Author: Zhixin Shu, Analyst

I spent the last two and a half weeks travelling in China, meeting with companies, government think-tanks, officials and ordinary citizens.  Although the economic picture is rapidly changing due to accelerated deterioration of the external environment from overseas, my general sense about the place is that consumers are still holding up relatively well. The hardest hit sectors are export and property and its supply chain (construction, steel and cement). A number of measures, both monetary and fiscal, have been announced by the government in recent weeks to minimise the impact of the external shock. The key focus of these measures is to stimulate domestic consumption and to invest in infrastructure. Some of my observations and thoughts are summarised below.

Monetary Policy

The loose monetary policy is likely to continue. There have already been three rate cuts; one asymmetric - in response to the difficulties of small and medium enterprises (SMEs), and two symmetric - in response to the global financial and economic crisis. Although in the government some are still concerned about inflation pressure, the rapidly deteriorating external environment makes inflation worries a less important issue for the time being.

Fiscal Policy

Primary Objective: Protect 8% GDP growth 

Technically, this is not a difficult task as China's GDP is calculated based on output only. If the government chooses to ramp up production or investment regardless of demand, they have the ability to achieve the GDP number they choose. This was what happened during the Asian Crisis. The government managed to keep the GDP growth close to 8%.

There is a realisation by the government that China needs to shift from the external demand driven economy to a domestic consumption one. This requires a structural shift of its industry. In general, the decision making style of the current government is consensus building. Its policy initiatives are likely to be done piece by piece and they will then wait to see the result before doing more unless the Chinese economy slows drastically and warrants a dramatic solution.

The fiscal policy has room to stimulate both investment and consumption. Lack of social security has been one of the key reasons that the savings ratio is very high in China. To change consumer behaviour, China needs to develop an adequate social security system. How are they going to do it? Several areas have been outlined as fiscal policy priorities.

Proposals have been put forward for the government to invest in the following areas:

Social Welfare

• Provide free education for the first 9 years
• Establish a basic public healthcare, pension and social security system
• Provide economic housing, both rental and purchase, for the low income population (cap on rent and price). This will boost the property related sectors and current fixed asset investment (FAI) shortfall from developers. This may not necessarily be beneficial for developers, as margins are much lower for this type of housing, but it will benefit steel and cement makers. 

Infrastructure Investment

• Investment has previously been focusing on China’s roads, ports and airports. Attention has now turned to investment in China’s railway system.
• Invest in the north east, central and western China where the economic development is still behind the south and coastal areas
• Invest in environmental protection.

Rural development

• Land reform: details are still sketchy but the basic principle is to improve rural income. Farmers can use land as collateral to borrow from banks or lease it out to a big farm which then gains a greater economy of scale and farming efficiency
• Rural healthcare - build a chain of rural hospitals.

These are all long term projects. Changing behaviour so Chinese consumers save less and spend more, will take a long time. China is likely to fund the above projects through a combination of fiscal deficit and government reconstruction bond issues to the public. Chinese people are very keen on buying government bonds. In the latter case, the government, in effect, takes the savings out of people's hands and spends it for them (if they don't do it themselves). The government could comfortably raise between 150 to 200 billion RMB. In the past, the multiplier is that for every 1 RMB of government investment there will be 3 RMB of private investment.

Other fiscal measures include:

• VAT reform
• Corporate tax reform - potential for tax reduction
• Implementation of resource tax (tax levy on extractive industry which in turn will pass on the cost to the energy intensive manufacturing industry)
• Increase in the starting point (2000RMB/mth) of personal income tax. However, only 3% of the population pay taxes, so the effect of this action is likely to be insignificant.

Chinese Property

Following the announcement of the central government’s stimulus package (6 measures) for Chinese property, I met several property companies. Some of my observations are summarised below.

The stimulus is largely targeted on low end buyers - first time buyers and apartments less than 90 sqm.  There is no direct help for property developers. Significant pressures by the public exist on the government with regards to the affordability of housing and resentment of property developers is widely spread. The central government assisted the property market for two main reasons. Firstly, property investment accounts for 25% of total China’s FAI and 10% of GDP. The slow down has already had a profound secondary effect on its related sectors such as steel, cement, construction industries and on employment in these industries, especially the latter which employs a large number of migrant workers. Secondly, land sale is an important revenue source for local governments (up to 40-50% revenue of some local governments). Since the slow down of the property market, this revenue has declined considerably year to date - only 25% of that of 2007.

One key point in the stimulus package is to allow flexibility for local governments to adjust their own policy for the property sector - we have already seen some 18 cities with their own loosening policy on property before this package. Now they have the central government’s endorsement. More cities are likely to follow.

The general view from the developers is that the new policy is good on sentiment, but not big enough to cause a sea change. We will continue to see slow volume and prices on the downward trend. The most optimistic company I met believes it will take 3 months to see the behaviour change by buyers. Most believe volume will not bottom until Q2/09. 

Taiyuan

Taiyuan is the provincial capital of Shanxi, about 400km southwest of Beijing. The province has 1/40th of China's population (China has a total of 31 districts/provinces) and is a major producer of coal. Its coal output accounts for 25% of China's total coal production, 70% of which is exported to other provinces. 

Taiyuan’s economy relies on heavy industries; coal, steel, aluminium, power generation and cement. Its per capita GDP in 2007 was below the national average, at 88.9%, and has been so for some years. In general, the economic development is lagging behind the coastal and major cities as the government’s past economic development plan has focused on these areas. Driving around the city, it has the feel of Beijing in late 1990s in terms of the stage of development and it is definitely behind Jinan, a coastal provincial capital of Shandong to the east.

In the past few years, rising coal prices have boosted the local economy and there is also increasing attention from the central government to develop the hinterland. The GDP growth here has been greater than the average. The provincial government’s goal is to reach the national average per capita GDP growth by 2011-2012, i.e. outgrow the average by 2% pa. This may be challenging due to the recent decline in commodity price as coal accounts for 1/3 of industrial contribution to the GDP of the province. Out of 119 counties, 94 produce coal. The local governments’ revenue reliance on coal is 40-50% on average.   

The most interesting finding in Taiyuan was that the province had over 4000 mines in the past. Many have been shut down with only 2800 remaining. The policy is to shut down any mine producing less than 70kt pa and with safety concerns. Due to the consolidation, 60% of the provincial production is under the control of 7 government related enterprises. If the coal price falls too much, they are likely to implement a production cut to boost the price. 

The other interesting finding was that property prices are still quite low here. At the prime locations, the average asking price is about 5000-6000 RMB/sqm, and in the suburbs, it is only 3000 RMB/sqm. A miner would make 1500 RMB/month in small mines and 2000-3000 RMB/month in State Owned Enterprises (SOEs). A typical factory worker would make 1000-1200 RMB/month, with food and board provided. Civil servants are still provided with subsidised housing (same quality apartments can be purchased at a reduced price). Although there is no property bubble here, the locals believe that price pressure experienced elsewhere has spread to this province and that there is no hurry to buy.

CAUTION: The opinions expressed in this document are the views of Rexiter Capital Management Limited. This document is intended for institutional investors only and is not suitable for retail clients.