn in transaction activity.

Consumer Will Be Found Wanting

As we explain in the Consumer Outlook section (pps

27-30) those looking for a consumer boom to replace the

investment boom will likely be disappointed. Indeed, the

real estate boom was itself a consumer boom of sorts,

which has saddled consumers with unproductive assets.

Turning to consumer services and durable goods, this

section of the economy is highly unlikely to carry the

burden of growth. The negative wealth effect of falling

home prices is likely to seriously undermine consumer

condence, causing private consumption growth to fall,

rather than rise. To put it in perspective, a Shanghai

resident who bought a new 100 square metre home two

years ago, which currently costs around US$350,000

(the current average selling price according to China

Real Estate Index System), is likely sitting on equity of

up to US$100,000. To see this equity evaporate would

deliver a savage blow to high-end retail, which has

performed so impressively over the past few years. We

are forecasting private consumption to grow by 8.5%

in 2012, down from an expected 9.0% in 2011. Beyond

this, private consumption growth should fall furtherto 8.4% in 2013, albeit outperforming the economy

as a whole.

The outlook for the export sector is perhaps the biggest

unknown in our view. Our core view is that Chinas

major export markets will see import growth slow but

remain positive as these economies muddle through,

which should see Chinese export growth slow sharply

from current levels but remain in positive territory.

We are forecasting export growth to fall to 8.0% thisyear and fall further to 5.0% in 2012. This should see

net exports contribute negatively to headline growth

to the tune of 0.4 percentage points (pp) and 0.6pp.,

respectively.

Will China Stimulate?

Money supply growth in China has fallen to a level where

the government announced its unprecedented stimulus

package in November 2008, and the economy faces

headwinds similar to the ones it faced back then. Thisbegs the questionwill China enact another stimulus?

Our core view is that they will not. The main reason

is that we do not envisage a collapse in growth in the

export sector similar to that seen in 2008, and so a

similar reaction will likely not be required. Even in

the event of a sharp slowdown, we believe that fears

over a banking crisis given the hidden bad debts in the

system would prevent an all-out stimulus drive being

enacted. Meanwhile, the likelihood of interest rate cuts

C ScSharp Slowdown Ahead (% chg)

f = BMI forecasts. Source: BMI, NBS

2010 2011f 2012f 2013f

Private Consumption 8.7 9.0 8.5 8.4

GFCF 16.4 10.8 7.5 6.3

Real GDP 10.3 9.2 8.1 7.5


14/61


SPeCial rePorT

in the near term, even if growth cools further, is slim

given the high rate of ination.

Scenario 2: Outright Recession 20%

Under this scenario, an outright collapse in the housing

market as liquidity conditions are further constrained

leads to a contraction in investment spending and a

sharp slowdown in consumer spending. This scenario

also envisages a US recession, which would tip Chinese

exports into negative territory.

Although it seems to be regarded as impossible by most

observers, a contraction in growth in China is not out

of the question. Should the property bubble burst ag-

gressively, it is not difcult to imagine a situation whereconstruction spending falls by double digits. Construc-

tion spending in the US is currently down 30% from its

peak after a similar decline in home prices, and the house

prices never fall mentality that drove the construction

boom in the US appears even more visible in China

today, which we see as a worrying signal. This could

easily drag investment growth into negative territory.

As an example, should investment spending contract

by a similar magnitude as it did in 1989 (the last time

GFCF turned negative), then this could send real GDPgrowth plunging to -5.5% as the top right table shows.

As for consumer spending, while we do not envisage

a collapse, one cannot be ruled out under an outright

property market collapse. While the low savings rate

suggests there is tremendous long-term potential for

private consumption, a simultaneous drop in exports

and investment could trigger a surge in the domestic

savings rate, undermining private consumption growth.

Not only is the global economy facing a deleveraging

process on a scale never seen before, but Chinas ex-

porters have to compete for a subdued level of external

demand with an increasingly strong exchange rate and

rising labour costs in coastal regions brought about by

the property bubble. In a worst-case scenario we could

see export growth turn sharply negative, as was the case

in the global nancial crisis of 2008-2009.

Under a hard landing scenario, Beijing would likely

respond by embarking on another huge stimulus drive.

However, given the damage caused to the economic

structure and the overcapacity in housing and infra-

structure that has resulted from the previous invest-

ment boom, any additional measures would be highly

unlikely to have as much of a positive effect. If Beijing

did throw caution to the wind and re up the printingpresses once again, then Chinas constructive long-term

growth outlook would be placed in serious jeopardy.

Scenario 3: Goldilocks Scenario 10%

Although we assign little probability to this outcome,

a continued growth boom cannot be entirely ruled out.

In the near term, a re-emergence of strong growth in

Chinas key export markets would be essential, as would

positive news on the debt situation at local investment

CHINAECONOMIC ACTIVITY

2008 2009 2010 2011f 2012f 2013f 2014f 2015f

Nominal GDP, CNYbn 31,490.2 34,502.4 39,788.7 45,890.9 51,215.5 56,708.2 62,439.2 68,612.7

Nominal GDP, US$bn 4,531.4 5,050.5 5,878.0 7,087.4 8,008.7 8,957.6 10,064.2 11,284.9

Real GDP growth, % change y-o-y 11.7 9.2 10.3 9.2 8.1 7.5 6.9 6.8

GDP per capita, US$ 3,411 3,783 4,382 5,259 5,917 6,590 7,374 8,239

Population, mn 1,328.3 1,334.9 1,341.3 1,347.6 1,353.6 1,359.4 1,364.8 1,369.7

Industrial production index, % y-o-y, ave 12.9 11.1 14.4 10.8 7.8 8.2 8.5 8.0

Unemployment, % of labour force, eop 4.2 4.8 4.4 4.4 4.3 4.2 4.2 4.1

Notes: National Bureau of Statistics (NBS), BMI. f = BMI forecasts.

Sc 2Outright Recession (% chg)

f = BMI forecasts. Source: BMI

2010 2011f 2012f 2013f

Private Consumption 8.7 9.0 -0.3 5.0

GFCF 16.4 10.8 -13.0 2.0

Real GDP 10.3 9.2 -5.5 3.3


15/61



vehicles, to the effect that the situation is not as bad as

we currently believe. Stability in the housing market

would also be necessary, indicating that the housing

market is not as overvalued as our core scenario sug-

gests. Over the medium term, productivity gains would

be needed to compensate for the slowdown of inputsinto the economic growth function (due to slower capital

spending growth and labour force growth). Moreover,

opening up to further investment and policies to boost

labour market exibility could see growth remain in the

high single digits over the coming years.

2010 2011f 2012f 2013f

Private Consumption 8.7 9.0 9.5 9.5

GFCF 16.4 10.8 9.5 9.0

Real GDP 10.3 9.2 9.2 9.1

Sc 3Continued Strong Growth (% chg)

f = BMI forecasts. Source: BMI, NBS


16/61


SPeCial rePorT

Ppty mkt: a Thks of a TpBMI View: Chinas housing market is exhibiting signs

typically seen at the end of a property bubble. Transac-

tion volumes have fallen sharply, prices have stagnated,

and sellers have begun to offer perks to avoid cutting

headline prices. The next phase will likely see more

interesting developments ensue. Prices should begin

to fall in earnest, and nancial problems at developers

will exacerbate price declines. We estimate that prices

need to fall by 30% nationwide before price excesses areunwound but could fall further in an adverse scenario.

Once property prices begin to fall, equities are unlikely

to see renewed interest.

The continued, albeit minor, price gains seen in Chinas

property market over the past six months have come

as a surprise to us. We see the hitherto robustness of

the market as a testament to the sheer scale of Chinas

money supply boom and the rampant expansion of

the off-balance sheet banking system that has allowedcredit to be extended beyond the regulators already

expansionary limits. This has meant that piecemeal

r estt outk

measures have had only localised or temporary suc-

cess as homebuyers have skirted cooling policies, and

momentum on the whole has continued to push higher.

Data Is Mixed, But Momentum Is Clearly Waning

The data on home prices has been mixed of late, with

some agencies reporting substantial price declines and

others showing continued gains. According to ofcial

statistics, home prices in Beijing and Shanghai stopped

rising in July following sustained gains over the past

two years, adding to the 14 other cities (of 70 tracked)that showed a reduction in average selling prices. Ac-

cording to China Real Estate Index System, however,

residential property prices in 100 major cities were

largely at, with property prices rising in 56 cities

and falling in 44. Meanwhile, according to the Beijing

Real Estate Association, the citys average home price

has dropped by more than 8% year-on-year (y-o-y) in

the January-July period, and developers have begun to

discount prices aggressively.

Transaction Volumes Drying Up

While the price data is mixed, transaction volumes are

CHINAMONETARY POLICY

2008 2009 2010 2011f 2012f 2013f 2014f 2015f

Consumer prices, % y-o-y, eop [3] 1.2 1.9 4.6 4.8 3.1 3.1 3.0 3.0

Consumer prices, % y-o-y, ave [3] 5.9 -0.7 3.3 5.6 3.2 3.0 3.0 2.9

Producer prices, % y-o-y, eop [3] -1.1 0.7 3.9 3.2 2.9 2.6 2.6 2.5

Producer prices, % y-o-y, ave [3] 6.9 -5.5 3.7 3.2 2.9 2.6 2.6 2.5

Wholesale prices, % y-o-y, ave [3] 7.0 -5.0 3.9 3.8 3.6 3.0 3.1 3.1Wholesale prices, % y-o-y, eop [3] -1.5 3.4 4.0 3.8 3.6 3.0 3.1 3.1

M1, CNYbn [4] 16,620.0 19,057.8 21,875.2 25,240.5 29,017.7 33,008.8 37,864.7 43,438.2

M1, % y-o-y [4] 9.0 14.7 14.8 15.4 15.0 13.8 14.7 14.7

M2, CNYbn [4] 47,520.0 60,825.6 73,781.4 85,586.5 95,293.3 105,298.6 115,723.7 126,936.3

M2, % y-o-y [4] 17.8 28.0 21.3 16.0 11.3 10.5 9.9 9.7

Central Bank policy rate, % eop [1,5] 5.31 5.31 5.81 6.81 6.56 6.81 6.81 6.81

Lending rate, %, eop [4] 3.8 2.2 2.2 3.5 3.0 3.0 3.0 3.5

Lending rate, %, ave [4] 3.6 3.0 2.2 2.8 3.2 3.0 3.0 3.2

Real lending rate, %, eop [2,4] 2.6 0.3 -2.4 -1.3 -0.1 -0.2 -0.0 0.5

Real lending rate, %, ave [2,4] -2.3 3.7 -1.1 -2.8 0.0 -0.0 -0.0 0.3

Notes: e = BMI estimates. f = BMI forecasts. 1 One-Year Lending Rate; 2 Real rate strips out the effects of ination; Sources: 3 National Bureau ofStatistics, BMI; 4 IMF, BMI; 5 Peoples Bank of China, BMI; 6 BMI.


17/61



starting to dry up, which we see as a clear sign of declin-

ing momentum. China Vanke Co, the countrys largest

property developer by market share, said sales in August

fell from a year ago due to a slower pace of project

launches and lower average sales prices. Furthermore,

according to China Real Estate Information Corp (CRIC),

August new home sales in Shanghai dropped to the low-

est in seven years as tighter purchase restrictions further

eroded already-slack buying sentiment. This slowdown

in transactions should feed through into outright declines

in the months ahead as developers inventories swell and

their nancial conditions deteriorate.

Developers Feeling The Squeeze As Unsold Inven-

tory Grows

In another sign that a peak in the housing market is near-

ing, developers are offering add-ons rather than cutting

prices outright. Developers are also helping buyers secure

nancing, with Pan Hong Property Groupproviding

bank guarantees for buyers and low interest rate loans.

These vendor nancing schemes may be a sign thatproperty developers are running short of funds, having

built up high levels of land banks in recent quarters.

In fact, rst half results from Chinas main property

developers show that despite a surge in revenues and

prots, inventories rose by roughly 40% and cash ow

remains negative, suggesting that developers may have

to unload if nancial conditions deteriorate. Furthermore,

as homes are usually pre-sold, with revenues accruing

only on completion, these gures likely represent sales

that were made several months ago, possibly overstating

the current strength of the market.

The M2 Headwind Is Getting Strong

The main headwind facing asset markets in China at

present is the sharp reduction in lending growth. Money

supply (M2) growth fell to a seven-year low of 13.5%

y-o-y in August, from 14.7% in July. This is by far the

biggest headwind for Chinas property market, and we

see it continuing to gather pace. While there is grow-

ing coverage of rampant underground lending taking

place all over China, we do not see this as a sign of

still-rampant liquidity as it does not add to the overall

money supply but rather represents the scarcity of new

funds available to those without political connections.

30% Correction Needed

Although it is tough to put a gure on it, we estimate

that property prices could be as much as 50% overvalued

nationwide, with rental yields in the 1.0-2.0% range

expct a Sub-Z PtChina - Official House Price Index, % chg y-o-y

Source: BMI, National Development & Reform Comission (NDRC)

-4

-2

0

2

4

6

8

10

12

14

Aug-05

Nov-05

Feb-06

M

ay-06

Aug-06

Nov-06

Feb-07

M

ay-07

Aug-07

Nov-07

Feb-08

M

ay-08

Aug-08

Nov-08

Feb-09

M

ay-09

Aug-09

Nov-09

Feb-10

M

ay-10

Aug-10

Nov-10

Feb-11

a wyg CbtChina - M2 Money Supply Growth And CPI (% chg y-o-y)

-5

0

5

10

15

20

25

30

35

CPI M2

Source: BMI, NBS, PBoC

0

5

10

15

20

25

30

35

1996

1996

1997

1997

1998

1998

1999

2000

2000

2001

2001

2002

2003

2003

2004

2004

2005

2005

2006

2007

2007

2008

2008

2009

2010

2010

2011

2011

2012

Spread


18/61


SPeCial rePorT

adding support to this view. Our view is that overall

prices need to fall by at least 30% before we can say

that homes are reasonably priced. While this may seem

like a large fall, Chinas banking regulator has been

warning of a 50% drop for several months and has

used this gure as a stress test for the banking system.

The possibility of an outright collapse, where falling

property prices trigger an outright recession, leading to

a negative feedback loop, is not out of the question. In

some areas, where policy-driven construction has run

rampant in recent years and continues unabated despite

single-digit occupancy rates (such as Ordos in Inner

Mongolia), we would not be surprised to see property

prices fall by more than half.

Will Money Flow Into The Stock Market?

We do not put a high probability on a slump in the real

estate market leading to a rise in the stock market. While

we did see a fall in the equity market leading to a rise in

the housing market in mid-2008, it is important to stressthat this was the result of the Peoples Bank of China

creating new credit and did not represent a simple shift-

ing of portfolios away from stocks amd into housing.

In the absence of another forceful stimulus package,

we would expect malinvested credit to be destroyed

(simply vanishing) rather than heading to the stock

market. In fact, we would expect to see the market fall

further given the hit to earnings. Equity valuations are

historically cheap, but they are by no means at bargain

basement levels, with the Shanghai Composite Index

trading at 2.1X book value and a P/E ratio of 13.2. China

Railway Group could be the canary in the coalmine

for the broader equity market.

Cp But St T G CpChina - Shanghai Composite Index

Source: BMI

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

Jun-01

Nov-01

Apr-02

Sep-02

Feb-03

Jul-03

Dec-03

May-04

Oct-04

Mar-05

Aug-05

Jan-06

Jun-06

Nov-06

Apr-07

Sep-07

Feb-08

Jul-08

Dec-08

May-09

Oct-09

Mar-10

Aug-10

Jan-11

Jun-11

Nov-11


19/61



ivstt outk

C Bubb: Cs Stuy Trs & F of hg-Sp rBMI View:Back in February 2011, we identied Chinas

massive high-speed rail expansion as a textbook exam-

ple of the malinvestment activity taking place across

the country. Since then, the sectors fall from grace has

been spectacular, with the Ministry of Railways suffering

record losses and railway equities plummeting in value.

With so much money channelled into other areas of

infrastructure that are likely to yield poor rates of return

(not least the real estate segment), the next example of

malinvestment does not appear far off.

On February 25 2011, we published an article entitled

Railway Boom Unsustainable, which looked at the

nancial and economic prospects facing Chinas high-

speed rail sector. From our perspective, the poor economic

viability of these signature projects was a tell-tale sign of

overinvestment in the sector a view we had been running

for quite some time at the macro level.

We stated at that time that:We have long held a sceptical view of the sustainability of

Chinas infrastructure boom, believing that inefciencies

would at some point come back to haunt the government,

undermining long-term economic growth. The argu-

ment that China has a need for railway infrastructure

investment is certainly valid, but we believe there has

been too much focus placed on the positive impact of

such infrastructure on facilitating near-term economic

growth, and not enough focus on the long-term costs

associated with these benets.

Using the high-speed rail line connecting Chengdu

to Shanghai as an example, it is easy to see how this

has been a boon for the local economy. Not only has

the project helped create jobs in the region and boost

real GDP growth gures, but it has halved travel time

between the two cities. However, if this does not make

an operating prot, it will act as a long-term drag on

the countrys resources, undermining economic growth,

particularly given the astronomical debt burden that the

Ministry of Railways (MoR) has taken on to build it,

and other projects.

At a reported cost of roughly CNY2,330 for a top-end

ticket, it is questionable whether workers from Sichuan

Province, with a GDP per capita of just CNY17,300

per annum, can afford to use this service. With this in

mind, we believe that these operations are likely to

make a loss for a long time to come.

For us, this debt-fuelled spending spree on railway ex-

pansion would not be sustainable. We estimated that the

MoR had racked up debts worth at least CNY2.0trn by

the end of 2010, and with interest rates on the rise, the

burden of nancing this debt would spike astronomi-

cally. Since our warnings, the sectors fortunes have

unravelled at a truly remarkable pace. Financialstatements released by the Shanghai Clearing House

reveal that Chinas Ministry of Railways (MoR) incurred

a loss of CNY3.76bn (US$578mn) in Q111. Faced with

a liquidity crunch, The MoR attempted to issue US$3bn

worth of short-term nancing bonds, but these failed

to attract sufcient investors despite offering interest

rates of 5.18% (double the 2.59% interest for bonds

issued by the MoR on July 2010). Furthermore, this

was followed in July by a fatal train collision on the

high-speed railway line in Wenzhou, Zhejiang prov-

hg Sp ecyChinas High Speed Railways

Source: BMI


20/61


SPeCial rePorT

ince. A total of thirty-ve passengers were killed and

192 injured in the accident according to ofcial data,

making it the countrys worst railway disaster since

high-speed railway services began in China in 2008.

This is a highly disconcerting statistic, especially given

that the government itself has conceded that the accident

was due to poor safety standards.

Financial Market Implications

In our February article, we singled out China Rail-way Construction Corporation (CRCC) and China

Railway Group (CRG) as particularly vulnerable to a

substantial correction in the equity markets. Both stocks

looked technically awful to us, and despite cheap valua-

tions, we believed that both could well trade below book

value. Since then, CRCC and CRG have nosedived,

slumping 38% and 36%, respectively, and bailouts

or bankruptcy for both look likely. Besides railway

construction companies, we also believed that Chinese

railway equipment manufacturers would face downside

pressure in their equity values as questions would be

asked about the reliability of their equipment. China

South Locomotive , along with CanadasBombardier,

had constructed the trains involved in the accident.

More China Railways To Come

With all new high-speed rail projects now suspended,

our concerns over the overinvestment in the sector have

been justied. What is more, with railway investment

accounting for around 3% of total capital spending, this

is a major factor reinforcing our core view that grossxed capital formation will fall to a 15-year low of 8.7%

next year, with risks heavily weighted to the downside.

The unprecedented nature of Chinas credit binge, and

the poor price signalling in the market, means that more

examples of investment excesses are likely to crop up

in the coming months and quarters (particularly in the

real estate sector). With this in mind, the troubles facing

Chinas railway sector provide a clear micro example of

the China slowdown call that we have been gunning for.

C Bubb: Cs Stuy 2 luckrug out F mcu CssBMI View: Despite the well-known positive long-term

story of Macaus gaming industry and economy, we

believe the current growth boom is being driven over-

whelmingly by the credit bubble in China. A tightening

of liquidity on the mainland, together with a slowdown

in growth and a tougher crackdown on corruption, will

undermine Macaus gaming revenues. Having identied

weaknesses in July, we expect to see further downsidemoves in a number of casino stocks with heavy exposure

to the region.

The Bullish Long-Term Case Is Well Known...

Booming Macau is expected to turnover ve times more

in gaming revenues in 2011 than its beleaguered US

counterpart Las Vegas. The bullish case for continued

rampant growth in the Special Administrative Region

(SAR) is clear: world-beating Chinese income growth

combined with a cultural love of gambling mean the

Uctty Gs ov hg Sp SpgChina Railway Infrastructure Industry Value Forecasts

e/f = BMI estimates/forecasts. Sources: National Bureau of Statistics/

China Statistical Yearbook/ILO

0

10

20

30

40

50

60

70

80

90

100

0

50

100

150

200

250

300

350

400

2007

2008

2009

2010e

2011f

2012f

2013f

2014f

2015f

2016f

2017f

2018f

2019f

2020f

Railways Infrastructure Industry Value, CNYbn

Railways Infrastructure Industry Value Real Growth, (%) chg y-o-y

Sg of Tgs T C?China - China Railway Group, CNY

Source: BMI

4

5

6

7

8

9

10

Jan-10

Feb-10

Mar-10

Apr-10

May-10

Jun-10

Jul-10

Aug-10

Sep-10

Oct-10

Nov-10

Dec-10

Jan-11

Feb-11

Mar-11

Apr-11

May-11

Jun-11

Jul-11

Aug-11

BMI goesbearish

railwaystocks


21/61



future is bright. The lacklustre performance of Las Vegas

in the heart of one of only two US states where growth

contracted in 2010, meanwhile, is forcing US casino

majors such as MGM Resorts International to shift

focus away from the US and towards the roaring eastern

market. These forces combined to see revenue growth hit

44.8% year-on-year (y-o-y) in the January-July period,

the highest on record, and gaming stocks have rallied

aggressively to reect the tremendous growth potential.

...But The Bearish Case Merits AttentionThe bearish case, however, merits some serious atten-

tion. With 85% of arrivals coming from the mainland

and Hong Kong, and roughly half of the revenues gener-

ated from these sources reportedly coming from either

government ofcials or senior managers in state-run

companies, we caution that Macaus current run of luck

could be largely an outgrowth of a Chinese liquidity

bubble that is set to burst.

Over the long term, Macaus growth story is likely toremain intact, supported by the above-mentioned positive

factors. However, a slowdown in the mainland Chinese

economy, (particularly given the heavy reliance on the

largesse of Chinese ofcialdom), is a huge concern for

us. Indeed, it suggests that a hard landing could await

the Macau gaming industry in 2012 as the impact of

China monetary boom wears off and the cash available

for Chinas local government ofcials dries up.

In a previousBMIMacau report (see Betting The House

On The Gaming Industry, December 2), we called for

a sharp slowdown in Macaus gaming industry, which

contributed 82.8% of GDP at the time. However, the

industry has continued to power ahead, far exceeding

our expectations, making us increasingly concerned thata hard landing may result. Real GDP growth came in

at 24.0% y-o-y in Q111, led by a 39.0 y-o-y increase in

services exports. The driver, of course, was the 47.9%

y-o-y growth in gaming revenues, which hit a new

monthly high of MOP24.3bn (US$3.0bn) during the

month. Highlighting the importance of high-rollers to

the SARs top line, the VIP Baccarat tables were the

source of an incredible 73.0% of all gaming revenues,

equivalent to an estimated 61.0% of GDP.

Chinese Ofcials A Major Source Of Revenue

A 2010 study by the Macau Polytechnic Institute sug-

gests that 47% of these Chinese high-rollers are either

government ofcials or senior managers in state-run

companies. We have written a great deal about the

impact of Chinas money supply boom and the distor-tions it has caused in the Chinese economy. To put it

into perspective, we calculate that the increase in M2

per capita since the start of the stimulus in November

2008 has been equivalent to US$3,500, roughly in line

average annual income. With this sort of an increase in

cash sloshing around the economy and with a political

system that gives excessive power to unaccountable

local ofcials, it is no surprise that some of the funds

found their way onto Macaus Baccarat tables. In one

high-prole case, Li Weimin, a mayor of small town in

T hus hs B wgMacau - Gross Gaming Revenue, MOPmn

Source: BMI, Statistics And Census Service

0

5

10

15

20

25

30

Jan-05

Apr-05

Jul-05

Oct-05

Jan-06

Apr-06

Jul-06

Oct-06

Jan-07

Apr-07

Jul-07

Oct-07

Jan-08

Apr-08

Jul-08

Oct-08

Jan-09

Apr-09

Jul-09

Oct-09

Jan-10

Apr-10

Jul-10

Oct-10

Jan-11

Apr-11

Jul-11

ws Fstst Gg ecyMacau - Real GDP Growth, %


-60

-40

-20

0

20

40

60

80

100

Q105

Q205

Q305

Q405

Q106

Q206

Q306

Q406

Q107

Q207

Q307

Q407

Q108

Q208

Q308

Q408

Q109

Q209

Q309

Q409

Q110

Q210

Q310

Q410

Q111

Q211

Real GDP GrowthGFCFServices Exports


22/61


SPeCial rePorT

Guangdong, was sentenced to 20 years in prison after

gambling away US$12mn in 2006.

To circumvent restrictions on the ow of money out

of the country, many gamblers are reported to travel

on junkets run by companies that lend them money to

gamble and then collect debts once they return. Beijing

has imposed tighter restrictions on state employees

travelling to Macau, limiting the number of trips they

can make each year. However, the problem still persists.

The Chongqing Evening News recently reported on a

local ofcial named Lin Xinyong, dubbed the gambling

king, who is currently awaiting the death penalty after

allegedly extorting US$4.0mn in bribes and losing

US$250,000 during a two-day gambling spree in Macau.Consistent with these widespread reports of embezzle-

ment, according to a recently leaked document from the

Peoples Bank of China (PBoC), between 16,000 and

18,000 corrupt Chinese ofcials have siphoned more than

US$120.0bn out of the country in less than two decades.

Major Income Driver Set To Stall

Based on the wealth of anecdotal evidence, media reports

and studies, we do not believe it is an exaggeration to

say that Macaus current economic boom relies over-

whelmingly on the cash available to Chinas ofcialdom.

With this in mind, we believe the tables could be turning

against the SAR for two main reasons. Firstly, liquid-

ity is drying up. After two and a half years of rampant

money supply growth, rising prices are forcing the PBoC

to apply the brakes, and we have seen money supply

growth drop severely from a peak of 30.05% y-o-y to

the current level of 13.5% y-o-y in August. Moreover,

local government nances are in terrible shape, with

loans extended to investment vehicles during the boom

increasingly squeezing local budgets at a time when

receipts from land sales (the largest single source of

income) are in sharp decline. These factors suggest that

the days of virtually unlimited access to funds could be

nearing an end, which will put a squeeze on the spending

habits of government ofcials. Private Chinese business

leaders who have also seen their wealth skyrocket over

the past few years will also likely feel the pinch from a

cooling economy and tightening liquidity.

Secondly, ofcial graft is a leading source of public

resentment towards the government, and as we have

seen in recent weeks, there seems to be a rising intensity

in the publics opposition to corruption. Bomb attacks

on government ofces in the south-east city of Fuzhou,Fujian, and the crackdown on protestors in Lichuan,

Hubei, were allegedly both in opposition to corrupt local

ofcials. We expect this kind of opposition to continue

to intensify as the economy weakens, leading to an

increasingly harsh response by the central government

to control wayward local leaders. Combined, these two

factors should help to reduce the prevalence of public

funds being taken out of the mainland bound for Macau.

Cs Gbs Pucg abv Twgt

Macau - Average Tourist Spending Per Visit


0

500

1,000

1,500

2,000

2,500

3,000

MainlandChina

Japan

Americas

SoutheastAsia

Oceania

Europe

HongKong

Taiwan

0

1

2

3

4

5

6Average Spending, MOP (LHS)

Average Spending, % of GDP Per Cap ita

Tug off T TpsChina - M2 Money Supply Growth, % chg y-o-y

Source: BMI, PBoC

12

14

16

18

20

22

24

26

28

30

32

Jan-05

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Jan-11


23/61



Parabolic Charts Warn Of Potential Collapse

Back in July, we highlighted the unsustainable nature

of Macaus gaming industry boom, suggesting that its

main growth driver rampant liquidity growth in main-

land China was about to lose steam (see GamblingBoom: A House Of Cards?, June 22). We also argued

that casino operators with heavy exposure to this boom

were extremely overvalued and faced a potential col-

lapse. Since then, a number of gaming counters have

experienced signicant weakness, and further losses

look highly likely.

MGM Resorts International, which we maintain could

face solvency issues in the near future, is already down

by over 25% since we initiated our bearish view, and afurther fall back to the all-time low of US$1.80 from the

current level of US$9.50 (80% further downside) is not

out of the question. The recently launchedMGM China

is also suffering and looks set to test its all-time low.

Wynn Macau has held up relatively well in recent

weeks, but the technical chart pattern is pointing to po-

tentially severe losses, having posted bearish divergence

on the weekly relative strength index (RSI) following

what appears to be a signicant topping pattern. A clean

break through HKD21.50 would open up a rapid move

down to HKD18.00.

One stock which has held up surprisingly well despite

the global sell-off is Galaxy Entertainment. Trad-

ing in excess of 8x book value and with an incredibly

high price-to-earnings (P/E) ratio of 82, we believe the

potential downside for Galaxy is huge. After rallying

40-fold over the past two years, the stock has posted

two key reversal weeks in quick succession, and with

triple negative divergence on the weekly RSI, a major

decline could be around the corner.

at ru at T lsMGM Resorts International Equity Price

Source: BMI

-10

10

30

50

70

90

110

2007

2008

2009

2010

2011

MGM China Equity Price

Source: BMI

12

13

14

15

16

17

18

19

02-Jun-11

16-Jun-11

30-Jun-11

14-Jul-11

28-Jul-11

11-Aug-11

25-Aug-11

wyg Stk ovWynn Macau Equity Price & RSI

5

10

15

20

25

30

Source: BMI

0

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20

30

40

50

60

70

80

90

Oct-09

Nov-09

Dec-09

Jan-10

Feb-10

Mar-10

Apr-10

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Jun-10

Jul-10

Aug-10

Sep-10

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Feb-11

Mar-11

Apr-11

May-11

Jun-11

Jul-11

Aug-11

Sep-11

Oct-11


24/61


SPeCial rePorT

Tp ngtv dvgc ws of mj TpGalaxy Entertainment Group Equity Price & RSI

0

5

10

15

20

25

Source: BMI

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10

20

30

40

50

60

70

80

90

100

Dec-07

Feb-08

Apr-08

Jun-08

Aug-08

Oct-08

Dec-08

Feb-09

Apr-09

Jun-09

Aug-09

Oct-09

Dec-09

Feb-10

Apr-10

Jun-10

Aug-10

Oct-10

Dec-10

Feb-11

Apr-11

Jun-11

Aug-11

Oct-11


25/61



Bkg Sct outk

Bkg Sct istbtyPybkBMI View:As the repayment capacity of loans extended

to local government investment vehicles comes under

threat, we continue to expect instability in Chinas bank-

ing system. In this article, we detail our core views on

how the process will play out and its impact on economic

growth and local asset markets. In terms of the nancial

markets, we continue to expect the H-Financials Index

to underperform the broader market.

Earlier this year, Chinas National Audit Ofce (NAO)provided some rare insight into the problems faced by

Chinas banking system as a result of the proliferation

of liabilities racked up to local governments i

Documents

BMI Special Report China 2012 From Miracle to Meltdown 2011-09-01