Third Quarter Economic Outlook

As we head into the third quarter, it is what lies under the surface that attracts our interest. On the economy, the anti-inflation measures are slowly, slowly starting to have some effect but the economy won’t decelerate to the extent that it will meet the government’s stated 7% GDP growth rate for the year. Property is still buoyant. We still expect growth for the year to be in the high 8% range, with third quarter growth at 9%. We also think Beijing would be more than happy with 8%+ growth for the year, given the fragility that persists in the world economy.

We expect banks’ reserve ratios, interest rates and the yuan all to rise further throughout the rest of the year, with the inflation rate coming off its mid-year highs by September, providing the arrival of rains this weekend doesn’t presage a false end to the drought that has hit the farmlands of central China and along the Yangtze valley. We suspect that the impact on grain crops, in particular, will be greater than the optimistic official expressions allow, but there are reserve stocks to dip into.

The drought is also causing the seasonal power shortages to occur in those industrial areas supplied by hydropower sooner than usual and they are likely to be deeper than is customary, but industry is not working flat enough out for them to affect output significantly. Demand from reconstructing Japan should start to boost exports, offsetting in some part weak demand in the West. The Party’s 90th birthday bash in July should also give domestic demand a transitory boost.

Beneath the surface lies, as ever, the risk of the property bubble going bursting, or the local government debt bomb exploding, the two are so closely linked that the one would likely trigger the other, and the conjoined twins are the banking system’s greatest vulnerabilities.

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