1. F E B R U A R Y 2 0 1 2 CHINA ECONOMIC AND POLICY OUTLOOK - Economy tracks moderating growth trend; Monetary policy on hold amid global uncertainty CHINA TRADE AND RMB INTERNATIONALIZATION Grace Ng Senior China Economist J.P. Morgan Chase Bank +852 2800 7002 grace.h.ng@jpmorgan.com

2. 2 Source: J.P. Morgan Economics China Economic Outlook: major economic indicators and forecasts

3. 3 The China economy: steady, moderate economic growth Growth momentum moderated in 2011 but remain solid Growth broadening out and better balanced Source: CEIC and J.P. Morgan estimates

4. 4 Upgrading of manufacturing sector Political cycle plays a role The likelihood of a FAI collapse in 2012 is small Public housing to gather momentum Moderate, but solid FAI growth in 2012

5. 5 12 th 5-year plan: macro policy targets  Real GDP growth averaging at 7% for the next five years, focusing on enhancing the quality and efficiency of economic growth. (This is modestly lower than the 7.5% growth target set during the 11th five-year plan over 2006- 2010.)  Focus on economic restructuring. Regarding industrial structure, in addition to pushing for industrial upgrading and the support for strategic new industries (including the sectors of new energy, energy-saving and environment protection, bio-medical, information and technology as well as high-tech manufacturing), the government highlights the need to support the service sector. In particular, the government aims to raise the service sector’s share of GDP by 4% over the next five years. Besides, the government aims to lift the urbanization rate from 47.5% to 51.5% during the 12th five-year plan.  In order to facilitate the shift of the growth engine towards domestic demand, the government highlights that household and employment income should at least grow at the same pace of overall economic growth and labor productivity. As such, the aim is to lift the share of household income in the overall economy, with urban and rural real per capita income rising at above 7% annual pace, and with the target of total urban new job creation at 45 million for the next five years. Besides, the coverage ratio of urban affording housing should reach 20% during this five-year plan.

6. 6 12 th 5-year plan, infrastructure spending Infrastructure investment the key focus Urbanization rate to reach 60% by 2020  Policymakers have targeted for the urbanization rate to reach 60% in 2020 from 46.6% in 2009. This suggests that the infrastructure investment and construction will continue to be the focus in coming years, especially in western and inland areas. (In early July 2010, policymakers announced a RMB682 billion investment plan for 23 major infrastructure projects in the western areas.)  Solid public investment and steadily strengthening private consumption should ensure that the economy expands at a solid 8-9% pace over the next five years, despite still cloudy outlook on global demand.  This year, local governments will gear up to start new projects, especially given that this is the first year of the 12 th 5-year plan. Together with the central government’s efforts to meet the new 10 million unit affordable housing target, and the support on manufacturing investment with improving external demand, fixed investment is set for solid growth in 2011.

7. 7 Consumption: stable source of growth  Consumption growth is relatively stable this year  Bad news: some stimulus measures expired in 2011, e.g. preferential tax treatments in the auto sector and fiscal stimulus to promote home appliances in rural areas  Policies to encourage consumption  Increase income / reduce income inequality: wage increase; income tax cuts  Improve social safety network: Social Insurance Law in 2008; pension system; health care reform that aims at universal coverage

8. 8 Consumption is a stable source of growth Retail sales continued to show decent growth Auto sales weakening reflect policy impact Non-auto retail sales see steady rebounding Driven by wage increases

9. 9 Fiscal revenue, industrial profit and income growth Household consumption to support growth Source: CEIC and J.P. Morgan estimates Income distribution: a key issue under the 12 th 5-year plan Higher share of national income distributed to household sector in next five years Gradual improvement in labor market

10. 10  We expect:  Export growth slows down from 20.4% in 2011 to 10% in 2012  Trade balance deficits in a few months in 1H12  Net exports drag 1.0 percentage points from growth  Weak global demand could persist for a while due to fiscal tightening and weak recovery in the DM world  Challenge to move away from export-driven growth model External headwind continues to carry through in 2012

11. 11 Global headwinds drag on external demand Trade sector weakened since Q2 Trade surplus narrowed Exports likely to remain soft in near term Export orders on the soft side

12. 12 China’s export breakdown by region Sequential trend to US and EU softened Softer export is broad-based by product groups Exports likely to remain on the soft side in the near term

13. 13 Impact of rising wages on export sector Labor productivity is rising on capital deepening China’s share of global market still elevated Exporters’ profit margin on the rise despite rising wage concern Export sector moving up the value-added chain

14. 14 Import prices surged at a faster pace Notable widening of China’s trade deficit with major trading partners Volume growth in exports and imports Narrowing of trade surplus to continue Earlier easing in commodity imports has stabilized

15. 15 China’s trade balance with major trade partners REER and exports FX policy outlook – CNY/USD to reach 6.1 by end 2012 CNY/USD 1-year NDF rate Global rebalancing gradually sets off

16. 16 China's demand and strategies for commodities/resources/energy increasing shares/contribution to global GDP growth China has become the key source of marginal demand for commodities

17. 17 China's demand and strategies for commodities/resources/energy Commodity import closely related to fixed investment But the impact is quite different across groups of commodities Energy import carries its own trend China’s growth cycle closely related to commodity demand

18. 18 Half of bank deposits in HK are in foreign currencies Prospects for RMB internationalization China maintained twin surpluses in external accounts Mainland traveler’s spending increased steadily RMB deposit in Hong Kong jumped significantly

19. 19 Significant scope of expanding the size of merchandise trade Prospects for RMB internationalization JPY as a benchmark for potential trade settlement scope China’s sustained trade surplus Outlook of RMB deposits in HK:  Scenario 1: 10% of import and 3% of export to be settled in RMB; 10% annual growth  2.6 trillion by 2015  Scenario 2: 20% of import from EMEs, 10% of import from ROW, 3% of export to be settled in RMB; 10% annual growth  3.5 trillion by 2015

20. 20 Outward FDI could be settled in RMB now Prospects for RMB internationalization China’s foreign assets mainly held in the form of official reserves New guidelines formalizing use of RMB FDI into China Next step of RMB settlement - capital account

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