China Business Forecast Report Q1 2008

Overheating An Increasing Concern Despite economic growth slowing slightly in Q307, China now looks guaranteed to secure its fastest annual pace of expansion in 14 years in 2007. Real GDP data for Q307 revealed that growth slowed to 11.5% y-o-y, down from a 12-year high of 11.9% in the previous quarter, and with full year growth anticipated to be far in excess of 11.0%, Chinese authorities will now be under real pressure to increase measures to prevent the economy from overheating. We are forecasting economic growth to slow to 10.4% in 2008, and further still in 2009 to 9.7%, as China takes further steps to slow the pace of growth. However, we note that the pace of tightening is unlikely to increase significantly, as officials appear largely satisfied with the deliberate and measured approach to monetary policy currently being employed.

The Chinese Communist Party (CCP)'s Congress, which drew to a close on October 22, has provided a strong indication of who is to succeed President Hu Jintao, and his premier, Wen Jiabao, when the two stand down in 2012-13. The selection of two younger 'fifth generation' officials, Xi Jinping and Li Keqiang, to the Politburo Standing Committee, China's highest decision-making body, suggests that the two men are now well placed to assume new state posts when the National People's Congress (parliament) meets in spring 2008. Overall though, we expect broad policy continuity going forward.

With the economy growing in excess of 11.0% y-o-y, and inflation remaining far in excess of the government's 3.0% target, it appears that officials are no longer able to keep their currency undervalued for risk of the economy overheating. As such, we see faster yuan appreciation as an inevitability. However, having run a series of scenarios for accelerated currency gains, we note that allowing the yuan to appreciate too quickly may result in a dramatic economic slowdown. Yet, with ensuring stability the overriding objective for policymakers, it is likely they will continue to err on the side of caution with respect to exchange rate policy, at least for the time being.

Our recently updated business environment ratings have revealed that while China's overall score has improved, from 51.6 to 52.5, its ranking has fallen, from 59th to 61st out of 167 countries.

Where China suffers in our ratings is its poor scores for institutions and market orientation. More specifically, the country achieves a very low ranking for bureaucracy (123rd) and legal framework (127th), which drags its overall institutions score down to 42.7, and for taxes (144th), which see its market orientation score constrained to 46.7. These are three areas in which China must markedly improve if it is to become a more attractive place in which to do business.