l li & fung china trade quarterly i – domestic and foreign4 li & fung china trade...

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IN THIS ISSUE :

Part One : Domestic Trade

I. Recent development 2

II. Highlights 10

III. Outlook 14

Part Two : Foreign Trade

I. Recent developments 18

II. Highights 25

III. Outlook 28

LI & FUNG China Trade Quarterly

– Domestic and ForeignJuly 2011 Issue 23

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Domestic TradeRetail sales of consumer goods reached 8,583.3 billion yuan in 1h11, up nominally by 16.8% yoy. Among commodities, sales of “gold, silver, and jewelry” registered the strongest growth of 49.6% yoy in 1H11, followed by “petroleum and related products” (39.2% yoy). The growth of sales of “automobiles” declined to 15.0% yoy in 1H11. The consumer confidence index rebounded in June.

Rural household consumption grew strongly. The per capita cash expenditure on consumption of rural households registered growth of 23.1% yoy in nominal terms in 1H11, much higher than the growth of the per capita consumption expenditure of urban households (11.4% yoy).

cPI growth reached 6.4% yoy in June, the highest in thirty six months. In June, the price index of food soared by 14.4% yoy, while that of non-food was up by 3.0% yoy.

The debate on the reform of the consumption tax and import duties policies levied on mid- and high-end products has not reached a conclusion. Many luxury brands are monitoring very closely the latest developments.

The transaction value of china’s online retailing market soared by 76.7% yoy in 2Q11. It is estimated that the transaction value will exceed 200.0 billion yuan in 3Q11.

The “amendments to the Individual Income Tax Law” was passed on 30 June. The minimum threshold for individual income tax will be raised from 2,000 yuan to 3,500 yuan; and the number of tax brackets will be reduced from nine to seven. We believe the amendments will help boost consumption demand in China.

Foreign TradeBoth china’s exports and imports showed moderating growth. Overall, in 1H11, China’s exports totaled US$ 874.3 billion, up by 24.0% yoy; Imports amounted to US$ 829.4 billion, up by 27.6% yoy. China recorded a quarterly trade surplus of US$ 46.8 billion in 2Q11.

asean overtook Japan to become china’s third largest trading partner. In 1H11, Sino-EU trade amounted to US$ 265.9 billion in 1H11, up 21.3% yoy; Sino-US trade rose by 20.1% yoy to US$ 206.4 billion in 1H11; Sino-ASEAN trade increased by 25.4% yoy to reach US$ 171.1 billion in 1H11; Sino-Japan trade grew by 19.0% yoy to US$ 162.3 billion in 1H11.

Total value of deals signed at the 109th canton Fair increased by 5.8% from the previous session. It is noteworthy that the value of deals signed with buyers from the other four members of the BRICSs (Brazil, Russia, India and South Africa) soared by 30.1% from the previous session.

The RMB appreciated by 2.3% against the us dollar in 1h11. We expect the RMB to appreciate to around 6.2-6.3 at end-2011.

The WTO ruled against china’s export restrictions on raw materials such as coke, bauxite, magnesium, etc. Industry players believe that the WTO ruling will encourage foreign countries to file complaints to the WTO over China’s export restrictions on rare earths, which may provoke serious trade disputes between China and its trading partners in the future.

Helen Chin, Timothy CheungTel: (852) 2300 [email protected] [email protected]

Li & Fung Research centre11/F, LiFung Tower,

868 Cheung Sha Wan Road,

Hong Kong

Tel : (852) 2300 2470

Fax : (852) 2635 1598

E-mail: [email protected]

http://www.lifunggroup.com/LI & Fung ReseaRch cenTRe

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LI & FUNG China Trade Quarterly July 2011 Issue 23

LI & Fung ReseaRch cenTReMeMBeR OF The LI & Fung gROuP

Part One: Domestic Trade

I. Recent Development

1. china’s economic growth remained strong at 9.5% yoy in 2Q11

China’s real GDP rose by 9.5% yoy in 2Q11, compared to the growth of 9.7% yoy in 1Q11. On a seasonally-adjusted basis, the real GDP growth edged up from to 2.1% qoq in 1Q11 to 2.2% qoq in 2Q11. These figures eased the recent concerns about a hard landing of the Chinese economy. Overall, in 1H11, China’s nominal GDP amounted to 20.4 trillion yuan, up by 9.6% yoy in real terms. (See exhibit 1)

Among different industries, the contribution of the secondary industry to China’s nominal GDP was 50.0% in 1H11, up from 46.9% in 2010; the contribution of the tertiary industry edged down from 43.0% in 2010 to 42.3% in 1H11; and the contribution of the primary industry was 7.7% in 1H11, down from 10.2% in 2010.

In 1H11, investment played a more important role than consumption in driving China’s economic growth. In 1H11, the contribution of gross capital formation to the GDP growth was 5.1 ppt, higher than that of final consumption expenditure (4.6 ppt).

Looking ahead, we expect the Chinese economic growth to further moderate in the near term, due to the slowing domestic demand and export demand. Nevertheless, we believe the probability of an economic hard landing is low. Domestic demand will continue to be boosted by the local governments’ accelerated efforts to build public housing; and China’s export growth will be supported by rising demand from the emerging economies. Besides, if the Chinese economy shows further signs of a deceleration, we expect that the government will introduce fiscal stimulus measures and put on hold its tightening monetary policies to avoid a hard landing. (See the Outlook section for more discussion.)

exhibit 1: china’s real gDP growth, 3Q10 - 2Q11

FY10 10.3%

3Q10 9.6%4Q10 9.8%

1Q11 9.7%2Q11 9.5%

Source: National Bureau of Statistics, PRC

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Domestic and Foreign


2. Retail sales of consumer goods witnessed steady growth in the first half of the year

According to the National Bureau of Statistics (NBS), the total retail sales of consumer goods expanded nominally by 16.8% yoy to reach 8,583.3 billion yuan in 1H11. By month, the retail sales grew nominally by 17.1% yoy, 16.9% yoy and 17.7% yoy in April, May and June respectively. (See exhibit 2)

exhibit 2: china’s total retail sales of consumer goods, Jul 2010 - Jun 2011


From April 2011 onwards, the NBS released the month-on-month (mom) growth figures of the retail sales. On a seasonally-adjusted basis, the mom growth of the retail sales stayed relatively stable throughout February to June, ranging from 1.31% to 1.40%. (See exhibit 3)

exhibit 3: china’s total retail sales of consumer goods, Feb - Jun 2011

mom growth(%), seasonally adjusted Feb Mar apr May JunTotal retail sales 1.31 1.40 1.33 1.35 1.38


In 1H11, the urban retail sales totaled 7,445.0 billion yuan, up nominally by 16.9% yoy; while the rural retail sales amounted to 1,138.3 billion yuan, up by 16.2% yoy.

By mode of sales, the retail sales of commodities were 7,625.4 billion yuan, up nominally by 16.9% yoy in 1H11; those of the catering industry gained 16.2% yoy nominally to reach 957.9 billion yuan.1

1 Since January 2010, the NBS has adopted new categories for the total retail sales of consumer goods. “Retail sales of commodities” and “retail sales of the catering industry” replaced the previous categories of “retail sales in the wholesale and retail industries” and “retail sales in the accommodation and catering industries”.

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The retail sales of commodities of enterprises above designated size2 reached 3,610.8 billion yuan in 1H11, up by 24.2% yoy. Among commodities, sales of “gold, silver, and jewelry” registered the strongest growth of 49.6% yoy in 1H11, followed by “petroleum and related products” (39.2% yoy). Meanwhile, the growth of sales of “automobiles” declined to 15.0% yoy in 1H11, 22.1 ppt lower than that of the same period of the previous year. The slowdown in growth was caused mainly by the withdrawal of the government subsidies on car purchases and the government measures to limit new car registrations in some cities. According to the media reports, to stimulate sales, some renowned Chinese automakers have already cut prices of their products in recent months. Housing-related items saw slower growth of sales as well, due to government’s efforts to cool down the housing market. For example, the growth of sales of “furniture” was 30.0% yoy in 1H11, 8.5 ppt lower than that in 1H10; and the growth of “home appliances and video equipments” was 21.5% yoy, 7.3 ppt lower than that in 1H10.

Exhibit 5 demonstrates the growth of China’s retail sales of enterprises above designated size by commodity.

exhibit 4: china’s total retail sales, 2010 - 1h11

yoy growth (%) FY10 1Q11 1h11Total retail sales 18.4 16.3 16.8- Commodities 18.5 16.5 16.9 of which: enterprises above designated size 29.9 23.0 24.2- Catering 18.0 15.3 16.2


exhibit 5: china’s retail sales of enterprises above designated size by commodity, 2010 - 1h11

yoy growth (%) FY10 1Q11 1h11Clothing, shoes, hats and textiles 24.5 22.3 23.9Cosmetics 16.0 17.8 20.0Stationeries and offices accessories 23.4 20.2 21.8Goods for daily use 24.9 22.7 24.5Home appliances and video equipments 26.9 20.5 21.5Furniture 37.5 24.5 30.0Grain, oil, food, beverages, tobacco, and liquor 23.7 23.1 24.7Gold, silver, and jewelry 45.8 51.8 49.6Telecommunication equipments 19.2 22.8 27.0Automobiles 34.5 14.2 15.0Petroleum and related products 34.5 37.6 39.2Building and decoration materials 31.6 25.5 28.3Sports and entertainment products 18.5 19.0 15.8Chinese and western medicine 23.4 21.0 19.6


2 Enterprises above designated size refer to enterprises with annual sales of 5 million yuan or above and with an employment of or over 60.

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3. Consumer confidence index rebounded in June

After rebounding to 107.6 in March, the consumer confidence index declined slightly to 106.6 in April and 105.8 in May, and then rebounded to 108.1 in June, the highest since July 2010.3 The index reading indicates that Chinese consumers have become more optimistic about the economy and are likely to spend more. (See exhibit 6)

Exhibit 6: China's consumer confidence index, Jul 2009 - Jun 2011

Jul 10 107.8Aug 107.3Sep 104.1Oct 103.8Nov 102.9Dec 100.4Jan 11 99.9Feb 99.6Mar 107.6Apr 106.6May 105.8Jun 108.1


4. Per capita cash expenditure on consumption of rural households grew strongly in 1h11

In 1H11, both urban and rural household income recorded strong growth, boding well for domestic consumption. The nominal growth rate of the per capita cash income of rural households accelerated to 20.4% yoy in 1H11, up from 13.1% yoy in 2010. In 1H11, the per capita cash income of rural households reached 3,706.0 yuan. In comparison, the per capita disposable income of urban households, which amounted to 11,041.0 yuan in 1H11, grew at a slower pace. The nominal growth rate was 13.2% yoy in 1H11, higher than that in 2010 (11.3% yoy).

Nevertheless, the real income growth of Chinese households was eroded by inflation. In comparison to the nominal growth rates, the real growth rates of both urban and rural household income were much lower in 1H11, hitting only 7.6% yoy and 13.7% yoy respectively.

The per capita consumption expenditure of urban households registered growth of 11.4% yoy in nominal terms in 1H11, compared to the growth of 9.8% yoy in 2010. It is noteworthy that the nominal growth rate of the per capita cash expenditure on consumption of rural households was much higher in 1H11, reaching 23.1% yoy.

3 A reading above 100 indicates that consumers tend to be optimistic; a reading below 100 indicates that consumers tend to be pessimistic.

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5. China’s inflation rate reached 6.4% yoy in June, the highest in thirty six months

Driven by the rise in both food prices and non-food prices, China’s inflation rate continued its upward trend in recent months. The yoy growth rate of China’s consumer price index (CPI)4 rose all the way from 4.9% yoy in February to 6.4% yoy in June, the highest in thirty six months. In June, the price index of food soared by 14.4% yoy, while that of non-food was up by 3.0% yoy. (See exhibits 7 & 8)

Looking ahead, inflationary pressure is expected to be intense in the near term. The recent droughts and floods may threaten agricultural production, thereby putting upward pressure on food prices. At the same time, non-food prices are also set to trend upward, influenced by factors such as the pass-through of higher raw materials costs and labour costs, greater inflationary expectations, etc. Nevertheless, the yoy growth of the CPI may moderate in the following months, given the higher comparison base in 2H11.

exhibit 7: china’s cPI growth, Jul 2009 - Jun 2011

Jul 10 3.3%Aug 3.5%Sep 3.6%Oct 4.4%Nov 5.1%Dec 4.6%Jan 11 4.9%Feb 4.9%Mar 5.4%Apr 5.3%May 5.5%Jun 6.4%


exhibit 8: china’s cPI growth by commodity, Jan - Jun 2011

yoy growth (%) Jan 11 Feb Mar apr May JunFood 10.3 11.0 11.7 11.5 11.7 14.4Tobacco & liquor 1.8 1.9 2.1 2.4 2.6 2.7Clothing -0.2 0.4 0.8 1.4 1.8 2.1Household services, maintenance and renovation 1.4 1.4 1.9 2.1 2.5 2.5Medical healthcare & personal care 3.2 3.0 3.2 3.2 3.2 3.4Transportation and communication -0.1 -0.3 0.1 0.5 0.7 0.9Recreational, educational products & services 1.0 0.3 0.5 0.5 0.6 0.6Housing 6.8 6.1 6.6 6.1 6.1 6.2


4 The CPI, compiled by the National Bureau of Statistics of China, measures the price of a basket of goods and services that a typical household purchases.

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After edging up from 7.2% yoy in February to 7.3% yoy in March, the growth rate of China’s producer price index of industrial products (PPI)5 moderated a bit to 6.8% yoy both in April and in May, but then rebounded to 7.1% yoy in June. (See exhibit 9)

Looking ahead, we believe the PPI will further trend upward in coming months, due largely to the pass-through of higher raw materials costs, labour costs and financing costs. According to the local media, amid the tight credit conditions, financing costs for enterprises have risen considerably in recent months. Also noteworthy is that local governments in fifteen provinces/municipalities such as Beijing, Shanghai, Guangdong, Zhejiang, etc. raised minimum wage levels in their jurisdictions in the first seven months of 2011. We expect that the minimum wage levels in many other provinces will be adjusted upward in coming months. Besides, a few provinces/municipalities such as Shanghai, Shandong, Hebei, etc. issued new salary guidelines on salary rise in the past few months. Although these guidelines are not mandatory for employers to follow, they are regarded as an important reference. It is likely that workers’ expectation of salary rise will be heightened, accelerating the increase in labour costs. Nevertheless, as both the domestic demand and foreign demand have slowed recently, we believe that manufacturers in China will have limited room to pass through the higher costs to downstream users in the near term.

exhibit 9: china’s PPI growth, Jul 2009 - Jun 2011



After increasing to 10.4% yoy in February, the yoy growth rate of the purchaser price index of industrial products6 remained high at 10.5% yoy, 10.4% yoy, 10.2% yoy and 10.5% yoy in March, April, May and June respectively. The rapid growth of the price index raises concerns not only about the problems of production cost pressure and squeezed producers’ margins, but also about stronger inflationary pressure on downstream prices in the near and medium term. (See exhibits 10 & 11)

The input prices sub-index of China’s manufacturing PMI, a leading indicator of upstream prices, dropped all the way from the recent high of 70.1 in February to 56.7 in June, the lowest level in eleven months. The decline in the index corresponded to the recent softening of international commodity prices. However, it is noteworthy that input prices stayed elevated, albeit rising at slower pace. Cost pressure on manufacturers was still intense.

5 The PPI, compiled by the National Bureau of Statistics of China, measures the prices of industrial products when they are sold for the first time after production.

6 The purchasing price index of raw material, fuel and power was renamed the purchaser price index of industrial products, effective from January 2011. The price index, compiled by the National Bureau of Statistics of China, measures the prices of production inputs such as raw materials, fuels and power purchased by industrial enterprises.

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exhibit 10: The purchaser price index of industrial products, Jul 2009 - Jun 2011 (% yoy growth)



exhibit 11: The purchaser price index of industrial products by selected commodity, Jan - Jun 2011

yoy growth (%) Jan Feb Mar apr May JunFuel & power 8.7 8.9 9.9 11.6 11.7 12.0Ferrous metals 14.5 15.8 14.2 10.9 9.4 8.9Non-ferrous metals 12.4 14.8 13.9 13.2 14.5 17.2Raw materials for the chemical industry 11.7 11.9 11.8 11.7 11.6 12.5


6. china’s industrial output recorded stronger growth of 15.1% yoy in June

After moderating all the way from 14.8% yoy in March to 13.3% yoy in May, the yoy growth of the value-added of industrial output (VAIO) in China rebounded to 15.1% yoy in June, the highest since May 2010.7 (See exhibit 12) On a seasonally-adjusted basis, the VAIO growth accelerated from 1.10% mom in May to 1.48% mom in June. The stronger growth of the industrial output in June could be attributed to the easing power shortages, as Chinese manufacturers had more room to increase their output. Boosted by the higher output of hydropower plants in China due to the recent heavy rain, the power production registered faster growth of 16.2% yoy in June, up from 12.1% yoy in May. Overall, China’s industrial output registered a 14.3% yoy growth in 1H11, compared to 15.7% yoy in FY10.

Among different industries, the industrial output of heavy industry rose by 14.7% yoy; while that of light industry increased by 13.1% yoy in 1H11.

Looking ahead, we expect the industrial output to maintain double-digit growth in the near term. It is noteworthy that the government planned to begin the construction of 10 million units of public housing in 2011, and 56.6% of which has started construction as of end-June. To meet the target set for the year, we believe the government will intensify its efforts to build public housing in 2H11, thereby driving the demand for construction materials such as cement,

7 The National Bureau of Statistics has changed the method of compiling the value added of industrial output (VAIO), effective from January 2011. The statistical threshold for industrial enterprises has been raised to cover those with annual revenue of 20 million yuan or above, up from the previous threshold of 5 million yuan or above. According to the bureau, the adjustment would have limited impact on the growth figures.

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steel, copper, aluminum, glass, etc. Besides, the negative impact of Japan’s earthquake on the global supply chains is expected to dissipate. The production of Chinese manufacturers which rely on components and parts made in Japan to produce final products such as automobiles and high-end electronics could normalize in coming months.

However, as summer is the peak season for electricity consumption, the power shortage problem may intensify again soon, constraining China’s manufacturing output in the near term.

exhibit 12: china’s industrial production growth, Jul 2009 - Jun 2011

Jul 10 13.4%Aug 13.9%Sep 13.3%Oct 13.1%Nov 13.3%Dec 13.5%Jan-Feb 11 14.1%Mar 14.8%Apr 13.4%May 13.3%Jun 15.1%


7. china’s FaI (excluding rural households) maintained rapid growth of 25.6% yoy in 1h11

China’s nominal fixed asset investment (FAI) (excluding rural households) maintained rapid growth of 25.6% yoy in 1H11, reaching 12.5 trillion yuan.8 On a seasonally-adjusted basis, the nominal FAI (excluding rural households) gained 2.41% mom in April and 0.17% mom in May, but then fell by 1.04% mom in June. (See exhibit 13)

Among different industries, FAI (excluding rural households) in the tertiary industry totaled 6.7 trillion yuan in 1H11; that in the secondary industry was 5.5 trillion yuan; and that in the primary industry was 284.5 billion yuan. FAI (excluding rural households) in the tertiary industry recorded a growth of 24.7% yoy in 1H11, lower than that in the secondary industry (27.1% yoy). Although the Chinese government has implemented a series of property tightening measures since early 2010, growth of FAI (excluding rural households) in real estate development stayed robust at 32.9% yoy in 1H11, softening from 34.1% yoy in 1Q11.

Looking ahead, we expect FAI growth to remain strong in the near term. Particularly noteworthy is that the growth of the planned FAI in newly started projects rose from -12.7% yoy in 1Q11 to 14.9% yoy in 1H11, suggesting that investment demand will accelerate in the foreseeable future. In addition, local governments are expected to greatly increase investment in public housing in 2H11.

8 The National Bureau of Statistics has expanded the coverage of the monthly statistics on FAI from the urban areas to rural enterprises and institutions, effective from 2011. Thus, “FAI (excluding rural households)”, the new indicator, has been released by the bureau since March 2011 to replace “urban FAI”, the old indicator. Besides, a new statistical criterion has been adopted. The statistical threshold for the size of investment project has been adjusted upward from 500,000 yuan to 5 million yuan. According to the bureau, the adjustment would have limited impact on the growth figures.

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exhibit 13: china’s FaI (excluding rural households), Jan - Jun 2011

yoy growth(%) Jan-Feb Jan-Mar Jan-apr Jan-May Jan-JunFAI (excluding rural households) 24.9 25.0 25.4 25.8 25.6


II. highlights

1. a number of consumer products companies have increased prices or announced plans to raise prices

In order to curb inflationary pressure, the National Development and Reform Commission (NDRC) had urged several leading consumer products companies in the past months to delay their plans to raise prices, despite the fact that enterprises had faced growing margin pressure due to the escalating raw materials and labour costs.

Nevertheless, the price control over edible oil ended on 30 June 2011, according to a spokesperson of the price setting department of the NRDC. It was reported that a few edible oil companies raised prices tentatively in early July. At the same time, a number of well-known consumer products companies in various sectors such as sports apparel, milk powder, fast food and cosmetics have announced plans to raise the prices of their products. Indeed, facing increasing input costs, consumer products companies with pricing power have strong motivation to pass through the higher costs to consumers.

2. Debate on the reform of the consumption tax and import duties policies levied on mid- and high-end products has not reached a conclusion

Currently, luxury goods in China are generally more expensive than those in overseas markets because of consumption tax and import duties, prompting many Chinese consumers to purchase luxuries overseas. In the past few years, there has been growing discussion on whether China should lower the consumption tax and import duties on luxury goods. Recently, the spokesperson of the Ministry of Commerce (MOFCOM) said that China would study on reforming the consumption tax and import duties policies on mid- and high-end products in order to boost domestic private consumption, drawing huge attention from players in the luxury industry.

Soon after that, however, an article was posted on the website of the Ministry of Finance (MOF), arguing that import duties should instead be increased to protect the interests of the public. Far from cutting taxes on imported luxury goods, China needs to raise duties on luxury products to promote wealth redistribution; customs collected from luxury goods can be used to that end by helping low-income groups. Besides, consumption tax on luxury products in China is not the only reason for consumers buying overseas. The distrust of local shops and the RMB appreciation have also prompted consumers to purchase luxuries overseas.

Conclusion on whether consumption tax and import duties on mid- and high-end consumer products should be lowered has not yet been reached. Many luxury brands are monitoring very closely the latest developments, which will bring huge implications to their business in China.

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3. The transaction value of china’s online retailing market soared in 2Q11

According to iResearch, the transaction value of China’s online retailing market reached 179.2 billion yuan in 2Q11, registering a 76.7% yoy growth. It is estimated that the transaction value of China’s online retailing market will exceed 200.0 billion yuan in 3Q11.9 (See exhibit 14)

exhibit 14: Transaction value of china’s online retailing market, 1Q10 - 2Q11

Source: iResearch

In the past years, the expanding Internet population has been one of the key drivers behind the impressive growth of the online retailing market in China. However, growth in China’s Internet population has decelerated. According to the China Internet Network Information Center (CNNIC), China’s Internet population reached 485 million as of end-June 2011, up by only 6.0% from the end of 2010.

4. The “amendments to the Individual Income Tax Law” was passed on 30 June

On 30 June, the Standing Committee of the National People’s Congress passed the “Amendments to the Individual Income Tax Law”, effective from 1 September 2011.10 According to the amendments, the minimum threshold for individual income tax will be increased from 2,000 yuan to 3,500 yuan. Besides, the number of tax brackets will be reduced from nine to seven. (See exhibit 15)

The main purpose of the amendments is to achieve a more even income distribution, through relieving the tax burdens on low- and middle-income individuals and increasing the burdens on high-income individuals. It is estimated that the number of individual income taxpayers will be reduced by 60 million, and the total tax revenue will be reduced by 160 billion yuan in a full year. We also believe the amendments will boost domestic consumption demand in China.

9 According to iResearch, scale of online retailing market is the sum of customer-to-customer (C2C) and business-to-consumer (B2C) transaction value. Scale of C2C online retailing market is calculated by the total value of purchases, including that on the B2C arm of C2C platforms. Scale of B2C online retailing market has excluded download payments of digital products, air tickets, online pill payment services as well as offline sales of B2C platform operators.

10 http://www.npc.gov.cn/npc/xinwen/lfgz/zxfl/2011-07/01/content_1662343.htm

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exhibit 15: Individual income tax brackets and tax rates: before and after the amendments

The current 9-bracket progressive tax rate The 7-bracket progressive tax rate scheme scheme (effective from 1 september 2011)(Minimum threshold: 2,000 yuan) (Minimum threshold: 3,500 yuan)

Monthly taxable income (yuan) Tax rate Monthly taxable income (yuan) Tax rate500 and below 5% 1,500 and below 3%500-2,000 (the next 1,500) 10% 1,500-4,500 (the next 3,000) 10%2,000-5,000 (the next 3,000) 15% 4,500-9,000 (the next 4,500) 20%5,000-20,000 (the next 15,000) 20% 9,000-35,000 (the next 26,000) 25%20,000-40,000 (the next 20,000) 25% 35,000-55,000 (the next 20,000) 30%40,000-60,000 (the next 20,000) 30% 55,000-80,000 (the next 25,000) 35%60,000-80,000 (the next 20,000) 35% >80,000 (remainder) 45%80,000-100,000 (the next 20,000) 40%>100,000 (remainder) 45%

Source: National People’s Congress

5. china’s central bank continued to tighten credit conditions in the recent months

Compared to 1Q11, the yoy growth rates of both money supply and RMB loans moderated in 2Q11. As of end-June, the broad money supply (M2) rose by 15.9% yoy, lower than the 16.6% yoy growth registered as of end-March. The amount of total outstanding RMB loans increased by 16.9% yoy as of end-June, compared to the 17.9% yoy growth as of end-March. The total amount of the new RMB loans was 4.2 trillion yuan in 1H11, lower than that in 1H10 (4.6 trillion yuan). (See exhibit 16)

To combat inflation, China’s central bank continued to take action to tighten credit conditions in the recent months. The moves included banks’ reserve requirement ratio (RRR) hikes on 18 May and 20 June; as well as upward adjustments in the benchmark deposit and lending rates on 7 July. (See exhibits 17 & 18)

Amid the tight credit conditions, the financing costs for enterprises, especially the small- and medium-sized enterprises (SMEs), have increased rapidly in recent months. Domestic demand has also slowed, as indicated by the new orders sub-index of China’s manufacturing PMI. The index dropped all the way from 58.3 in November 2010 to 50.8 in June 2011. Nevertheless, it is likely that that the central bank will further raise the RRR and the interest rates again during the rest of the year, given that China’s inflationary pressure is still intense. Achieving price stability is still a top priority, as confirmed by President Hu Jintao when he presided at the politburo meeting on 22 July to set the work priorities of economic tasks in 2H11.

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exhibit 16: Broad money supply (M2) and RMB loans

As of Broad money supply (M2) Total outstanding RMB loans amount (trillion yuan) yoy growth amount (trillion yuan) yoy growthEnd-Jul 10 67.4 17.6% 45.1 18.4%End-Aug 68.8 19.2% 45.7 18.6%End-Sep 69.6 19.0% 46.3 18.5%End-Oct 70.0 19.3% 46.9 19.3%End-Nov 71.0 19.5% 47.4 19.8%End-Dec 72.6 19.7% 47.9 19.9%

End-Jan 11 73.6 17.2% 48.4 18.5%End-Feb 73.6 15.7% 48.9 17.7%End-Mar 75.8 16.6% 49.5 17.9%End-Apr 75.7 15.3% 50.2 15.8%End-May 76.3 15.1% 50.8 17.1%End-Jun 78.1 15.9% 51.4 16.9%

new RMB loans (trillion yuan) FY09 9.59FY10 7.95

Jul 10 0.53Aug 0.54Sep 0.60Oct 0.59Nov 0.56Dec 0.48

Jan 11 1.04Feb 0.54Mar 0.68Apr 0.74May 0.55Jun 0.63

Source: People’s Bank of China

exhibit 17: adjustments in one-year benchmark deposit and lending rates, Jan 2010 - Jul 2011

effective date adjustment One-year benchmark deposit One-year benchmark lending rate after the adjustment rate after the adjustment20 Oct 10 +25 bps 2.50% 5.56%26 Dec +25 bps 2.75% 5.81%

9 Feb 11 +25 bps 3.00% 6.06%6 Apr +25 bps 3.25% 6.31%7 Jul +25 bps 3.50% 6.56%


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exhibit 18: RRR adjustments, Jan 2010 - Jul 2011

effective date adjustment RRR for the major banks after the adjustment*18 Jan 10 +50 bps 16.0%25 Feb +50 bps 16.5%10 May +50 bps 17.0%16 Nov +50 bps 17.5%29 Nov +50 bps 18.0%20 Dec +50 bps 18.5%

20 Jan 11 +50 bps 19.0%24 Feb +50 bps 19.5%25 Mar +50 bps 20.0%21 Apr +50 bps 20.5%18 May +50 bps 21.0%20 Jun +50 bps 21.5%

* The major banks include Bank of China, Industrial and Commercial Bank of China, Agricultural Bank of China, China Construction Bank, Bank of Communications, and Postal Savings Bank


III. Outlook

1. We see little risk of a hard landing of the chinese economy

Recently, there have been growing concerns about a hard landing of the Chinese economy, caused by the aggressive monetary tightening, the weaker property market, as well as the power shortage problem.

Indeed, some indicators suggest that the Chinese economy has shown early signs of moderation. For example, China’s manufacturing PMI, one of the leading indicators of the economy, fell from 52.9 in April to 52.0 in May, and then dropped to a twenty-eight-month low of 50.9 in June, indicating continued growth moderation in the manufacturing sector in China. One of the main reasons for the decline in the index was the weaker domestic demand. The new orders sub-index of China’s manufacturing PMI dropped all the way from 55.2 in March to 50.8 in June. In addition, the growth of sales of automobiles, a major consumption hotspot, decelerated to 15.0% yoy in 1H11, compared to 34.5% yoy in FY10. Meanwhile, we also notice that the domestic demand for raw materials such as cotton, nylon, viscose staple fiber, natural rubber, etc. have declined in recent months, contributing to the drop of prices of these raw materials.

In our view, the slowdown in domestic demand was mainly attributable to the tight credit conditions. On the other hand, the sharp decline in growth of automobile sales was largely due to the withdrawal of government subsidies on car purchases and the government measures to limit new car registrations in some cities.

Looking ahead, we see the following downside risks to the Chinese economy: First, in response to the intense inflationary pressure, it is widely expected that the government will continue to tighten credit conditions, further weakening the domestic demand. Second, the continuous implementation of the property tightening measures

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could have serious negative impact on the property market soon, causing the marked drop of FAI in real estate development and the sales of housing-related items, and the increase in the amount of non-performing loans. Third, large amounts of debts in local government financing vehicles (LGFV) could be defaulted, triggering a banking crisis in China. Fourth, the governments in the US and in many Eurozone countries are under great pressure to lower fiscal expenditures, hindering the world economic recovery as well as China’s export growth.

Nevertheless, we believe the probability of an economic hard landing is low. The domestic demand will be boosted by the local governments’ accelerated efforts to build public housing. On the other hand, China’s export growth will be supported by rising demand from the emerging economies. Besides, if the Chinese economy shows further signs of a deceleration, the government is likely to introduce fiscal stimulus measures and put on hold its tightening monetary policies to avoid a hard landing. We remain optimistic about the medium- to long-term growth outlook of China, given the ongoing urbanization. China’s urbanization rate is still quite low compared to many countries in the world. It is expected that about 300-400 million rural residents will migrate to the cities in the next few decades, thereby creating huge demand for public infrastructure, housing, housing-related products, consumer goods and services, etc.

2. China’s Entrepreneur Confidence Index dropped to 132.4 in 2Q11, the lowest in six quarters

Chinese entrepreneurs, in general, were less optimistic about the prospects of their respective industries in 2Q11, as China’s Entrepreneur Confidence Index (ECI) dropped from 137.4 in 1Q11 to 132.4 in 2Q11, the lowest in six quarters.11 In our view, the decline in the ECI was mainly associated with the slowing domestic demand and foreign demand, as well as the mounting cost pressure. (See exhibit 19)

Compared with 1Q11, 5 of the 8 sectors surveyed recorded lower index readings in 2Q11. It is noteworthy that the ECIs of the secondary industry and the construction sector posted relatively sharp qoq decline in 2Q11, down by 6.5 points and 6.6 points respectively from the previous quarter. On the other hand, 3 sectors recorded higher readings in 2Q11, compared with 1Q11. The information transmission, computer service and software sector registered the biggest qoq gain, the ECI of which rose by 7.9 points from the previous quarter.

In 2Q11, the ECIs in the eastern, central and western regions declined to 132.4, 132.1 and 132.8, down by 3.4 points, 8.5 points and 4.6 points respectively from the previous quarter. (See exhibit 20)

Exhibit 19: Entrepreneur Confidence Index

3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11120.1 127.7 135.5 133.0 135.9 137.0 137.4 132.4


11 China’s Entrepreneur Confidence Index (ECI) ranges from 0 to 200. A reading above 100 indicates an expectation of improving economic situation; a reading below 100 indicates an expectation of worsening economic situation.

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Exhibit 20: Entrepreneur Confidence Index, by sector

1Q11 2Q11 compared with the previous quarterNational 137.4 132.4 Lower

By sectorSecondary industry 135.4 128.9 Lower- Mining 154.5 - -- Manufacturing 134.2 - -- Electricity, gas & water 135.3 - -Construction 145.6 139.0 LowerTransportation, storage & post service 131.2 128.5 LowerWholesale & retail 148.0 144.2 LowerProperty 112.3 107.5 LowerSocial services 136.8 139.5 HigherInformation transmission, computer service 155.6 163.5 Higher and softwareHotel & catering 131.3 135.3 Higher

By regionEastern region 135.8 132.4 LowerCentral region 140.6 132.1 LowerWestern region 137.4 132.8 Lower


3. The PMI dropped to a twenty-eight-month low of 50.9 in June

China’s manufacturing PMI fell from 52.9 in April to 52.0 in May and then dropped to a twenty-eight-month low of 50.9 in June, indicating continued growth moderation in the manufacturing sector in China. We believe that the slowdown was due to weaker domestic demand caused mainly by the government’s monetary and property tightening measures, softening export demand, as well as the power shortage problem. It is, however, noteworthy that the June PMI stayed firmly above the 50-mark, which means that the manufacturing sector is still expanding, albeit in a slower manner. (See exhibit 21)

Both the domestic demand and the export demand have continued to slow in recent months. The new orders index declined all the way from 53.8 in April to 50.8 in June, while the new export orders index edged down from 51.3 in April to 51.1 in May, before dropping to 50.5 in June. Corresponding to the slowing demand growth, the output growth moderated. The output index fell all the way from 55.3 in April to 53.1 in June.

The only good news is that the input prices index dropped markedly from 66.2 in April to 60.3 in May, and then went down to 56.7 in June, the lowest in eleven months, suggesting that upstream cost pressure has eased a bit for manufacturers.

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The purchases of inputs index slid from 53.8 in April to 53.6 in May, before moderating to 51.5 in June. The deceleration in purchases was attributable to the recent softening of international commodity prices, which lowered the incentives for manufacturers to hoard raw materials, as well as the weaker downstream demand. Consequently, the stocks of major inputs index fell all the way from 52.0 in April to 48.5 in June. Nevertheless, the stocks of finished goods index still stayed above the critical level of 50 throughout April to June. Manufacturers may be under pressure to start another destocking cycle, which could constrain the growth of industrial output in the coming months.

Looking forward, we expect the headline PMI to fluctuate between 51-53 in 3Q11. Industrial activities will continue to be supported by the local governments’ accelerated efforts to build public housing and the robust consumption demand. Downside risks, however, include the liquidity crunch problem facing Chinese enterprises if the monetary and credit tightening continues, intensifying power shortages and power supply restrictions during the summer peak season for energy consumption, spiraling labour cost, as well as escalated measures to curb inflation and real estate speculation.

exhibit 21: china’s manufacturing PMI at a glance, June 2011

Index s. adj Index Index compared with the Previous Month DirectionPMI 50.9 Lower ExpandingOutput 53.1 Lower ExpandingNew Orders 50.8 Lower ExpandingNew Export Orders 50.5 Lower ExpandingBacklogs of Orders 45.9 Lower ContractingStocks of Finished Goods 51.0 Higher ExpandingPurchases of Inputs 51.5 Lower ExpandingImports 48.7 Lower ContractingInput Prices 56.7 Lower ExpandingStocks of Major Inputs 48.5 Lower ContractingEmployment 50.2 Lower ExpandingSuppliers’ Delivery Time 49.8 Lower Slackening

Source: Li & Fung Research Centre

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Part Two: Foreign Trade

I. Recent development

1. The growth rates of both china’s exports and imports slowed in 2Q11

China’s export growth moderated from 35.8% yoy in March to 29.9% yoy in April, and further decelerated to 19.4% yoy in May and 17.9% yoy in June. We believe the slowdown in export growth could be attributed to the higher comparison base in the same period of the previous year, weakening export demand, the RMB appreciation against the US dollar, the rapid rise in labour costs and raw materials prices, as well as the tight credit conditions. Nevertheless, in absolute terms, China’s exports amounted to US$ 162.0 billion in June, the highest on record. Overall, China’s exports reached US$ 874.3 billion in the first six months of 2011, up by 24.0% yoy. (See exhibits 22, 23 and 24)

In 1H11, the growth rates of China’s exports to both the EU and the US, the first two export destinations, were 16.9% yoy, much lower than the growth of China’s total exports (i.e. 24.0% yoy). On the other hand, in the aftermath of Japan’s earthquake, China’s export growth to Japan decelerated from 28.1% yoy in 1Q11 to 19.9% yoy in 2Q11. China’s export growth to some non-traditional markets was still robust in 1H11. For example, China’s exports to Russia, Indonesia, Brazil, Vietnam, Thailand and Australia expanded by 46.1% yoy, 42.6% yoy, 41.3% yoy, 36.1% yoy, 35.5% yoy, and 30.2% yoy respectively in 1H11.

China’s import growth declined from 32.6% yoy in 1Q11 to 23.1% yoy in 2Q11, due largely to slowing domestic demand, as well as the shortages of key components caused by Japan’s earthquake. Overall, China’s imports amounted to US$ 829.4 billion in 1H11, up by 27.6% yoy.

Overall, China’s trade balance rose from US$ -1.0 billion in 1Q11 to US$ 46.8 billion in 2Q11.

exhibit 22: china’s quarterly foreign trade data, 3Q10 - 2Q11

USD billion (yoy growth) exports Imports Trade BalanceFY10 1,577.9 (31.3%) 1,394.8 (38.7%) 183.1 (-6.4%)

3Q10 429.8 (32.2%) 364.2 (27.4%) 65.6 (67.1%)4Q10 443.4 (24.9%) 380.7 (29.7%) 62.7 (1.9%)1Q11 399.6 (26.5%) 400.7 (32.6%) -1.0 (-107.3%)2Q11 474.9 (22.1%) 428.1 (23.1%) 46.8 (14.1%)

Source: China Customs

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exhibit 23: china’s monthly foreign trade data, Jul 2010 - Jun 2011

USD billion (yoy growth) exports Imports Trade BalanceJul 10 145.5 (38.0%) 116.8 (23.2%) 28.7 (170.3%)Aug 139.3 (34.3%) 119.3 (35.5%) 20.0 (27.5%)Sep 144.9 (25.1%) 128.1 (24.4%) 16.8 (30.5%)Oct 136.0 (22.9%) 108.8 (25.3%) 27.2 (14.1%)Nov 153.3 (34.9%) 130.4 (37.7%) 22.9 (20.7%)Dec 154.2 (17.9%) 141.1 (25.6%) 13.1 (-28.9%)

Jan 11 150.7 (37.7%) 144.3 (51.0%) 6.4 (-54.1%)Feb 96.7 (2.4%) 104.0 (19.4%) -7.3 (-199.7%)Mar 152.2 (35.8%) 152.1 (27.3%) 0.1 (-101.9%)Apr 155.7 (29.9%) 144.3 (21.8%) 11.4 (704.5%)May 157.2 (19.4%) 144.1 (28.4%) 13.1 (-32.6%)Jun 162.0 (17.9%) 139.7 (19.3%) 22.3 (10.5%)


exhibit 24: growth rates of exports and imports, Jul 2009 - Jun 2011


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exhibit 25: exports by category, 2010 & 1h11

yoy growth (%) of export value, calculated in US$ 2010 1h11Textile materials & products 28.4 28.8Garments & clothing accessories 20.9 23.7Footwear 27.1 21.7Toys 29.4 11.4Coal -5.2 51.7Crude oil -23.4 43.0Refined oil 35.9 9.1Steel 65.3 33.3Mechanical & electrical products 30.9 19.5


exhibit 26: Imports by category, 2010 & 1h11

yoy growth (%) of import value, calculated in US$ 2010 1h11Cereal & cereal flour 70.1 10.8Soybean 33.5 19.8Iron ore 58.4 54.0Crude oil 51.4 42.5Refined oil 31.3 49.1Steel 3.3 10.2Synthetic yarn 24.4 17.2Vehicles and related parts 99.1 35.5


exhibit 27: Foreign trade of china (general & processing trade), 2010 - 1h11

yoy growth (%) share (%)Item FY10 1Q11 2Q11 FY10 1Q11 2Q11exports 31.3 26.5 22.1 100.0 100.0 100.0 Of which: General Trade 36.0 31.7 29.3 45.7 46.5 49.0 Processing Trade 26.1 21.7 13.9 46.9 46.2 43.4

Imports 38.7 32.6 23.2 100.0 100.0 100.0 Of which: General Trade 43.7 37.4 28.8 55.1 57.9 57.1 Processing Trade 29.5 20.9 11.6 29.9 26.8 27.7

Total of Imports and exports 34.7 29.5 22.5 100.0 100.0 100.0 Of which: General Trade 39.9 34.8 29.1 50.1 52.2 52.8 Processing Trade 27.3 21.4 13.0 38.9 36.5 35.9


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2. general trade continued to grow faster than processing trade

The trade value under general trade12 grew faster than that under processing trade13 in 2Q11, as both exports and imports under general trade showed strong growth. In 2Q11, China’s exports under general trade grew rapidly by 29.3% yoy, while imports under general trade also soared by 28.8% yoy. (See exhibit 27)

Compared to the previous quarter, growth of exports and imports under processing trade decelerated in 2Q11. Exports and imports under processing trade increased by 13.9% yoy and 11.6% yoy respectively in 2Q11, compared to the growth rates of 21.7% yoy and 20.9% respectively in 1Q11.

The share of processing trade in China’s total trade declined from 36.5% in 1Q11 to 35.9% in 2Q11. Nevertheless, processing trade still plays an important role in China’s foreign trade, especially as processing trade recorded a large trade surplus of US$ 87.1 billion in 2Q11. In contrast, general trade recorded a trade deficit of US$ 12.0 billion over the same period.

3. asean overtook Japan to become china’s third largest trading partner in 1h11

Same as in 2010, the European Union (EU) was China’s biggest trading partner in 1H11, accounting for 15.6% of China’s total foreign trade. Sino-EU trade amounted to US$ 265.9 billion in 1H11, increasing by 21.3% yoy.

The US was China’s second largest trading partner in 1H11. Sino-US trade rose by 20.1% yoy to US$ 206.4 billion in 1H11, accounting for 12.1% of China’s total foreign trade. China’s export growth to the US declined from 21.4% yoy in 1Q11 to 16.9% yoy in 1H11, implying that the export demand from the US moderated in 2Q11.

The Association of South East Asian Nations (ASEAN) overtook Japan to become China’s third largest trading partner in 1H11. China’s trade with ASEAN increased by 25.4% yoy to reach US$ 171.1 billion in 1H11, accounting for 10.0% of China’s total foreign trade. It is noteworthy that trade cooperation between China and the member countries of ASEAN have been enhanced by the ASEAN-China Free Trade Area (ACFTA) agreement effective since 1 January 2010.

Japan became the fourth largest trading partner of China in 1H11. Sino-Japan trade grew by 19.0% yoy to reach US$ 162.3 billion in 1H11, accounting for 9.5% of China’s total foreign trade. China’s trade with Japan recorded lower growth in the aftermath of Japan’s earthquake. The growth of China’s imports from Japan decelerated from 26.4% yoy in 1Q11 to 6.4% yoy in 2Q11. On the other hand, China’s export growth to Japan went down to 19.9% yoy in 2Q11, compared to 28.1% yoy in 1Q11. (See exhibits 28 & 29)

12 General trade refers to the import or export of goods by enterprises in China with import-export rights. According to the Chinese statistics, the scope of general trade covers: import and export using loans or aids; the import of materials by foreign invested enterprises (FIEs) for processing of goods for sale in the domestic market; the export of goods purchased by FIEs or manufactured by processing domestically-produced materials; the import of food and beverages by restaurants and hotels; the supply of domestically-produced fuel, materials, parts and components to foreign vessels or aircraft; the import of goods as payment in kind in lieu of wages in labour service cooperation projects with foreign countries; and the export of equipment and materials by enterprises in China for their investment abroad.

13 Processing trade refers to the business activity of importing all or part of the raw and auxiliary materials, parts and components, accessories, and packaging materials from abroad, and re-exporting the finished products after processing or assembling by enterprises within the Chinese Mainland.

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4. china’s export growth to Brazil and Russia were much faster than china’s total export growth in 1h11

China’s exports to some major emerging economies have become an increasingly important driver of China’s export growth. For example, China’s export growth to Brazil and Russia were 41.3% yoy and 46.1% yoy respectively in 1H11, much higher than China’s total export growth of 24.0% yoy in 1H11. The other three members of the BRICs, namely, Brazil, Russia and India, jointly accounted for 6.2% of China’s total exports in 1H11. On the other hand, together they accounted for 6.4% of China’s total imports in 1H11, up from 6.1% in 2010. The growth of China’s imports from Brazil and Russia stayed robust at 37.4% yoy and 34.2% yoy respectively in 1H11. Nevertheless, the growth of China’s imports from India decelerated to 5.9% yoy in 1H11, down markedly from 21.9% yoy in 1Q11. (See exhibits 28 & 29)

exhibit 28: china’s trading partners, 1h11

country Trade value share of export value Import value yoy growth (%)/Region (usD billion) total trade (%) (usD billion) (usD billion) Total trade exports Imports

EU 265.9 15.6 164.5 101.4 21.3 16.9 29.1 US 206.4 12.1 145.5 60.9 20.1 16.9 28.4 ASEAN 171.1 10.0 80.1 91.0 25.4 24.0 26.6 Japan 162.3 9.5 68.2 94.2 19.0 23.7 15.8 Brazil 36.7 2.2 14.6 22.2 38.9 41.3 37.4 Russia 35.9 2.1 17.2 18.7 39.6 46.1 34.2 India 35.3 2.1 22.6 12.6 16.1 22.6 5.9


exhibit 29: china’s trading partners, comparing the growth rates of 2010 & 1h11

yoy growth (%)country/Region Total trade exports Imports 2010 1h11 2010 1h11 2010 1h11 EU 31.8 21.3 31.8 16.9 31.9 29.1 US 29.2 20.1 28.3 16.9 31.7 28.4 ASEAN 37.5 25.4 30.1 24.0 44.8 26.6 Japan 30.2 19.0 23.7 23.7 35.0 15.8 Brazil 47.5 38.9 73.3 41.3 34.7 37.4 Russia 43.1 39.6 69.0 46.1 21.7 34.2 India 42.4 16.1 38.0 22.6 51.8 5.9


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5. The top seven provinces/municipalities in terms of foreign trade value jointly accounted for 82.4% of china’s total foreign trade in 1h11

The top seven provinces/municipalities in terms of foreign trade value – Guangdong, Jiangsu, Shanghai, Beijing, Zhejiang, Shandong and Fujian – jointly accounted for 82.4% of China’s total foreign trade in 1H11, down slightly from 83.2% in FY10. (See exhibit 30)

Among the abovementioned provinces, Guangdong, Jiangsu, Shanghai, Zhejiang and Shandong witnessed slower export growth in 2Q11, compared to 1Q11. For example, the growth rate of exports from Guangdong, the biggest contributor to China’s exports, moderated from 33.9% yoy in 1Q11 to 28.2% yoy in 1H11. On the other hand, the growth rate of exports from Fujian rose slightly from 22.7% yoy in 1Q11 to 23.9% yoy in 1H11; and the growth rate of exports from Beijing improved from 1.3% yoy in 1Q11 to 4.0% yoy in 1H11.

exhibit 30: The top seven provinces/municipalities in terms of foreign trade value, 1h11

Provinces Total trade exports/municipalities amount yoy growth amount yoy growth (usD billion) (%) (usD billion) (%) Guangdong 435.1 26.0 250.7 28.2Jiangsu 257.4 20.0 147.5 20.4Shanghai 207.9 21.0 98.2 17.7Beijing 185.6 28.7 27.0 4.0Zhejiang 144.6 23.1 100.5 22.3Shandong 110.6 28.5 59.2 26.8Fujian 62.9 26.2 40.5 23.9


6. FDI in china grew by 18.4% yoy in 1h11

In 1H11, China’s FDI totaled US$ 60.9 billion, up by 18.4% yoy. (See exhibit 31) Of which, FDI in the service sector recorded relatively stronger growth of 21.4% yoy. In 1H11, FDI in the service sector amounted to US$ 28.1 billion, accounting for 46.1% of China’s total FDI. On the other hand, FDI in the manufacturing sector rose by 15.6% yoy in 1H11. FDI in the manufacturing sector accounted for 46.8% of China’s total FDI in 1H11, down slightly from 46.9% in FY10.

Among regions, the eastern region was the largest recipient of FDI, attracting US$ 51.8 billion in 1H11, while the central and the western regions attracted US$ 4.4 billion and US$ 4.7 billion respectively over the same period. Also noteworthy is that FDI in the central and the western regions registered marked growth of 31.8% yoy and 35.2% yoy respectively in 1H11, much higher than China’s total FDI growth of 18.4% yoy over the same period.

In 1H11, FDI from the US declined by 22.3% yoy to US$ 1.7 billion, while FDI from the EU rose slightly by 1.2% yoy to US$ 3.5 billion. By contrast, FDI from the ten countries/regions in Asia (i.e. Japan, the Philippines, Thailand, Malaysia, Singapore, Indonesia, South Korea, Hong Kong, Macau and Taiwan) increased strongly by 23.9% yoy to US$ 52.5 billion in 1H11.

Looking ahead, FDI is expected to post positive growth in the foreseeable future, given the huge potential of the service sector in China.

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exhibit 31: china’s foreign direct investment (FDI), Jul 2010 - Jun 2011

amount (us$ billion) yoy growthFY10 105.7 17.4%1h11 60.9 18.4%

Jul 10 6.9 29.2%Aug 7.6 1.4%Sep 8.4 6.1%Oct 7.7 7.9%Nov 9.7 38.6%Dec 14.0 15.6%

Jan 11 10.0 23.4%Feb 7.8 32.2%Mar 12.5 32.9%Apr 8.5 15.2%May 9.2 13.4%Jun 12.9 2.8%

Source: Ministry of Commerce, PRC

7. china’s foreign exchange reserves ballooned to us$ 3.2 trillion as of end-June 2011

As of 30 June 2011, China’s foreign exchange reserves ballooned to US$ 3.2 trillion.

It is noteworthy that the accumulation of the foreign exchange reserves declined from US$ 197.4 billion in 1Q11 to US$ 152.8 billion in 2Q11. Considering that China’s trade balance increased sharply from US$ -1.0 billion in 1Q11 to US$ 46.8 billion in 2Q11, we believe that the sharp decline in the foreign exchange accumulation in the quarter was mainly attributable to the slowdown in foreign capital inflows. (See exhibit 32)

Nevertheless, the foreign exchange reserves are expected to continue to post positive gains in the next few quarters. The bright economic prospect, the anticipation of RMB appreciation and the interest rate hikes in China are factors which will continue to attract hot money inflows.

exhibit 32: Foreign exchange reserves by quarter, 3Q10 - 2Q11

USD billion accumulation end of the quarterFY10 448.1 2,847.3

3Q10 194.0 2,648.34Q10 199.0 2,847.31Q11 197.4 3,044.72Q11 152.8 3,197.5

Source: State Administration of Foreign Exchange, PRC

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II. highlights

1. Total value of deals signed at the 109th canton Fair increased by 5.8% from the previous session

The total value of deals signed at the 109th China Import and Export Fair14 (famously known as the Canton Fair), held in Apr-May 2011, amounted to US$ 36.9 billion, up by 5.8% from the previous session held in Oct-Nov 2010. (See exhibit 33) According to the local media, most orders were scheduled to be fulfilled within the range of three months to six months. The Canton Fair is widely regarded as the barometer of China’s trade. In our view, the abovementioned figures suggested that China’s exports would continue to increase in the near term.

Looking closer at the country breakdown, the value of deals signed with buyers from the EU and the US, China’s largest and second largest export destinations, in this fair rose by 12.4% and 14.1% respectively from the previous session. Besides, the value of deals signed with buyers from the other four members of the BRICSs (i.e. Brazil, Russia, India and South Africa) soared by 30.1% from the previous session, indicating that the demand from these emerging countries was still robust. By contrast, the value of deals signed with buyers from Japan, ASEAN and the Middle East decreased by 19.1%, 3.7% and 11.4% respectively from the previous session. The decline in export orders from buyers from Japan suggested that China’s exports to Japan, China’s fourth largest export market, may show negative growth in coming future.

exhibit 33: Total value of deals signed at the china Import and export Fair, 2008 - 2011

With buyers from: growth rate of the value of deals signed in the apr-May 11 session, compared with the previous session held in Oct-nov 10EU 12.4%US 14.1%Japan -19.1%ASEAN -3.7%Brazil, Russia, India and South Africa 30.1%Middle East -11.4%Source: The official website of the China Import and Export Fair

14 The China Import and Export Fair is China’s largest and oldest trade exhibition.

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2. Power shortages are likely to affect china’s exports in 4Q11

Many provinces have suffered power shortages since April, according to the media reports. Local governments in provinces such as Guangdong, Zhejiang, Jiangsu, Jiangxi, Hunan, Hubei, Anhui, Chongqing, etc. have limited power supply to industrial users (and some have even limited residential power use).

To cope with the power shortages, many Chinese manufacturers have relied more on their own diesel power generators for electricity. However, this has pushed up the manufacturing cost of their products, since the cost of running their own generators is much higher than the electricity tariffs. Even worse, many factories have been forced to suspend part of their production activities. According to Stanley Lau, the vice-chairman of the Federation of Hong Kong Industries, manufacturers normally enter into negotiations with overseas buyers on Christmas orders in July, and many of them dare not accept production orders to their full capacities. We therefore believe that, if the problem persists, China’s exports in 4Q11 will be adversely affected.

It is noteworthy that, currently, the overall utilization of thermal power generation capacity is similar to the historical average. Therefore, we believe that the power shortage problem is largely an incentive issue, as many individual power producers (IPPs) are reluctant to produce due to losses under the government’s tariff control. In our view, the power shortages simply reflect “supply-demand imbalance (excess demand)” given a below-equilibrium price, and can be solved by raising on-grid power tariffs in the short-term and electricity pricing reform in the longer-term. To alleviate the losses of IPPs, the government announced to raise the midstream on-grid tariffs in a number of provinces on 30 May.15 The government also announced to raise the retail power tariffs in many provinces on the same day. According to the local media, the power shortages in many provinces have eased a bit since early June. The output of hydropower plants in China has also rebounded due to the recent heavy rain.

Looking ahead, the situation is not optimistic, especially as the month of August will continue to be the peak season for electricity consumption.

3. The RMB appreciated by 2.3% against the us dollar in 1h11

The RMB appreciated by 2.3% against the US dollar in 1H11, compared to the 3.1% appreciation from late June to end-December 2010.16 The nominal RMB/USD exchange rate was up from 6.6227 on 31 December 2010 to the recent peak of 6.4426 on 27 July 2011. (See exhibit 34)

On the other hand, after having depreciated from 8.5567 on 10 January to the recent low of 9.6413 on 5 May, the nominal RMB/Euro exchange rate fluctuated within the range of 9.0665- 9.5058 in the following months. (See exhibit 34)

According to the Bank for International Settlements, the real effective exchange rate (REER) of the RMB declined to a fourteen-month low of 116.31 in June, implying that the RMB depreciated by 1.4% in real terms against its trading partners in 1H11.17 (See exhibit 35)

15 http://www.ndrc.gov.cn/zcfb/zcfbtz/2011tz/t20110602_416528.htm16 After the People’s Bank of China (PBOC), China’s central bank, announced to “proceed further” with the reform of the RMB exchange

rate regime on 19 June 2010, the RMB has started to appreciate against the US dollar. http://www.pbc.gov.cn/detail.asp?col=100&ID=366417 The Bank for International Settlements (BIS) calculates effective exchange rate (EER) indices for a total of 58 economies (including

individual euro area countries and, separately, the euro area as an entity). Nominal EERs are calculated as geometric weighted averages of bilateral exchange rates. Real EERs are the same weighted averages of bilateral exchange rates adjusted by relative consumer prices. The weighting pattern is time-varying, and the most recent weights are based on trade in 2005-07.

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Looking ahead, we maintain that the RMB appreciation against the US dollar will continue in the near term, thereby bringing down the prices of imported commodities in RMB terms and helping to alleviate the inflationary pressure in China. It is forecast that the nominal RMB/USD exchange rate will appreciate by 5.1-6.8% overall in FY11 to reach 6.2-6.3 at end-2011.

exhibit 34: RMB/usD and RMB/euro, Jul 2010 - Jul 2011

Source: State Administration of Foreign Exchange

exhibit 35: RMB ReeR, Jul 2010 - Jun 2011

Source: Bank for International Settlements

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4. The WTO ruled against china’s export restrictions on certain raw materials

On 5 July, the World Trade Organization (WTO) ruled that the export duties and export quotas for various raw materials such as coke, bauxite, magnesium, etc. imposed by the Chinese government are inconsistent with the WTO rules, after having investigated the complaints filed by the US, the EU and Mexico.18 On 6 July, China's Ministry of Commerce (MOFCOM) expressed regret over the WTO’s decision. It is widely believed that the MOFCOM will appeal against the WTO ruling soon. However, some experts expect that the WTO is unlikely to overturn its original ruling. If the appeal is rejected, China will be required to remove the export restrictions on those raw materials.

In fact, industry players believe that the WTO ruling will encourage foreign countries to file complaints to the WTO over China’s export restrictions on rare earths. For example, Karel De Gucht, the EU Trade Commissioner, has recently urged China to ensure ‘free and fair’ access to rare earth supplies. Rare earths are nonrenewable resources, and are vital components in various types of high-tech products and weapons. According to the MOFCOM, China accounts for 80%-90% of the global output and global trade in rare earths, though the country only has around 30% of the global reserves. In contrast, in 2010, the resources were not mined in the US, one of the countries which are involved in the rare earth disputes with China, though the US owns 11.8% of the global reserves, according to the US Geological Survey.

Considering the strategic importance of rare earths, the Chinese government is unlikely to remove the export restrictions on them. This may provoke serious trade disputes between China and its trading partners in the future.

III. Outlook

1. The recovery of the us economy has slowed recently

Of particular concern to China’s foreign trade outlook is the US economy. Although the US GDP growth figure for 2Q11 has not been released yet, the more recent indicators suggest that the recovery of the US economy has slowed. (See exhibit 36)

On the production side, after rising by 0.7% mom in March, the industrial production registered negative mom growth of -0.1% in April and in May, and then edged up by 0.2% mom in June. (See exhibit 37) According to the Institute for Supply Management, the manufacturing PMI dropped sharply from 60.4 in April to 53.5 in May, before rebounding a bit to 55.3 in June. The decline in the PMI indicated the weaker growth momentum in the manufacturing sector. According to the US Department of Commerce, new orders for manufactured durable goods decreased markedly by 2.1% mom in June on a seasonally-adjusted basis, posting negative mom growth in two of the last three months.

The US non-manufacturing sector has also expanded at a slower pace. According to the Institute for Supply Management, the non-manufacturing index (NMI) dropped from 54.6 in May to 53.3 in June, the second lowest in ten months.

18 http://www.wto.org/english/news_e/news11_e/394_395_398r_e.htm

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On the other hand, the US consumption demand slowed in recent months. After posting mom growth of around 0.8-1.3% throughout January to March, the US retail sales edged up by 0.2% mom in April, then declined by 0.1% mom in May, and increased slightly by 0.1% mom in June, according to the US Department of Commerce. Caused mainly by the renewed concerns about the outlook for the economy, the US consumer confidence index declined from 74.3 in May to 71.5 in June. (See exhibit 38)

The US job market has deteriorated again recently. After trending downward throughout October 2010 to March 2011, the US unemployment rate started an upward trend and rose to 9.2% in June, the highest in six months. (See exhibit 39) The non-farm payroll employment continued to increase, albeit in a slower pace. After rising by 217,000 in April, the non-farm payroll employment increased mildly by 25,000 in May and 18,000 in June.

Looking ahead, we expect the US economic growth to remain slow in the near term, constrained by the decline in government spending and the weak housing market. In its latest report released in mid-June, the International Monetary Fund (IMF) revised downward its earlier forecasts about the economic growth of the country.19 The institution predicted that the US economy would grow by 2.5% and 2.7% in 2011 and 2012 respectively, down 0.3 ppt and 0.2 ppt respectively from its previous projections made in April.

exhibit 36: us national accounts, 2009 - 1Q11

annual growth (%) 2009 2010 2Q10 3Q10 4Q10 1Q11GDP -2.6 2.9 1.7 2.6 3.1 1.9

Source: US Department of Commerce

exhibit 37: us industrial output growth, Jan - Jun 2011

mom growth(%), seasonally adjusted Jan Feb Mar apr May JunIndustrial production 0.2 -0.3 0.7 -0.1 -0.1 0.2

Source: US Federal Reserves

exhibit 38: us consumer market, Jan - Jun 2011

Jan Feb Mar apr May JunRetail and food services sales 0.8 1.3 0.8 0.2 -0.1 0.1 (mom growth %, seasonally adjusted)Reuters/University of Michigan index 74.2 77.5 67.5 69.8 74.3 71.5 of consumer sentimentCPI (yoy growth %) 1.6 2.1 2.7 3.2 3.6 3.6

Source: US Department of Commerce, Reuters/University of Michigan Surveys of Consumers, US Department of Labor

19 IMF, World Economic Outlook Update, 17 June 2011

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exhibit 39: us employment situation

unemployment nonfarm payroll employment, Jul 2010 - Jun 2011 rate (%) In thousands, seasonally adjusteded2009 9.32010 9.6

Jul 10 9.5Aug 9.6Sep 9.6Oct 9.7Nov 9.8Dec 9.4

Jan 11 9.0Feb 8.9Mar 8.8Apr 9.0May 9.1Jun 9.2

yearly figures: annual average; monthly figures: seasonally adjustedSource: US Department of Labor

2. The eurozone gDP growth rose from 0.3% qoq in 4Q10 to 0.8% qoq in 1Q11

The real GDP growth in the Eurozone20 rebounded from 0.3% qoq in 4Q10 to 0.8% qoq in 1Q11, boosted by the stronger growth of investment, government expenditure and exports. (See exhibit 40) In 1Q11, investment rose strongly by 2.1% qoq, after registering zero growth in 4Q10. Government final consumption expenditure increased by 0.8% qoq in 1Q11, compared to the negative growth of -0.1% qoq in 4Q10. The growth rates of exports and imports went up to 1.8% qoq and 1.9% qoq respectively in 1Q11, compared to 1.7% qoq and 1.3% qoq respectively in 4Q10. In 1Q11, the growth rate of household final consumption expenditure came in at 0.3% qoq, the same as in 4Q10.

The economies of China’s major export destinations in the region, in general, showed relatively strong growth in 1Q11. The real GDP in Germany, France, and Netherlands grew by 1.5% qoq, 1.0% qoq and 0.9% qoq respectively in 1Q11. Nevertheless, the real GDP growth in Italy, one of the European countries that faces sovereign debt crisis, stayed low at 0.1% qoq in 1Q11.21

The latest indicator suggested that consumption in the Eurozone was still sluggish. The volume of retail trade in the region dropped sharply by 1.1% mom in May, registering negative growth in two of the last three months. (See exhibit 41) The weak consumption demand could be attributed to the poor labour market, given that the unemployment rate in the region stayed high at 9.9% in May. (See exhibit 42)

20 Estonia has become the 17th member of the Eurozone since 1 January 2011. And the other member countries include Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, Netherlands, Portugal, Slovenia, Spain and Slovakia.

21 China’s exports to these four countries accounted for 11.2% of China’s total exports in FY10.

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Also noteworthy is that both the manufacturing sector and the service sector in the region have expanded at a slower pace in recent months. According to Markit Economics, the Eurozone manufacturing PMI fell to 52.0 in June, the lowest in eighteen months; the Eurozone services PMI dropped to an eight-month low of 53.7 in June.

In response to the strong inflationary pressure, the European Central Bank, for the second time in three months, raised the interest rates in early July. Looking ahead, we expect the growth of the Eurozone economy to stay weak in coming months, impacted by the fiscal consolidation and higher borrowing costs in the region.

exhibit 40: eurozone gDP growth, 2009 - 1Q11*

2009 2010 2Q10 3Q10 4Q10 1Q11GDP (qoq growth %) 1.0 0.4 0.3 0.8GDP (yoy growth %) -4.1 1.8 2.0 2.0 1.9 2.5

* The figures in 2009 and 2010 do not reflect Estonia’s membership of the Eurozone, which has begun on 1 January 2011.Source: Eurostat

exhibit 41: eurozone consumer market, Jan - Jun 2011

Jan Feb Mar apr May JunVolume of retail trade 0.2 0.2 -0.9 0.7 -1.1 - (mom growth %, seasonally adjusted)Annual inflation (%) 2.3 2.4 2.7 2.8 2.7 2.7

Source: Eurostat

exhibit 42: eurozone labour market, Dec 2010 - May 2011**

Dec 10 Jan 11 Feb Mar apr MayUnemployment rate (%) 10.0 10.0 10.0 9.9 9.9 9.9

** The figures in 2010 were revised to reflect Estonia’s membership of the Eurozone, which has begun on 1 January 2011.Source: Eurostat

exhibit 43: eurozone economic sentiment indicator, Jan - Jun 2011

seasonally adjusted Jan Feb Mar apr May JunEconomic sentiment indicator 106.8 108.0 107.3 106.1 105.5 105.1Source: Eurostat

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3. china’s export growth is set to further moderate in 3Q11

In its World Economic Outlook Update released in mid-June, the IMF suggested that the world economic growth would reaccelerate in 2H11, after slowing in 2Q11. The institution projected that the world economy would grow by 4.3% and 4.5% in 2011 and 2012 respectively. The growth rates of the advanced economies were projected to be 2.2% and 2.6% in 2011 and 2012 respectively, while the emerging and developing economies were projected to grow by 6.6% and 6.4% in 2011 and 2012 respectively. (See exhibit 44) However, the IMF revised downward its earlier forecasts about the economic growth of the US and Japan. The institution predicted that the US economy would grow by 2.5% and 2.7% in 2011 and 2012, down 0.3 ppt and 0.2 ppt respectively from its previous projections made in April. Besides, the IMF’s forecast about Japan’s GDP growth in 2011 was revised downward from 1.4% to -0.7%. We therefore expect that the export demand from the US and Japan, China’s main export destinations, may further slow in the near term.

Looking ahead, in view of the moderating foreign demand from the advanced economies, we think China’s export growth is set to decline from 24.0% yoy in 1H11 to 15-20% yoy in 3Q11. Nevertheless, we remain optimistic about the outlook for China’s exports, given the bright economic prospects of the emerging economies. Exports to the emerging economies have become an increasingly important driver of China’s export growth. In 1H11, China’s exports to some emerging economies such as Russia, Indonesia, Brazil, Vietnam, and Thailand grew robustly by 46.1% yoy, 42.6% yoy, 41.3% yoy, 36.1% yoy, and 35.5% yoy respectively, much higher than China’s total export growth of 24.0% over the same period.

exhibit 44: gDP growth forecasts by the IMF

yoy growth (%) FY10 FY11 FY12 (Previous (Latest (Previous (Latest forecast) forecast) forecast) forecast)World economy 5.0 4.4 4.3 4.5 4.5

Advanced economies 3.0 2.4 2.2 2.6 2.6- US 2.8 2.8 2.5 2.9 2.7- Eurozone 1.7 1.6 2.0 1.8 1.7- Japan 3.9 1.4 -0.7 2.1 2.9

Emerging and developing economies 7.3 6.5 6.6 6.5 6.4- China 10.3 9.6 9.6 9.5 9.5- India 10.4 8.2 8.2 7.8 7.8- ASEAN-5* 6.9 5.4 5.4 5.7 5.7- Brazil 7.5 4.5 4.1 4.1 3.6- Russia 4.0 4.8 4.8 4.5 4.5

* Indonesia, Malaysia, the Philippines, Thailand, and Vietnam.Source: IMF

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