China in 2012: Time to reflate

It's time to start reflating China's economy. Inflation has fallen rapidly, but growth is also decelerating and leading indicators point to a further slowdown into 2012.

The European crisis and falling property prices will only add to downside pressure on growth. This means the major macro risk in China is quickly shifting from inflation to disinflation, calling for more aggressive easing in policy in 2012. China's annual price growth peaked at 6.5 per cent in mid-2011, but will cool gradually.

Several other favourable factors should help contain inflationary pressures during 2012. Commodities prices have softened since the downturn in the global trade cycle and are unlikely to rally, implying much less imported inflation. Also, the faster than expected slowdown in producer prices should translate into lower inflationary pressures. And food prices, key to China's consumer price inflation, should slow thanks to another bumper harvest – the eighth running – a peaking of pork prices and Beijing's measures to promote agricultural production.

Growth is set to overtake inflation as Beijing's top policy concern in 2012.

So, will the deceleration in inflation turn to deflation? We think not, although disinflationary forces are likely to be more prominent in early 2012. First, money supply growth is likely to be steady rather than decelerate sharply. Second, growth should hold up well despite the modest slowdown. Third, Beijing is likely to push through resources tax and price reforms when inflation eases sufficiently.

Hence, growth is set to overtake inflation as Beijing's top policy concern in 2012. The key worry is that the full impact of a slowdown in global exports, coupled with the lagged impact of the government's recent tightening measures, will hit manufacturing. Export growth is likely to decelerate to single digits, threatening job cuts and slower income growth.

The tough property tightening measures are expected to be kept in place to ensure prices fall to what Premier Wen has called "reasonable levels". This would encourage genuine homebuyers to jump into the market and help stabilise both prices and developers' cash flows but the worst-case scenario is an overcorrection led by entrenched expectations about further price declines. In a severe downturn, many potential homebuyers may hesitate if they believe prices will fall further.

Lacking experience of a major downturn, Beijing policymakers will have to fine-tune the public's expectations about future prices to avoid a major correction. This will require a careful balancing act; the last thing they want is houses prices to start rising sharply again.

But policymakers should still stick to an 8 per cent growth target. Anything lower may cause significant lay-offs that could risk social unrest. While there are challenges ahead, the good news is that inflation is petering out, leaving room for policy easing to support growth and employment.

Beijing policymakers will have to fine-tune the public's expectations about future prices.

This officially marks the beginning of the monetary easing cycle, in response to the noticeable slowdown of both the latest inflation and growth data. We expect Beijing to ease monetary policy more aggressively by more reserve ratio cuts and a larger new loan quota.

Reserve ratio cuts are likely to become the primary tools for maintaining reasonable liquidity and credit growth. Quantitative easing via such cuts is now needed. The Peoples' Bank of China made a surprise 50bp cut in November and we expect another 150bp of reserve ratio cuts during the first half of 2012.

The market has also priced in lower interest rates. We believe rate cuts will be used as secondary monetary policy tools with the People's Bank of China cutting interest rates by 25bp when inflation slows to below 3 per cent, probably in the third quarter of 2012.

Weaker global demand means China's trade surplus – which peaked at 7.5 per cent of GDP in 2007 – will shrink further from its current level of around 2 per cent and the ratio of current account surplus to GDP, once more than 10 per cent, is likely to fall below 4 per cent. This suggests China is making significant progress towards improving its international balance of payments.

That being said, Beijing should be able to use fiscal measures to counterbalance weaker external demand. There is plenty of room to reduce the tax burden and expand fiscal spending to support growth and employment. Fiscal adjustments are likely to be tilted to smaller firms, services industries and public housing construction, but with more than 10trn renminbi in fiscal revenue in 2011, we believe Beijing can allow tax reductions equivalent to around 1 per cent of GDP, or 400bn to 500bn renminbi.

Beijing is likely to keep the fiscal deficit at around 2 per cent of GDP in 2012. This implies fiscal spending will continue to play an important role in supporting growth and employment. Public spending on construction work remains the most important policy tool to counterbalance the external shocks and we think Beijing looks certain to continue to finance ongoing infrastructure projects in 2012, but is unlikely to introduce a huge infrastructure-led stimulus package.

The expected combination of easing monetary policy and expansionary fiscal policy is likely to underpin China's domestic demand. Investment is always a useful tool for stimulating growth and has proved effective in the past. Investment growth is likely to slow from the current 24.9 per cent a year to around 20 per cent in nominal terms because of the lagged impact of credit tightening and the slowdown in property investment, but annual real investment growth is likely to exceed 15 per cent thanks to falling inflation.

Investment is always a useful tool for stimulating growth and has proved effective in the past.

What could go wrong? Beijing must strike a delicate balance between supporting growth and over-stimulating the economy. Past experiences suggest easing policies tend to go too far, not least because banks and local authorities are always keen to drive up lending, local investment and economic growth. Easing signals from the central government can easily be amplified at local levels.

But a faster than expected deterioration in economic conditions may trigger more aggressive easing measures. That might save the economy in the short term, but could plant the seeds for persistent imbalances in the mid to long term.

This report must be read with the disclosures, analyst certifications and the disclaimer.