So, nice and easy does it

Slower pace, demand-stimulating policies and efficient use of resources needed to promote balanced growth in coming years

Recovery, relaxation and rebalancing are the three key drivers that will shape the Chinese economy in 2012 and beyond. Unlike the United States and the European Union, China can probably grow out of the problem, but this requires that China's new leadership accepts a slower but more balanced growth model. While policy easing can partly offset an external slowdown and contain downside risks, sustained growth depends on demand-creating policy changes.

The global economy will face a period of prolonged slow growth and it remains unclear which part of the world will exit the global crisis first. In the eurozone, the sovereign debt crisis has dragged the economy into a recession, and growth in the US will likely remain weak in 2012. We expect industrial countries to grow 0.9 percent in 2012, the third lowest growth since 2000.

China will have to overcome weak global demand next year. China's export growth has not recovered to the pre-crisis level and we expect it to fall to single digits next year. In the first 10 months of 2011, exports grew only 12 percent per annum in nominal terms compared to the same period in 2007. The growth in 10 sectors (including base metals, machinery, wood products, vehicles, textiles, etc.) was down by more than 10 percentage points. These sectors accounted for 84 percent of China's total exports in 2011. Meanwhile, China's export growth to the EU dropped to 7.5 percent year-on-year in October, and was already -2 percent if adjusted for export prices.

As a result, assuming no late-2008 type stimulus, China will likely see its slowest economic growth in the past decade, 8.4 percent in 2012. Even during the global financial crisis, the economy grew 9.6 percent in 2008 and 9.2 percent in 2009.

Because of this, China's future growth will need to be more demand-driven. But the recent acceleration in domestic retail sales has not offset weak exports, which has intensified the overcapacity problems in related sectors. Unless the government promotes domestic demand, the external slowdown will weigh on investment in these export-oriented sectors. It is therefore critical for policy-makers to identify domestic demand that is able to offset the shortfall in overseas demand.

Policy relaxation is needed to compensate for the lost external demand - the key question is what domestic demand to stimulate, as the two traditional sources of demand, property and autos, are unlikely to lead the growth again.

In the property sector, administrative tightening may lead to a sharper than expected correction. If purchase restrictions are extended, as Chinese leaders have recently indicated, developers will either have to generate sales by cutting prices sharply to reach qualified buyers who cannot afford higher prices, or they will have to aggressively cut the pace of investment to preserve desirable levels of liquidity. Land sales and new floor area in October all recorded negative growth year-on-year. If this trend continues, property investment growth will likely be well below the late-2008 level.

Auto sales are highly correlated with transaction volumes in the property sector, and as such, auto sales will likely slow alongside lower property sector volumes, although they could see some support from rising household incomes and replacement demand. Due to the high base under the stimulus plus traffic control measures in many cities, auto demand will likely still be under pressure in 2012.

Infrastructure investment, which was the key driver of growth under the stimulus program, also appears to have limited upside potential. Due to massive investment in recent years, only the central and western provinces have significant potential for further investment. But many of them have already run well ahead of their peers in terms of infrastructure investment-to-GDP ratios. The majority of the provinces in central and western China posted a ratio above 20 percent in 2010, suggesting already over-investment in this sector. Unless more fiscal transfers or bank loans are made available for the non-coastal provinces, infrastructure investment will likely be capped.

In our view, a more balanced growth profile for China requires slower growth, the stimulating of marginal demand and more efficient use of resources. We believe it's inevitable that China's economic growth will have to be adjusted from of the recent base of 9-11 percent to a slower base of 6-8 percent in the coming decade. However, slower growth could still provide benefits to Chinese citizens if the quality of growth improves.

Marginal demand is likely in the service sector, though rising incomes should promote consumption in general. As China's GDP per capita is now more than $4,000, a structural change in demand is emerging. The consumption structure for the low-income group of urban households in the Chinese mainland is reminiscent of Taiwan's in 1976, and the high-income group structure is similar to that of Taiwan in 1985. It's thus possible to use the structure of 1985 and 1995 in Taiwan to predict the expenditure structure of low-income and high-income groups of urban mainland households in the coming decade. These suggest China's marginal demand will shift away from staples and towards healthcare, transportation and communications, and recreation and cultural activities.

Improving resource allocation efficiency is likely the key to sustaining growth after the high-investment period is over. If resources were allocated efficiently in the economy, China would require less investment to produce the same rate of growth. More competition and a normalized cost of capital are the two keys to improving resource allocation efficiency.

The author is the head of China Research, Citi Investment Research and Analysis.

(China Daily 12/14/2011 page8)