Asia Views

June 29, 2010

Goldman Sachs Global Economics,

Commodities and Strategy Research
at https://360.gs.com

Michael Buchanan
michael.buchanan@gs.com
After extensive client discussions, we still think the
+852 2978 1941 sequential slowdown in China will be greater than the
market has been expecting
After three weeks of meetings in Japan, continental Europe, UK and then this week in Hong
Kong, we continue to believe that the market is expecting less of a sequential slowdown in
Chinese growth than we think may occur in the near term.

 This follows our note on June 10, where we highlight that there are growing downside risks to
our forecasts, and also the webcast we did on June 21 after China announced the changes in
its currency regime.

 However, we remain very positive on the overall China outlook beyond the near term. In
particular, we still completely disagree with the vocal but small minority that see China as a
“credit driven investment bubble” – China has run aggressively counter-cyclical policy before
the global credit crisis and so had room for the substantial easing (700bps in FCI terms)
without seeing excess credit growth rise to the levels of other major countries.

 The temporary policy-driven slowdown could be offset subsequently by recalibration of

policy (hence the importance of our “risk based approach to tightening”, where the bulk of the
tightening is delivered by measures that are easy to adjust in response to changes in the
growth outlook (i.e. mainly loan guidance).

 While investors in Hong Kong have in general been more focused on the tightening than
those outside the region, even these investors do not seem to have been expecting much of a
near-term sequential slowdown.

 The only type of investors that seemed to have a similar view on the extent of the downturn
were a small number of dedicated commodity funds and some investors in the domestic
market, although the issue is becoming ever more the centre of attention.

The market reaction to the change in the CNY regime announced on June 19 may have been
misinterpreted by the market and partly explain the views above.

 Some investors felt that China would not have announced the change in exchange rate policy
if growth were slowing to any significant degree.

 However, we continue to argue that the primary motivation for the currency move is political
rather than economic – while that may appear obvious given the real risk of protectionist
measures in the US, it also implies that the amount of tightening delivered by nominal
appreciation will be modest and that it does not require strong sequential growth as a

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Goldman Sachs Global Economics, Commodities and Strategy Research Asia Views

precondition. Rather, it seems that China moved as soon as the extreme uncertainty about
Europe faded a touch.

 If our pre-existing CNY forecasts turn out to be right (and we continue to think they are
appropriate) – i.e. a 5% annualized appreciation against the USD, implying a touch under 3%
by end-year – this would deliver only a modest 30bps of tightening on our FCI (assuming no
changes in any other currencies). If our other global FX forecasts are right, then this would
imply an overall 4.5% trade-weighted appreciation, delivering around 50bps of tightening.

 This is modest compared to the more than 300bps of tightening China has delivered since last
year (and an original forecast for a total of 400bps of tightening by end-2010), and so can be
accommodated within the overall stance of policy without significant difficulty.

 So while it was the case that China would not appreciate its currency at all when there was
significant unemployment in the coastal areas last year, we do not think that the move this
month implies that there is no risk of a greater sequential slowdown now.

As we said in the piece on June 10, much of the sequential slowdown is probably already
happening even though it hasn’t shown up broadly in the macro data yet (see Incorporating
the new EUR forecasts in Asia amidst the inevitable China slowdown, Asia Views, June 10,
2010). There is thus much less room left now for further softening to still leave growth above
trend. In that piece, we noted in addition to the “good slowdown” that has always been in our
forecasts, driven the tightening in our Financial Conditions Index, there are more recent additional
downside risks to our baseline view. These come from the domestic housing market and broader
investment outlook and from the external side. The key points we made in the June 10 piece were:

 We were initially about 3 percentage points (ppt) above consensus on annual 2010 growth in
China when we published our current forecasts last summer, but that gap has since halved. In
addition, we have always had a sequential slowdown of more than 4 ppt in China and a
tightening of a similar magnitude in our China Financial Conditions Index (FCI).

 We have talked about this tightening and slowing repeatedly since last year, and lately it is
often the case that while our baseline has been for higher 2010 annual growth , we see more
of a slowdown during the year than many clients. This tightening and slowing was a key
reason why we reiterated our view in January that managed currencies were a better way of
playing our above-trend views on growth than equities (see Why we continue to like AEJ
currencies: it’s still “Broader, Deeper and Tighter” but accelerating inflation and exports
add further fuel post-payrolls, Asia Views, January 11, 2010). After a great run for those
trades, we subsequently took off most of the long currency recommendations in mid-April
due to fears that market risks were growing and Asia was significantly exposed in the short
term and are currently recommending defensive positions (see AEJ currency appreciation—
still some room but story changing, Asia Views, April 15, 2010).

 Looking forward, we assume a relatively smooth handover from the “normal” private
residential part of the Chinese property market to social housing construction, as discussed by
Helen Qiao and Yu Song earlier this month (see China: Policymakers will likely “wait and
see” for now, but policy reinforcement is key to watch, Asia Economics Flash, June 7, 2010).
Subsequent information suggests there are lots of second and third home purchases outside
the 1st tier cities, and some signs of sluggish start-up to social housing, based on feedback
from a recent property tour by our analysts. Given that the government is pressuring
developers to continue investment (via measures on their cash flow and restrictions on the
time taken to develop), we continue to think the most likely outcome is a gradual handover
from one part of the housing market to the other. However, if the private property pendulum
swings strongly negative before local governments have built out their social housing
programs, there could be a larger growth impact.

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Goldman Sachs Global Economics, Commodities and Strategy Research Asia Views

 There are also measures on other forms of investment, including sensible steps to ensure bank
financing to local government infrastructure companies is more subdued. These could also
add to the near-term slowdown.

 In addition, we highlighted that our US team continues to forecast a sequential slowdown in

2H2010 in the US, and this issue has moved more to the fore in recent weeks.

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 Goldman Sachs Global Economics, Commodities and Strategy Research Asia Views

I, Michael Buchanan, hereby certify that all of the views expressed in this report accurately reflect personal views, which have not been
influenced by considerations of the firm's business or client relationships.

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