| Overall, the domestic political situation in China is stable, with no current major rifts or power struggles within the ruling Communist Party [CCP]. To prevent any major social unrest, the administrations main aim is to preserve high economic growth in order to create jobs, combat inflation and develop a public welfare safety net. The protests and revolutions in the Middle East and North Africa have made the Chinese government alert to potentially similar developments in their own country. The authorities prevent public demonstrations and criticism of the government [via the internet] has become more difficult. But, despite some similarities between the political situation in China and in Middle Eastern countries, a key difference is that the living standards of many Chinese people has improved over the last couple of years: GDP per capita has risen from 847 US$ in 2000 to 5,000 US$ in 2011. However, there are sharp income differences between the rural and the urban population as well as between the coastal provinces and the Western parts of the country. In recent years, social discontent has grown in several provinces, fuelled by corruption in local government, environmental problems and weak protection of property and land rights. In many cases, farmland has been illicitly expropriated by the local authorities for commercial use. But, so far, protests have flared up only locally and have been swiftly contained by the security forces. Besides social issues, environmental problems are also attracting considerable attention. Beijing is increasingly concerned about the long-term availability of food as a result of the pace of farmland loss due to pollution and enforced industrialisation. The government has taken measures to cool the economy Chinas economy grew by 10.3% in 2010, marking its fastest annual pace since the onset of the global crisis. Growth in foreign trade recovered rapidly, surpassing pre-crisis levels and hitting a record high. Imports and exports together totalled US$ 2972.76 billion - a year-on-year growth of 34.7% - with exports of US$ 1577.93 billion and imports of US$ 1394.83 billion, up 31.3% and 38.7% respectively. However, concerns have grown about economic overheating and the sustainability of these high growth rates because of increasing asset price bubbles in the real estate sector and in stock markets, and also rising consumer prices, up 3.2% year-on-year after 2009s deflation, due to rising food, fuel and housing prices. Therefore the government has taken measures to cool down the economy, such as reducing stimulus measures and introducing a more restrictive monetary policy to stem the flood of liquidity that is fanning inflation and driving up property prices. The central bank has raised interest rates four times since October 2010, and has increased the amount of money that banks must keep in reserve five times so far this year in a bid to curb lending. In particular, the reserve requirements ratio of larger banks has been sharply increased: to 21%. Inflationary pressures continued into 2011 Nevertheless, inflation continued its rise in 2011, standing at 5.3% year-on-year in April, driven mainly by higher food prices [+11.2%], which account for 30% of the consumer price index. The Chinese authorities are increasingly worried that higher producer prices, resulting from higher labour costs and raw material prices, may translate into higher consumer prices. Besides its monetary tightening measures, the Chinese government has therefore introduced price controls for basic materials and increased subsidies to low-income families. Despite all these measures, inflation is expected to increase by 5% year-on-year in 2011. As a consequence of the governments new top priority of price stability and its subsequent steps to slow down the economy, GDP growth is expected to decelerate to 9% in 2011, as export growth and investment spending slow down. At the same time, the contribution of private consumption to economic growth will increase, due to higher salaries and government measures to stimulate private spending, such as increased spending on education, healthcare and pensions. Increasing risks in the financial sector Chinese banks played a prominent role in the massive 2008/2009 stimulus programme. Bank credit increased by 12% in 2008, 31% in 2009 and 18% last year, resulting in high investment spending, with a large share of investments made by local government investment companies [LGIC] financed by banks. However, it is estimated that about 20%-25% of those LGIC loans are highly risky, which has raised concerns about a deterioration of assets in the banking sector. Those concerns are also nurtured by banks´ large exposures to the overheated property market. While the government is urging banks to be more restrictive in their lending and non-performing loans [NPL] in the banking sector are still low [1.3%], since lending has grown strongly in the past the NPL ratio is expected to be much higher in the medium term. Economic policy focused on rebalancing The governments enormous stimulus package has led to economic imbalances, with investments, which account for 47% of GDP in 2011, still playing a dominant role in the economy. This is also a major economic risk as these investments have not all been efficient. The investment drive, together with the massive credit expansion over the past three years, has created the bubble in the property market. However, with higher spending on social services, the government is trying to rebalance the economy. Low public debt, but rising contingent liabilities At first sight, government finances are in a good shape. In 2010 the budget showed a deficit of 1.6% of GDP, and this year the deficit is expected to be 1.7% of GDP. Public debt is currently moderate but, when contingent liabilities are taken into account - such as bank restructuring in case of a deterioration of the financial sector and future pension and social security costs - that debt is much higher. Another issue is that of the finances of local government bodies, which played an important role in the massive stimulus policy of 2008 and 2009. There is much uncertainty about the quality of their investments and reports about high debt levels have created concerns about local governments´ financial health. According to the China Banking. Monetary policy: gradual Yuan appreciation To combat inflation the central banks monetary policy has been tightened by repeatedly raising interest rates and increasing the banks´ reserve requirements. The Yuan is de facto fixed, with a crawling peg to the US$, and an accelerated currency appreciation could help to contain inflationary pressures. In April 2011 the central bank allowed the Yuan to rise 0.9% as a reaction to high inflation figures in March. However, it is expected that any further appreciation will be gradual [in 2010 the Yuan appreciated by 2.7% against the US$] as a faster rate would hurt the international competiveness of Chinese industries and exports. Lower margins for Chinese exporters Chinese exporters are experiencing lower profit margins because of surging commodity prices in the global market, rising labour costs and the appreciation of the Yuan. Many companies have lowered their export targets and aim to Counter the sluggish global market by increasing domestic market demand. This is triggering a shift in production away from the coastal areas and towards the central and western regions. Business opportunities of reconstruction efforts in Japan The recent disaster in Japan has caused a reduction in its domestic industrial production due to the damage to production lines, disruption to power supplies and the destruction of the infrastructure in some areas. This should bring short-term opportunities for Chinese exporters and industries such as steel/metals, because: post-quake reconstruction in Japan creates huge demand; Japans export business may shift to neighbouring countries such as China and South Korea, in view of the damaged production capacity; Japans domestic needs may not be met, owing to the underproduction in some areas. Outlook: Good The government has recognised the potential for instability as a result of hidden unemployment in state-owned enterprises, higher food prices, and regional disparities, and so its policy of steady but gradual reform will remain unchanged. Local social unrest will continue, but is unlikely to result in a nationwide movement. Lower growth in 2011 and 2012 China plans to redirect stimulus spending away from fixed-asset investment and into social services, such as healthcare and education. Governmental measures to cool down the economy will slow growth to 9% in 2011 and 8.7% next year. Foreign trade will continue to grow in 2011, but there could be a slight decrease in growth rate compared to 2010. Imports are expected to grow faster than exports. The Chinese authorities are trying to ensure that inflationary pressures do not spill over into price pressures in areas of the economy other than food costs or into inflationary expectations, which may mean further cuts in lending quotas and more hikes in reserve requirements and interest rates. However, raising interest rates further could dampen growth more than is desired and attract more inflows of [speculative] foreign capital. Therefore the central bank may lay emphasis on further reserve requirement ratio increases instead. After a 5% increase this year, inflation is expected to fall to 3.8% in 2012. Risk in the banking sector will increase in the medium term, as the [politically motivated] strong increase in lending in recent years will result in deteriorating assets and higher non-performing loans [NPL]. China has a comfortable external position [with a low level of debt and positive balance of payments] and liquidity situation. Its international reserves will continue to increase due to the strong balance of payments. The high bilateral trade surplus and the exchange rate continue to be issues between Washington and Beijing, with the US administration pushing for a faster Yuan appreciation which it sees as a major precondition for more consumer spending in China and to limit global imbalances. Rising imports will lead to lower current account surpluses in 2011 and 2012. Challenges in the mid-term In the mid-term the Chinese authorities have to tackle structural economic imbalances, reflected in low household consumption and a high savings rate, by stimulating private consumption. The twelfth Five-Year Plan period [2011-2015] is crucial for deepening reform and to speed up the transformation of the pattern of economic development. At the same time, the country has a number of challenges: keeping the overall level of prices basically stable, adhering to the strategy of expanding domestic demand, quickly getting economic growth to be driven by a balanced mix of consumer spending, investment and exports, upgrading the manufacturing industry, and fostering and developing strategic emerging industries such as new energy, new energy vehicles, energy conservation, information technology, biopharmaceutical, and high-end equipment. | 
