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Country Outlook: China September 2009 OUTLOOK FOR 2009-10 The government's main priority is to support the economy amid concerns that rising unemployment could increase social unrest. But even if unrest grows, it is unlikely to result in a nationwide anti-government movement. Little improvement is likely in the strained relations between the majority Han ethnic group and Tibetan and Uighur minorities. The government will maintain its hard line against separatism, stoking wider ethnic grievances. Despite some tightening, monetary and credit policy will remain relatively loose. The Economist Intelligence Unit has raised its forecast for economic growth to 8.1% in 2009 to and 8.5% in 2010 (both stood at 8% previously). As manufacturing and rural investment boosts industrial and agricultural output, consumer price inflation will remain weak but producer costs will accelerate in 2010. Asset price bubbles will emerge in property and shares. Falling trade flows and tax breaks offered to businesses will reduce tax receipts in 2009. Coupled with rising spending, this will cause the budget deficit to widen to 4.2% in 2009. The deficit will then narrow to 3.2% in 2010. The outlook for exports is poor, but falling commodity prices will also depress the value of imports. The trade surplus will thus remain large. The current-account surplus will shrink to 6.1% of GDP in 2009 and 4.3% in 2010. DOMESTIC POLITICS: The recent violence in Xinjiang involving the Uighur minority has again raised the spectre of ethnic unrest, just a year after similar clashes in Tibetan regions. The government has also proved its ability to bring instability in minority areas under control relatively quickly. It remains unlikely that this type of event will challenge the stability of the regime; rather, by rallying ethnic-Han support around the cause of patriotism, the government has arguably strengthened its position. Nevertheless, the second major outbreak of ethnically based violence in two years suggests that the government's hardline approach to separatist movements is undermining relations with Tibetan and Uighur communities. A rethinking of policy in these regions would be welcome, but the chances of this happening are low. INTERNATIONAL RELATIONS: The recent improvement in relations between the mainland and Taiwan has been considerable, and is likely to continue. However, at some point in 2009-10 the two governments may find that there is a limit to how far ties can strengthen in the current political environment. Better relations between China and Taiwan will help to stabilise Sino-US ties. China and the US will continue to clash over economic issues, where they have a tense yet symbiotic co-existence, but their relationship should remain stable, as the US president, Barack Obama, is shying away from taking an aggressive approach on China's human rights policies. China's financial resources mean that many countries around the world are looking to it for help during the global economic crisis. This will strengthen its influence relative to the cash-strapped US in foreign relations. Nevertheless, recent spats with Australia, an important supplier of raw materials for the Chinese economy, have highlighted the unsophisticated nature of Chinese diplomacy. China's tendency to adopt extremely aggressive positions in situations when policy disagreements emerge with other nations (for example over its policies in ethnic minority regions) may damage the country's economic interests. POLICY TRENDS: China's aggressive loosening of credit policy and a surge in public spending, especially on infrastructure, appear to have had the desired effect of averting a sharp economic downturn in 2009. Investment has surged, led first by infrastructure spending and more recently by a recovery in property development. The government is unlikely to reverse rapidly its policy of supporting economic growth, but fiscal hawks will eventually bring more restraint to government spending--a development that will probably be preceded by increased monitoring by the central government of wasteful stimulus projects and schemes affected by corruption. Managing a deceleration in credit growth will also prove challenging; total lending was up by 31.4% year on year in July. Very loose monetary policy may suggest future problems with overcapacity and downward pressure on prices for manufactured goods, as credit tends to be channelled into investment. The bias towards investment at the expense of consumption will remain a problem in 2009-10. State welfare services remain underdeveloped, and efforts to increase spending in this area will move at a frustratingly slow pace. INTERNATIONAL ASSUMPTIONS: Forward-looking economic indicators continue to improve in many countries, owing to aggressive fiscal and monetary stimulus, and we have revised up our forecast for global GDP. We now expect the world economy at purchasing power parity (PPP) exchange rates to shrink by 1.4% (compared with a contraction of 1.7% previously) in 2009, before expanding by 2.7% (compared with 2.3% previously) in 2010. However, there is a high probability that growth will slow again in 2011 as the impact of the stimulatory measures that have been implemented dissipates. We have revised up our international oil price forecast, and we now expect prices for crude oil (dated Brent Blend) to average US$62/barrel in 2009 and US$74/b in 2010 (compared with our previous forecast of US$59/b in 2009 and US$70/b in 2010), in recognition of upgrades to our forecasts for key economies, including the US and the euro zone. Nevertheless, weak global demand will depress commodity prices, which will help to ensure that China suffers from deflation in 2009. China's direct exposure to the turmoil that has affected global financial markets is limited by high levels of domestic liquidity and a state-owned banking sector. ECONOMIC GROWTH: Given that real GDP growth had already reached 7.9% year on year in the second quarter of 2009, it now appears likely that China will overshoot the government's aim of 8% average growth for 2009 as a whole. GDP expansion will be driven largely by infrastructure investment linked to the government's stimulus package, but expenditure on property development will also rise in the second half of 2009 and in 2010, providing support as the expansion of infrastructure programmes slows next year. Private consumption growth will be strong, at an average of 9.1% a year in 2009-10. Although the job market has weakened in 2009, income growth seems to have stayed relatively healthy, supporting consumer demand. Deflation (which has boosted consumers' purchasing power, as it has outpaced the slowdown in wage growth) and rapid expansion in government transfers to individuals have played a part in the resilience of private consumption, as have a number of fiscal incentives for consumer purchases. These effects will weaken in 2010, but by then job creation will have accelerated, supporting consumer confidence. Government spending will accelerate sharply (especially in 2009) in order to support economic growth and ongoing reforms to expand the provision of social services, particularly healthcare and education. INFLATION: Investment is expanding rapidly, and as external demand is forecast to remain weak, production overcapacity is likely to be channelled into the domestic market, meaning that price competition remains intense in 2009-10. Coupled with the high-base effect of consumer price inflation of 5.9% in 2008, this will ensure deflation averaging 0.8% in 2009. The diminution of this base effect will see the return of inflation in 2010, albeit at a low rate of 1.6%. However, consumer prices will remain vulnerable to events affecting China's agricultural output, which in turn will have a big impact on food prices (the largest component of China's inflation basket). Producer prices have slumped in 2009 as global commodity prices have dropped amid the global economic downturn, but producer price inflation will rise to 3.5% in 2010 as a result of strong domestic demand and increases in state-mandated prices for fuel and utilities. Asset price bubbles may emerge, especially in property and stocks, in the second half of 2009 and in 2010 as monetary policy is kept artificially loose. It is possible that rapid money-supply growth could also spill over into wider consumer price inflation, although historically this has not tended to happen in China. EXCHANGE RATES: Despite strong pressure on the government from China's main trading partners to allow the renminbi to appreciate faster against the US dollar, the Chinese currency has barely strengthened against the dollar since July 2008. However, on a real effective trade-weighted basis the renminbi will rise sharply this year, presenting further challenges for the export sector. As the rate of economic growth continues rise in the remainder of 2009, the government will adjust its policy, allowing the renminbi to resume a slow but steady rise against the US dollar. Appreciation against the dollar will be faster in 2010 as China's strong economic growth relative to the rest of the world puts further upward pressure on the currency. Despite the problems that it causes for exporters, renminbi appreciation is desirable, as it should help to cut the huge surpluses on China's capital and current accounts, which are contributing significantly to global economic imbalances. EXTERNAL SECTOR: After posting average annual growth of 27% in US dollar terms in 2004-08, merchandise exports will contract sharply in 2009 in response to very weak global demand, and will experience only modest growth in 2010. Despite this, the trade surplus will remain huge in 2009-10, as falling raw-material and oil prices, together with reduced demand for components for assembly in China and subsequent re-export, lead to a big drop in merchandise imports. The weak global economy will cause international tourist arrivals to fall in 2009-10, ensuring that the services account remains in deficit. The surplus on the income account will be substantial in 2009-10, reflecting earnings from the country's growing stock of foreign-exchange reserves and income from rising overseas investment, although low global interest rates and falling dividend payouts will curb income inflows. The current-account surplus is forecast to narrow to the equivalent of 4.3% of GDP in 2010, from 9.6% in 2008. (c) 2009 The Economist Intelligence Unit Limited To buy the full EIU report on this country, visit the EIU Store

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