China Strategy Outlook Recovery

Asia China
Company
Strategy Update

4 January 2012

China: Themes and For 2012 as a whole, we expect the
Global Markets Research

8.3% GDP growth to support an EPS

Strategy for 2012
growth rate of around 10%. Given our
projection of over 9% sequential GDP
growth and 3% inflation in 2H12, there
is a high likelihood that MSCI China’s
forward PE will recover to 10.5x from
the current 8.2x. The multiple re-rating

From slowdown to recovery and our EPS growth outlook suggest
25–30% upside potential to MSCI China
for 2012.

Despite our bullish outlook for the
market for 2012, we are cautious in the
near term. 1Q12 will likely witness
significant growth deceleration, and the
“hard-landing fear” may intensify.

We expect PMI to begin recovering
from 2Q on the positive impact of
monetary and fiscal policy easing, as
well as possible incentives for first-
home buyers. The sequential economic
recovery should then provide key
support for a market rebound.

Major investment themes for 2012
include disinflation, resumption of public
investment and property sales, and
dissipating fear of bank NPLs. For long-
term investors, we highlight three
themes: sustainable demand for luxury
goods, earlier-than-expected peaking of
China’s demand for commodities, and
the fiscal resolution of LGFV debt.

With respect to sectors, we believe
banks, insurance, IPPs, oil refining, IT,
and luxury goods will outperform in
2012. Short-term buying opportunities
will emerge for developers, construction
materials, and construction machinery
when government policy turns more
supportive of infrastructure and real
estate.
Jun Ma, Ph.D Hui Miao, Ph.D
Chief Economist Strategist
(+852) 2203 8308 (+852) 2203 5934
jun.ma@db.com hui.miao@db.com

Deutsche Bank AG/Hong Kong
All prices are those current at the end of the previous trading session unless otherwise indicated. Prices are sourced from local
exchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject companies. Deutsche
Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm
may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single
factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1.
MICA(P) 146/04/2011.

Asia China
Strategy Update

4 January 2012
China: Themes and Strategy for 2012

From slowdown to
recovery
For 2012 as a whole, we expect the 8.3% GDP growth to support an EPS growth
rate of around 10%.

Given our projection of over 9% sequential GDP growth and 3% inflation in 2H12,
there is a high likelihood that MSCI China’s forward PE will recover to 10.5x from
the current 8.2x. The multiple re-rating and our EPS growth outlook suggest 25–
30% upside potential to MSCI China for 2012.

Despite our bullish outlook for the market for 2012, we are cautious for the near
term. 1Q12 will likely witness significant growth deceleration and an intensified
“hard-landing fear”.

We expect the PMI to begin recovering from 2Q on the positive impact of
monetary and fiscal policy easing, as well as possible incentives for first-home
buyers. The sequential economic recovery should then provide key support for a
market rebound.

We highlight the following investment themes:

Disinflation: to benefit IPPs, oil refineries, and select manufacturing firms
with falling material costs;

Property and public spending cycle: to provide a short-term buying
opportunity for construction materials and machinery;

Dissipating fear of small business and LGFV default: to support the
outperformance of banks;

Luxury goods: to recover to 25% CAGR from 2H; and

Peak of China demand for commodities: medium-term negative for
cement, steel, coking coal, and iron ore.

To summarize, we believe banks, insurance, IPPs, oil refining, IT, and luxury goods
will outperform in 2012. Short-term buying opportunities should emerge for
developers, construction materials, and construction machinery when government
policy turns more supportive of real estate and infrastructure.

Jun Ma, Ph.D Hui Miao, Ph.D
Chief Economist Strategist
(+852) 2203 8308 (+852) 2203 5934
jun.ma@db.com hui.miao@db.com

Deutsche Bank AG/Hong Kong
All prices are those current at the end of the previous trading session unless otherwise indicated. Prices are sourced from local
exchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject companies. Deutsche
Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm
may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single
factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1.
MICA(P) 146/04/2011.

4 January 2012 China: Themes and Strategy for 2012

Table of Contents

Macroeconomic outlook ................................................................... 6
A deeper qoq GDP trough in 1Q12 ........................................................................................... 6
GDP growth to accelerate to 8.6% in 2013 .............................................................................. 7
Property FAI growth to slow rapidly in early-2012 .................................................................... 8
2012 export growth to slow to 8% ......................................................................................... 10
Inflation to drop sharply until 3Q12 ......................................................................................... 10
3–4 RRR cuts to support 15-16% M2 growth......................................................................... 11
RMB should resume appreciating from 2Q ............................................................................ 12
Modest fiscal easing in 2012 .................................................................................................. 13
Real estate policy: incentive for first-home buyers ................................................................. 13

Equity market outlook..................................................................... 16
We expect 2012 EPS growth to reach 10%, and upward EPS revision to start in 2Q ............ 16
We expect 25-30% upside potential for MSCI China index for 2012, with the PE multiple
expanding to 10.5 by year-end ................................................................................................ 17
Market will likely be choppy in 1Q, as negative news flow on weaker growth intensifies ..... 18
Sequential economic recovery from 2Q should begin to offer solid support for the market .. 19
Themes for 2012 and beyond ................................................................................................. 20
Sector valuations..................................................................................................................... 22
Our top Buy list ....................................................................................................................... 23

Disinflation ....................................................................................... 26
CPI inflation will likely fall to 2.5% yoy in 2Q12 ...................................................................... 26
Power and oil refinery: earnings impact from relaxation of price controls .............................. 27
Raw material prices have declined and are unlikely to rebound any time soon ...................... 28
Manufacturing: earnings impact of lower input costs ............................................................. 29
Our disinflation basket and its performance during the previous disinflation cycle ................ 30

The property cycle ........................................................................... 32
Recent declines in property sales and prices .......................................................................... 32
We expect property prices to stabilize after another 10% fall ................................................ 33
We expect property FAI growth to slow to 13% in 2012 ....................................................... 35
Property slump could drag down GDP growth by 1-1.5ppts .................................................. 37
How much will other sectors be affected? ............................................................................. 38
Conclusion .............................................................................................................................. 39

Peak of China’s commodity demand ............................................. 40
China’s demand for commodities as a percentage of global total .......................................... 41
Comparison of per capita consumption is misleading ............................................................ 41
Cumulative commodity consumption is a better approach to demand projection .................. 42
China’s cement demand will likely peak in 2015 ..................................................................... 43
China’s steel demand will likely peak in 2017 ......................................................................... 44
China’s copper demand will likely peak in 2025 ...................................................................... 45
Per capita infrastructure length and urbanization rate are not a good guide ........................... 45
Conclusion .............................................................................................................................. 46

LGFV debt and impact on banks .................................................... 48
Quick re-cap of the LGFV issue ............................................................................................... 48
Local government bonds to refinance LGFV loans ................................................................. 51
Our view on how the LGFV issue should be resolved ............................................................ 52
Why government resolution will be politically desirable ......................................................... 56
Investment implications .......................................................................................................... 56

Informal lending and small business failure ................................. 59
Re-cap of informal lending ...................................................................................................... 59
We expect informal lending to be less of an issue in 2012..................................................... 60
Bank exposure to small firms and informal lending is minimal ............................................... 61

Page 2 Deutsche Bank AG/Hong Kong


Table of Contents (Cont'd)
Government to formalize informal lending market .................................................................. 62
Market implications ................................................................................................................. 63

Luxury goods ................................................................................... 64
Chinese consumption has driven growth in the world luxury market ..................................... 64
Why luxury goods in 2012? ..................................................................................................... 67

12th Five-Year Plans for sectors ..................................................... 71
Government plans for sector growth ...................................................................................... 71
Government policies ............................................................................................................... 74

Appendix A ....................................................................................... 77

Deutsche Bank AG/Hong Kong Page 3


Table of Figures
Figure 1: China: yoy and qoq GDP growth ................................................................................ 7
Figure 2: China: Macroeconomic forecasts (yoy%) .................................................................. 8
Figure 3: Real estate FAI growth forecasts ............................................................................... 9
Figure 4: Estimated composition of urban FAI by type of real estate investment, January–
November 2011 ........................................................................................................................ 9
Figure 5: Yoy percentage change in residential floor space started .......................................... 9
Figure 6: China export growth forecast, yoy and qoq % ........................................................ 10
Figure 7: CPI inflation forecast, yoy % .................................................................................... 11
Figure 8: China: Deutsche Bank forecasts .............................................................................. 15
Figure 9: MSCI China EPS growth vs real GDP growth (yoy %) ............................................. 17
Figure 10: MSCI China PE vs other markets, as of 30 December 2011 .................................. 18
Figure 11: Yoy and qoq (saar) growth forecasts (%) ............................................................... 19
Figure 12: Current PEs vs trough valuation in 2008 by sector ................................................ 23
Figure 13: Deutsche Bank’s top Buy list for 2012 ................................................................... 24
Figure 14: Monthly CPI forecast, yoy % ................................................................................. 26
Figure 15: Earnings impact from relaxation of price controls .................................................. 27
Figure 16: Agricultural product prices ..................................................................................... 28
Figure 17: Raw material prices................................................................................................ 28
Figure 18: USD index (DXY) is highly correlated with commodity index (SPGSCI) .................. 29
Figure 19: Sensitivity analysis: % commodity price decline for 1% drop in US/EU GDP ........ 29
Figure 20: Earnings sensitivity to raw material input cost changes......................................... 30
Figure 21: Stock basket that will benefit from disinflation ...................................................... 31
Figure 22: Share price performance of beneficiaries of disinflation in August 2008 – February
2009 ........................................................................................................................................ 31
Figure 23: Soufun property price index, 39 cities.................................................................... 32
Figure 24: Property sales volume in 39 major cities, yoy % ................................................... 33
Figure 25: Property price/annual household income (x) .......................................................... 34
Figure 26: Monthly mortgage payment/income (%) ............................................................... 34
Figure 27: Gross profit margin of 41 major developers, 1H11 ................................................ 34
Figure 28: Property sales volume and investment .................................................................. 36
Figure 29: Real estate FAI growth forecast ............................................................................ 36
Figure 30: FAI forecast by sector ............................................................................................ 38
Figure 31: Output decline due to 10% reduction in property investment ............................... 38
Figure 32: China’s population, GDP and share of global commodity consumption, 2010 ...... 41
Figure 33: Annual cement consumption (kg per capita) .......................................................... 42
Figure 34: Annual steel consumption (kg per capita) .............................................................. 42
Figure 35: Japan: accumulated steel consumption ................................................................. 43
Figure 36: US: accumulated steel consumption ..................................................................... 43
Figure 37: Japan: historical cement consumption................................................................... 43
Figure 38: US: historical cement consumption ....................................................................... 43
Figure 39: China: medium-term projection of cement consumption....................................... 44
Figure 40: China: medium-term projection of steel consumption ........................................... 44
Figure 41: US: historical copper consumption ........................................................................ 45
Figure 42: China: projection of copper consumption .............................................................. 45
Figure 43: Medium-term outlook of Chinese demand ............................................................ 45
Figure 44: Per capita length of railways and highways in different countries ......................... 46
Figure 45: US: steel consumption per capita .......................................................................... 46
Figure 46: Japan: steel consumption per capita ..................................................................... 46
Figure 47: P/B multiples of H share banks regressed against ROE, showing how the market
has punished Chinese bank stocks ......................................................................................... 48
Figure 48: Annual growth in local government debt ............................................................... 49
Figure 49: Where the LGFVs fit into the structure .................................................................. 49
Figure 50: Generic LGFV incorporation ................................................................................... 49
Figure 51: Estimated breakdown of RMB8.5tr in bank loans .................................................. 50
Figure 52: Debt maturity schedule for LGFVs as at end-2010................................................. 50
Figure 53: Landmark local government direct bond issuance ................................................. 51
Figure 54: A hypothetical resolution strategy for LG and LGFV debt (in RMB bn) .................. 52
Figure 55: A hypothetical resolution strategy for LG/LGFV debt ............................................. 53



Table of Figures (Cont'd)
Figure 56: Estimating the book value of local government unlisted SOEs .............................. 54
Figure 57: Chinese government expenditure growth can be reined in by 2ppts..................... 55
Figure 58: Annual EPS impact is likely to be 2-3%.................................................................. 56
Figure 59: Bank-specific exposure to varying degrees of government assistance.................. 57
Figure 60: Sources of informal lending in Wenzhou, 2010...................................................... 62
Figure 61: Uses of informal lending in Wenzhou, 2010 .......................................................... 62
Figure 62: Global luxury goods market sales, 2003-2010 (Euro bn) ........................................ 65
Figure 63: Mainland China luxury goods market sales, 2007-2010 (Euro bn) .......................... 65
Figure 64: The emergence of the Chinese middle class ......................................................... 65
Figure 65: Estimating the income of households in the top income bracket (> RMB100,000)66
Figure 66: Change in total income for households with income of more than RMB100,000 . 66
Figure 67: Consumer discretionary stocks have been winners for the past two years … ...... 67
Figure 68: … but stocks trended sideways in 2011, and are moving down ........................... 68
Figure 69: Consumer sentiment has declined since 2Q11, and we think this trend will carry on
into 1Q12 ................................................................................................................................ 68
Figure 70: PMI and sales of Gold, Silver and jewelry .............................................................. 69
Figure 71: Comparison of luxury duty rates ............................................................................ 69
Figure 72: Global luxury good company sales to Chinese consumers .................................... 70
Figure 73: Annual growth of market size in, or implied by, 12th FYP, CAGR ........................... 73
Figure 74: Estimated total investments in strategic emerging industries ............................... 74
Figure 75: Market share of top 10 producers, 12th FYP targets .............................................. 75
Figure 76: Listed China/Hong Kong stocks under Deutsche Bank coverage, 30 December
2011 ........................................................................................................................................ 77
2011, continued ...................................................................................................................... 78
2011, continued ...................................................................................................................... 79
2011, continued ...................................................................................................................... 80



Macroeconomic outlook
We expect annual GDP growth to slow from 9.1% in 2011 to 8.3% in 2012, and to
recover to 8.6% in 2013.

For 2012, we expect the economy to be characterized by: 1) disinflation; 2) initial growth
deceleration followed by a recovery; and 3) policy easing in 1H, followed by a more
cautious stance towards the end of the year.

We expect a qoq (saar) GDP growth trough in 1Q12 at 6.4%, mainly on the back of
deteriorating outlook for real estate FAI in the coming months. We continue to expect a
rebound in the sequential GDP growth from 2Q on policy easing.

The two major shocks to the economy in the coming months will likely be property FAI
deceleration and export slowdown. We expect property FAI growth to slow from the
current 30% yoy to 14% yoy in the first few months of 2012. We expect export growth
to decelerate from the current 15% yoy to 8% in 1Q12.

With respect to monetary policy, we expect 3–4 RRR cuts in 2012, which should permit
the average monthly RMB lending to rebound to RMB800–900bn/month in 1H, and
annual lending to reach about RMB8.4tr in 2012.

We expect modest fiscal easing in 2012. Fiscal priorities should include public housing,
completion of ongoing infrastructure projects, SMEs, services, and consumption.

We expect the RMB to start appreciating again from 2Q12. For 2012 as a whole, we
forecast that the RMB will appreciate 3.5% against the USD.

With respect to real estate policy, we do not expect any immediate changes. However,
we do not rule out the possibility that the government may be under pressure to provide
incentives for first-time buyers from 2Q.

A deeper qoq GDP trough in 1Q12
We cut our GDP growth forecast for 2012 to 8.3% in August 2011 and have since maintained
this forecast. Despite many changes in our global economic forecasts and recent
developments in China, we continue to believe our 8.3% GDP forecast remains reasonable.

Our European economists have downgraded their Eurozone GDP forecast for 2012 twice in the
past four months; the most recent revision was from 0.4% to the current -0.5%. As we (China
economics team) took a more bearish view on Europe in August, the recent changes in the
forecast for Europe only marginally worsened our annual outlook for China’s export growth.

Figure 1 reflects our current yoy and qoq (saar) GDP growth forecasts for 2012. The only
change we made last month was to further cut our qoq GDP growth forecast for 1Q12 to
6.4% from 6.8% because: 1) we expect a sharper slowdown in real estate FAI growth in the
coming months due to weakness in property sales; and 2) the contraction in European GDP
in 1Q is likely to be 1.6% on a qoq saar basis, versus the previous forecast of 0.4%.



Figure 1: China: yoy and qoq GDP growth
yoy % qoq (saar) %
2011Q1 9.7% 8.7%
2011Q2 9.5% 9.1%
2011Q3 9.1% 9.5%
2011Q4F 8.5% 7.3%
2012Q1F 7.7% 6.4%
2012Q2F 7.5% 9.0%
2012Q3F 8.7% 10.0%
2012Q4F 8.7% 9.7%
Source: Deutsche Bank, NBS

The three factors behind our projected sequential growth trough in 1Q12 are: 1) we believe that
the European economy is already in recession and its economic contraction will likely be the
worst in 1Q. This implies that China’s export growth will suffer the most from a weakening
European demand in 1Q. 2) China’s real estate sales have slowed sharply since September
2011, and developers will thus likely rein in their construction activities. Sequential slowdown in
construction should last until 1Q12, before property prices and sales may stabilize. 3) China’s
monetary easing, which began only in end-November (as marked by the RRR cut on 30
November), will likely become more visible in 1Q. With a one-quarter lag, monetary easing
should begin to support domestic demand from 2Q, especially investment activities.

Note that the qoq GDP growth rates before (and including) 3Q11 are estimates from the
National Bureau of Statistics (NBS). Our estimates differ as we use a different seasonal
adjustment methodology. The NBS uses its own methodology, but the agency does not
release its details and original data; therefore, it is not possible to replicate its estimates. We
believe its estimates are incorrect as the yoy and qoq growth rates appear inconsistent. In
particular, the NBS’s estimate of a sequential acceleration in GDP growth in 3Q11 was
contradictory to most other indicators when GDP became visibly weaker in that quarter.
These include the PMI, monetary and loan growth rates, commodity prices, as well as the
qoq change in power consumption. In particular, the PMI fell to around 50 in 3Q, and during
the quarter monetary conditions appeared to be the tightest in two years.

Given this difference in methodologies, we ask readers to take our qoq GDP estimates as
indicative (of our view of the momentum of the economy), rather than something that could
be verified by NBS data releases in the future.

GDP growth to accelerate to 8.6% in 2013
For investors who are looking for longer-term growth forecasts, we expect GDP growth to
rise to 8.6% in 2013, up from 8.3% in 2012. This largely reflects our view that GDP growth in
the US and Eurozone will be stronger in 2013 than in 2012. The rationale for this forecast
includes: 1) the worst phase of bank deleveraging, which causes contraction of the real
economy, would be in 2012; and 2) the fiscal contraction in the Eurozone (measured by the
reduction in cyclically adjusted fiscal deficit/GDP ratio) was as much as 1.4ppts in 2012, but
should improve in 2013. In other words, the impact of fiscal contraction will likely become
less of a drag on the Eurozone in 2013.

Stronger US and Eurozone growth should enhance Chinese growth via stronger exports. For
example, based on historical correlations, a 1% increase in the US and EU growth would
result in a 6ppt growth in Chinese exports. Thus, we forecast China’s export growth to
accelerate from 8% in 2012 to 14% in 2013. In terms of volume, China’s export growth will
likely accelerate by 3–4ppts. This should translate into a 0.5ppt increase in China’s GDP
growth. However, given that monetary and fiscal policies will likely become a bit more
restrained, we expect GDP growth in 2013 to accelerate only by 0.3ppts to 8.6%.



Other changes to the key components of the Chinese economy should largely offset each other
in terms of the impact on GDP. For example, we expect some modest deceleration in real
gross capital formation (as corporate profit margin will likely drop due to the long-term structural
trend of higher wage growth), but real private consumption will likely accelerate a little on better
income growth and higher government spending on social services and welfare.

Figure 2: China: Macroeconomic forecasts (yoy%)
2010 2011F 2012F 2013F
Real GDP 10.3 9.1 8.3 8.6
CPI 3.3 5.3 2.8 3.5
Broad money (M2) 19.7 13.5 16.0 14.5
Bank credit 19.9 15.0 15.5 14.0
Budget surplus (%of GDP) -1.7 -2.0 -2.2 -1.5
Fixed asset inv't 23.8 23.0 17.0 17.0
Retail sales 18.4 16.5 14.0 15.0
Industrial production (real) 15.7 13.0 11.5 12.0
Merch exports (USD) 31.3 20.0 8.0 14.0
Merch imports (USD) 38.7 24.0 9.0 16.0
1-year deposit rate 3.50 3.50 3.50 3.50
CNY/USD (eop) 6.59 6.30 6.10 5.86
Source: Deutsche Bank forecasts, CEIC

Property FAI growth to slow rapidly in early-2012
We believe that the decline in property investments by developers will become the most
serious challenge for the economy in the coming few months, more than the deceleration in
exports. This is because the average property price in 39 major cities has declined by about
13% in the past two months, according to Soufun. Sales and floor space have both
decelerated sharply. The growth of floor space started – a leading indicator of real estate
FAI – fell from 30% yoy in January-August to only 10% yoy in September and -1% yoy in
October. Based on historical correlation, the deceleration in floor space started will likely
translate into a visible slowdown in real estate FAI (correlation at 0.5–0.6). Thus, we expect
real estate FAI growth to decelerate from 30% yoy in 4Q11 to 14% yoy in 1Q12. On a qoq
basis, we expect the real estate FAI growth to slow to zero in 1Q12.



Figure 3: Real estate FAI growth forecasts Figure 4: Estimated composition of urban FAI by type of
real estate investment, January–November 2011

yoy qoq (saar)
Others, 12%
1Q 11 34% 75%
2Q 11 32% 35% Office/Comm
ercial, 16%

3Q 11 31% 17% Commodity
housing , 59%
4Q 11F 30% 7%
1Q 12F 14% 0%
2Q 12F 7% 18% Public
housing, 13%
3Q 12F 11% 25%
4Q 12F 19% 20%
Source: Deutsche Bank Source: Deutsche Bank, CEIC

Figure 5: Yoy percentage change in residential floor space started
250%

200%

150%

100%

50%

0%

-50%
Apr-08

Apr-09

Apr-10

Apr-11
Feb-08

Feb-09

Feb-10

Feb-11
Jun-08

Jun-09

Jun-10

Jun-11
Dec-08

Dec-09

Dec-10
Aug-08
Oct-08

Aug-09
Oct-09

Aug-10
Oct-10

Aug-11
Oct-11
Source: CEIC

Some readers have wondered whether real estate FAI can still be growing at positive rates
with residential property sales declining sharply. One thing to clarify here is that we are
projecting the total real estate FAI growth, rather than commodity housing FAI growth (i.e.,
investment by developers for sale at market prices). This is a part of FAI that will be
substantially affected by the slowdown in property sales. It accounted for about 60% of total
urban real estate FAI in the first 11 months of 2011, according to our estimates. The other
components of real estate FAI include public housing (about 13%), commercial and office
property FAI (16%), and others (including investments by urban work units). The growth of
these components is largely unaffected by the weakness of property sales in the private
market. When qoq total real estate FAI growth falls to zero in 1Q12, it will actually imply that
qoq commodity housing FAI growth has declined by 20% (given that the FAI of other real
estate components is growing at 30% yoy).

It is also important to distinguish between yoy and qoq growth of real estate FAI. The qoq
FAI growth can indeed fall very sharply (e.g., to zero in 1Q12) due to the recent decline in
property sales, but FAI can remain positive on a yoy basis as the yoy number reflects the
impact of the cumulative change over the past four quarters. In addition, we expect that by



2Q12, property sales and FAI will pick up due to improving affordability and possibly some
support from the government’s policy. Therefore, the annual FAI growth can still be at a
positive rate for 2012.

As for the impact on GDP, given that the real estate sector’s capital formation accounts for
about 10% of GDP, we estimate that a 7ppt deceleration in qoq (saar) real estate FAI growth
could reduce qoq (saar) GDP growth by 0.7ppts in 1Q12.

2012 export growth to slow to 8%
Our European economists are projecting that the Eurozone economy will be in recession
from 4Q11 through 1H12. The trough is projected in 1Q12. The driving forces behind further
deterioration in 1Q sequential growth include bank deleveraging, fiscal contraction, as well as
the effects of negative wealth arising from weaker consumer confidence. However, over the
coming months, we expect the Eurozone to show some progress towards fiscal
consolidation, permitting the European Central Bank (ECB) to further loosen monetary policy
and support the debt market, and help lift market and consumer confidence. The benefits for
the real economy are expected to kick in from 2Q12.

Given this European growth trajectory and a relatively steady pace of US economic growth
(at around 2.5% annualized rates for most quarters), we expect China’s qoq and yoy export
growth as shown in Figure 6.

Figure 6: China export growth forecast, yoy and qoq %
China export yoy China export(qoq saar) EU/US GDP (qoq saar)
1Q 11 26% 16.0% 2.0%
2Q 11 22% 7.7% 1.0%
3Q 11 21% 10.2% 1.3%
4Q 11F 15% 6.1% 0.7%
1Q 12F 8% 2.2% 0.3%
2Q 12F 6% 3.0% 0.4%
3Q 12F 6% 12.1% 1.5%
4Q 12F 11% 14.6% 1.9%
Source: Deutsche Bank, CEIC

According to our estimates, China’s qoq (saar) export growth will slow sharply to a mere
2.2% in 1Q12, down from 6.1% in 4Q11. As a result, yoy export growth will likely decelerate
to 8% in 1Q, stay weak in 2Q and 3Q, and finally recover in 4Q. For the year as a whole, we
now forecast export growth at 8% (vs the previous forecast of 10%). We have also lowered
our import growth forecast by 2ppts to 9%.

Ceteris paribus, the qoq export deceleration will lead to a reduction in qoq (saar) GDP growth
by about 0.4ppts in 1Q12. We expect only a small part of the GDP to be affected by the
deceleration in real estate FAI, and exports to be offset by monetary easing in that quarter.

Inflation to drop sharply until 3Q12
We continue to expect CPI inflation to decline sharply to 4.2% in November, 3.8% yoy in
December, and 3% in 2Q12. This reflects a significant decline in wholesale agriculture prices
in the past two months (by 7–8%) and its gradual pass-through to retail food prices. Based on
historical correlation, the food component of CPI should fall by at least 5% cumulatively
between the September peak and the next trough. Even if power tariffs are raised by 5% and
refined oil prices are increased by 10%, their boost to CPI will be only 0.3ppts, a small
fraction of CPI reduction (by 1.5%) due to a 5% drop in food prices.



Based on seasonality, we assume a 5% rise in food prices in January and February to reflect
the effect of the Chinese New Year. Even with this sequential rise in food prices, yoy CPI
inflation will still likely fall to 3% in 2Q and the full-year figure will likely be 2.8%.

Other key assumptions we made in this CPI projection include a modest decline in PPI in the
coming few months, with a recovery from 2Q12. For the whole year, we see PPI inflation at
about 4%, significantly lower than the recent peak of about 8%. This projection is supported
by the recent trend of declining input price index in the PMI report.

Another important contributor to disinflation is the fall in property prices, which will over time
translate into a decline in the housing component (which includes rents and imputed rents) of
the CPI. We estimate that a 10% drop in the prices of physical properties (Soufun property
price index) will eventually – after about six months – reduce the housing component of the
CPI by 1%.

Figure 7: CPI inflation forecast, yoy %
7%
6%
5%
4%
3%
2%
1%
0%
-1%
-2%
-3%
Dec-09

Dec-10

Dec-11

Dec-12
Aug-09
Oct-09

Aug-10
Oct-10

Aug-11
Oct-11

Aug-12
Oct-12
Apr-10

Apr-11

Apr-12
Sep-09
Nov-09
Jan-10
Feb-10

Sep-10
Nov-10
Jan-11
Feb-11

Sep-11
Nov-11
Jan-12
Feb-12

Sep-12
Nov-12
May-10

May-11

May-12
Mar-10

Jun-10
Jul-10

Mar-11

Jun-11
Jul-11

Mar-12

Jun-12
Jul-12

3–4 RRR cuts to support 15-16% M2 growth
We expect M2 growth to accelerate to 15-16% in 2012, up from 13% in Nov 2011. M2 growth
is typically set at 2-3ppts above nominal GDP growth. This time, given the consensus forecast
of 8.5% for real GDP growth and about 3.5% for CPI inflation, 14% will likely form the bottom
for discussion for 2012’s M2 growth range. However, arguments for some additional monetary
expansion will likely be made in the coming months to allow 1-2ppt additional M2 growth in
order to offset the global demand shock and the weakness in the real estate sector. Thus, the
outcome will likely be 15%-16% for M2 growth. An M2 growth rate of 15% should be
applicable if GDP growth stays above 8%, but an M2 growth of 16% is more likely when yoy
GDP growth slips below 8% for two quarters (in line with our forecast).

At the moment, we do not see any strong reasons why loan growth should be much different
from M2 growth in 2012. This implies that new RMB lending will be around RMB8.4tr for 2012
(i.e., loan growth of around 15.5%), up from the estimated RMB7.4tr for 2011.

We estimate that four RRR cuts may be required to generate enough liquidity (deposit growth)
in the banking system to support 16% loan growth in 2012. Our assumptions in this calculation
include: 1) in 2012, the net purchase of FX reserves by the PBOC would be USD300bn, about
half of that in 2010; 2) there is no change in outstanding PBOC bills in 2012; and 3) there are no



major changes in reserve money due to other open market operations. Under these
assumptions, the increase in reserve money due to PBOC’s FX purchase can generate an
increase of RMB7.3tr in M2. Given the fact that an RRR cut by 0.5% can increase the money
multiplier by about 0.07 and eventually boost M2 (after a time lag) by RMB1.4tr, four RRR cuts
will be needed to provide additional M2 of about RMB5.8tr. An increase in M2 by RMB13.1tr
(RMB7.3tr+RMB5.8tr) is needed to support 16% loan growth in 2012. Therefore, three-four
RRR cuts are likely if loan growth is to be in the range of 15%-16%.

As for the timing of the RRR cuts, we believe they will likely be front-loaded for several reasons.
First, the capital outflow due to expectations of a weak RMB will continue to restrain domestic
liquidity growth due to limited FX purchase by the central bank in the coming months. Second,
economic growth will likely be weak in 1H (worst in 1Q on a qoq basis, and worst in 2Q on a
yoy basis), and thus should prompt the government to be relatively more aggressive in policy
easing in 1H than in 2H. Third, the global quantitative easing (by the Fed and ECB) in the coming
months will likely begin to exert upward pressure on commodity prices in 2H12. Therefore,
towards the end of 2012, China’s monetary policy stance may become somewhat more
cautious again, due to the re-emergence of inflationary pressure.

RMB should resume appreciating from 2Q
The recent depreciation of the RMB vs the USD – by about 0.3% in November – reflected the
short-term change in the market’s expectation from the RMB and reduced PBOC
intervention, in our view. We believe China should be pleased to see that the market force is
finally generating some two-way volatility for the RMB. The two-way volatility has at least
two benefits. First, it provides a support to China’s argument with the US that it is not
manipulating its currency. Second, it is a major warning to short-term traders that they can
lose money anytime by taking positions on RMB appreciation, and thus helps deter some
speculative activities and reduce hot money inflows. Our previous study had shown that if
the RMB’s volatility (annualized daily volatility) rises from 1.5% to 3.5%, it can drastically
reduce the Sharpe ratio of investing in the RMB to 0.22 from 0.57. We believe China is now
moving in the right direction1 of increasing RMB volatility.

We expect short-term weakness in the RMB to persist for a few more months, as long as the
market expectation of China’s growth deceleration and export contraction remain. However,
as soon as sequential GDP growth begins to show signs of recovery as indicated by a rise in
the PMI and a pickup in the export orders index, the RMB should begin to resume its
appreciation. We believe this will likely occur from 2Q12. On a medium-term basis, we still
believe that China’s trade balance (including merchandize and services trade) will remain in
surplus for a few more years. Our projection, based on a CGE model, is that China’s trade
surplus will decline steadily in the coming few years, and turn to a deficit in 20162. Given that
the RMB’s internationalization and the capital account liberalization process may also permit
some net capital inflows, it implies that despite greater short-term volatility, the RMB will
likely continue its overall trend of appreciation for the coming four years. For 2012, we expect
the RMB to appreciate by 3.5% vs the USD, but it will likely be back-loaded (i.e., most of the
appreciation will take place in the last three quarters of 2012).

1
See Jun Ma, “China should adopt a flexible basket-based RMB exchange rate mechanism”, February 2010 (in
Chinese).
2
See Jun Ma, Mingzhi Xiao, and Yandong Jia, “A quantitative analysis of China’s trade surplus”, published in Jun Ma,
The Locus of Money, China Economic Press, August 2011 (in Chinese).



Modest fiscal easing in 2012
We expect some modest fiscal easing in 2012. Despite some official comments that the
fiscal deficit should not change in 2012, we believe that economic indicators will worsen in
the coming months – ahead of the March National People’s Congress – and will prompt a
slightly more aggressive budgeting for fiscal deficit than the current market expectation. Our
baseline forecast is that the deficit-GDP-ratio will rise slightly to 2.2% in 2012 (vs 2.0% in
2011). Specifically, we forecast that the total government fiscal deficit will rise to RMB1.1tr
(including RMB300bn for local government deficit/bond financing) in 2012, vs RMB900bn in
2011 (including RMB200bn for local government deficit/bond financing).

In the fiscal budget for 2012, we expect some more tax cuts to support SMEs, exporters,
consumption, and services. These tax cuts may be in the form of a reduction in the business
tax, more exemptions/deductions in the VAT, and some increase in VAT rebate for exporters.
Broader-based personal income tax cuts and VAT cuts are likely to be proposed, but these
are unlikely to be approved in the near future.

On the expenditure front, we expect priorities to be given to public housing, infrastructure
(e.g., resumption of railway projects, repair of reservoirs and dams), social services, and
consumption. There will likely be a significant increase in the government’s funding for public
housing and agriculture infrastructure, and a modest increase for railway projects. As a result
of the increased bank, bond, and government funding, we expect public housing investment
to rise 30% in 2012, and railway FAI to rise sequentially in 1H (on saar basis) in 2012 from
2H11 (but flat for the full year in 2012 vs 2011).

Real estate policy: incentive for first-home buyers
The recent sharp decline in property sales is generating serious downward pressure on the
economy. First, real estate FAI will likely slow significantly and become a major drag on the
economy. Second, land sales have also slowed remarkably as a result of weaker property
sales and the funding stress faced by developers. According to the Centaline Property
Agency, land sales in 130 major cities slumped 30.6% yoy in the first 11 months of 2011. As
local land revenues are a major funding source for local infrastructure and public housing
projects, the decline in land sales implies that locally-sponsored FAI may be significantly
curtailed at least in the early part of 2012, even if bank lending recovers.

We believe it is important that property sales recover to a healthy level from 2Q12 to avoid a
hard landing of the economy, or else the GDP growth will fall below 7% for two consecutive
quarters (GDP growth is most likely to be below 7% on a qoq basis in 1Q), and by then the
government will be concerned about its implication for social stability.

We see two scenarios under which property sales can rebound from 2Q:

1) A 20% drop in property prices will significantly improve affordability, and thus boost
demand. Over the past two months, property prices in 35 major cities have already declined
by 13%, according to Soufun, and a further 5-7% drop is quite possible in 1Q. With average
wages rising by 13% per year, affordability will likely improve by 33% yoy. This could be a
major reason for a meaningful resumption in property sales. This is what we call an
“automatic stabiliser”.

2) Consider a scenario when the automatic stabiliser does not work, and property prices
continue to spiral downwards after a 20% drop. The resulting further decline in property
sales, property FAI, and land sales could lead to sizeable lay-offs by developers, construction
companies, property agencies, cement and steel mills, as well as construction machinery
companies. This would force the government to take actions to stabilize the property market.
However, we do not believe the government will take any major actions in the immediate
future, as the fear of a hard landing and social pressure are not obvious yet. But by 2Q, if the



property downward spiral becomes visible, we believe the government will act. To deal with
this, our advice to the government is to provide incentives for first-home buyers with an
expiration date such as end-2012. These incentives can include a reduction in the deed tax, a
reduction in the down-payment ratio for mortgage loans, and a discount in mortgage interest
rates. The government should continue to keep the home purchase restrictions in place to
prevent another property bubble driven by speculative purchases. We believe this strategy
will work effectively to boost property sales and ensure a recovery for the overall economy.



Figure 8: China: Deutsche Bank forecasts
2010 2011F 2012F 2013F

National Income
Nominal GDP (USD bn) 5879 7031 8141 9516
Population (mn) 1374 1383 1389 1395
GDP per capita (USD) 4279 5084 5860 6819

Real GDP (YoY%)1 10.3 9.1 8.3 8.6
Private consumption 9.0 8.4 8.4 8.8
Government consumption 8.0 9.0 8.5 9.0
Gross capital formation 11.6 10.7 9.0 8.5
Exports 22.0 12.0 6.4 12.5
Imports 23.0 14.0 7.8 13.0

Prices, Money and Banking
CPI (YoY%) eop 4.6 3.8 3.0 3.5
CPI (YoY%) ann avg 3.3 5.3 2.8 3.5
Broad money (M2) 19.7 13.5 16.0 14.5
Bank credit (YoY%) 19.9 15.0 15.5 14.0

Fiscal Accounts (% of GDP)
Budget surplus -1.7 -2.0 -2.2 -1.5
Government revenue 21.3 22.7 22.5 22.5
Government expenditure 17.8 24.7 24.7 24.0

External Accounts (USD bn)
Merchandise exports 1578.0 1893.6 2045.1 2331.4
Merchandise imports 1395.0 1729.8 1885.5 2187.2
Trade balance 183.0 163.8 159.6 144.2
% of GDP 3.1 2.3 2.0 1.5
Current account balance 306.0 283.8 269.6 244.2
% of GDP 5.2 4.0 3.3 2.6
FDI (net) 124.9 100.0 70.0 50.0
FX reserves (USD bn) 2847.0 3270.0 3600.0 3900.0
FX rate (eop) CNY/USD 6.59 6.30 6.10 5.86

Debt Indicators (% of GDP)
Government debt 2 20.3 19.4 19.1 18.3
Domestic 19.7 18.8 18.6 17.8
External 0.6 0.6 0.5 0.5

General (YoY%)
Fixed asset inv't (nominal) 23.8 23.0 17.0 17.0
Retail sales (nominal) 18.4 16.5 14.0 15.0
Industrial production (real) 15.7 13.0 11.5 12.0
Merch exports (USD nominal) 31.3 20.0 8.0 14.0
Merch imports (USD nominal) 38.7 24.0 9.0 16.0

Financial Markets Current 3M 6M 12M
1-year deposit rate 3.50 3.50 3.50 3.50
10-year yield (%) 3.60 3.60 3.65 3.70
CNY/USD 6.30 6.29 6.18 6.10
Source: Deutsche Bank, Note: Growth rates of GDP components may not match overall GDP growth rates due to inconsistency between historical data calculated from
expenditure and product method. (2) Including bank recapitalization and AMC bonds issued.



Equity market outlook
For 2012 as a whole, we expect the 8.3% GDP growth to support an EPS growth
rate of around 10%.

Given our projection of over 9% sequential GDP growth and 3% inflation in 2H12,
there is a high likelihood that MSCI China’s forward PE will recover to 10.5x from the
current 8.2x. The multiple re-rating and our EPS growth outlook suggest a 25–30%
upside to MSCI China for 2012.

Despite our bullish outlook for the market for 2012, we are cautious in the near
term. 1Q12 will likely suffer from significant growth deceleration and an intensified
“hard-landing fear”.

We expect the PMI to begin recovering from 2Q on the positive impact of monetary
and fiscal policy easing, as well as possible incentives for first-home buyers. The
sequential economic recovery will then provide the major support for a market
rebound.

Major investment themes for 2012 include disinflation, resumption of public
spending and property sales, and dissipating fear of bank NPLs. For longer-term
investors, we highlight three themes: sustainable demand for luxury goods, earlier-
than-expected peaking of China demand for commodities, and the fiscal resolution
of LGFV debt.

With respect to sectors, we believe banks, insurance, IPPs, oil refining, IT, and
luxury goods will outperform in 2012. Short-term buying opportunities will emerge
for developers, construction materials, and construction machinery whenever
government policy turns more supportive of real estate and infrastructure.

We expect 2012 EPS growth to reach 10%, and upward EPS
revision to start in 2Q
Given our economic forecast that 2012 real GDP will reach 8.3% and nominal GDP growth
will reach 11%, our top-down forecast is that 2012 EPS growth for MSCI China will be
around 10%. This is supported by two regression analyses; one involving nominal GDP
growth vs EPS growth, and another of EPS growth on real GDP growth. Figure 9 shows the
historical correlation between real GDP growth and EPS growth, and the regression-based
forecast of EPS growth at around 9.5% yoy in 4Q12.



Figure 9: MSCI China EPS growth vs real GDP growth (yoy %)

65%
14%
13%
45%
12%
11%
25%
10%

5% 9%
8%

-15% 7%
Index EPS % yoy
6%
Real GDP growth % yoy, 1Q lag, RHS
-35% 5%

2011Q4F
2012Q2F
2012Q4F
2001Q4
2002Q2
2002Q4
2003Q2
2003Q4
2004Q2
2004Q4
2005Q2
2005Q4
2006Q2
2006Q4
2007Q2
2007Q4
2008Q2
2008Q4
2009Q2
2009Q4
2010Q2
2010Q4
2011Q2

Given that our bottom-up forecast for MSCI China’s 2012 EPS growth has been lowered to
4% from 15% (August 2011), it is likely in our view that upward revisions to EPS growth will
begin from 2Q12. This is consistent with our economic forecast that sequential GDP growth
will recover on the impact of policy easing. We expect the manufacturing PMI to rebound to
51-53 in 2Q12, up from 47–49 in the coming few months.

We expect 25-30% upside potential for MSCI China index for
2012, with the PE multiple expanding to 10.5 by year-end
Given our expectation that EPS will rise by 10% in 2012 and that the forward PE of MSCI
China will expand from the current 8.2x to 10.5x (i.e., up 20%) by the year-end, we
calculate that this justifies 25-30% upside potential for the MSCI China index in the coming
12 months. Below, we discuss the specific reasons why we think a rerating of the forward
PE to 10.5x is achievable.

We conducted a detailed regression analysis to ascertain the likely market valuation based on
our macroeconomic forecasts. We found that a regression with forward PE as the dependent
variable, and using sequential GDP growth (with a lag of two quarters) and the real interest rate
(with a lag of two quarters) as independent variables, provided a good fit. We note the simple
logic that a better growth outlook induces a re-rating of the market (by enhancing top-line
growth), although higher real interest rates tend to be negative for equities (by squeezing
margins). Given our expectation that sequential GDP growth will recover to around 9% in 4Q12
and that the real interest rate (one-year deposit rate minus CPI inflation) will rise to 0.5%, our
regression model forecasts that the forward PE will rise to 10.5x by the end of 2012.

Another reason for our bullishness on the China market over the medium term is that,
compared with other markets, MSCI China – trading at 8.2x forward PE – is now the
cheapest market. It is even trading at a significant discount to Europe (9.6x), which is
obviously heading towards an economic contraction. Relative to its own historical (10-year)
average valuation, MSCI China also offers the deepest discount compared with other
markets, at 33%, vs that of MSCI World at 24% and that of EM at 13%.


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