10 Things to Watch in 2015

We expect GDP growth to average 7.1% in 2015: 7.1% in Ql， 7.2% in Q2 and Q3， and 7.0% in Q4

CPI inflation should average 2%; disinflationary pressure is set to build over the next six monthsWe forecast one more interest rate cut in Ql; weakening employment is weighing onconsumption

Housing investment should improve in H2-2015， and economic reforms are likely to acceleratein 2015

2014 may have been a year ofslower economic growth， butit was also a year of positiveprogress on reforms. Theslowdown in GDP growth t0 7.3% v/vin Q3-2014 from 7.7% in Q4-2013 waspartly policy-driven， reflecting Beijing'spush to reduce excessive debt growthand industrial overcapacity and tackleenvironmental degradation. Reformsremain in focus. In the financial sector，the authorities have widened the USD-CNY trading band to +/-2% from +/-1%， lifted the deposit rate ceiling to1.2x from l.1x， simplified cross-bordercapital flows via the Shanghai-HongKong Stock Connect programmeand the pan-China CNY sweepingscheme， and introduced a depositinsurance clause. Rural reforms allowfarmers to earn more revenue fromrural land leasing， and encouragefarmers to migrate to small to medium-sized cities. The revised Budget Lawallows provincial governments to issuemunicipal bonds to fund economicdevelopment (with central governmentapproval) instead of relying on \"hidden\"debt for funding. The rationalisation ofgovernment regulations also seems tohave made it easier to start a business.

Looking ahead t0 2015， we outline10 key points to watch for. We expectGDP growth to moderate t0 7.1% froman expected 7.3% in 2014. We forecastquarterly GDP growth at 7.1% y/y inQ1， 7.2% in both Q2 and Q3， andy 7.0%in Q4 (Figure l). Achieving this willnot be easy amid the rising challengesof a weakening labour market，disinflationary pressures and relativelyhigh real lending rates. We expect onemore deposit rate cut of 25bps by thePeople's Bank of China (PBoC) in Ql-2015 to support the recovery， followingan initial cut in Q4-2014.

1. Actual economic growthis probably slower than the officialnumbers suggest. According to the'Keqiang Index'， growth in electricity，cement and steel product production-considered more reliable indicatorsofindustrial production (IP) and fixedasset investment (FAI)-have fallenby an average of 8ppt in 2014， muchmore than the 3ppt slowdown inofficial IP and FAI growth (Figures2 and 3). The gap between this indexand the official data continues towiden.

2. We forecast that GDPgrowth will ease t0 7.1% in 2015from an expected 7.3% in 2014.Beijing has signalled that it iswilling to tolerate slower short-term growth as it pursues long-termreforms and sustainable growth.To achieve this， China needs toimplement more decisive supply-side economic reforms to unlock itsgrowth potential. In our view， thisshould include plans to unify thecountry's fragmented social securitysystem to enhance labour mobilityand productivity growth; downsizeSOEs and open them up to marketcompetition; and further streamlinegovernment regulations (e.g.， byadopting a nationwide \"negativeinvestment\" list or expandingShanghai free-trade-zone policiesacross China) to reinvigorateentrepreneurship and innovation.We have already seen some progresson facilitating access to capitalmarkets for SMEs. By end-2014，we should know more about China's13th Five Year Plan (FYP)， whichsets key social and economic reformstargets for 2016-20.

3. The labour market is showingmore signs of stress. While themanufacturing sector has been losingjobs for three years， until recentlygrowth in services jobs was enoughto offset this. This has now changed.According to the employment sub-index ofthe offcial non-manufacturingPMI， employment in services began todecline in July 2014 (Figure 4). Moreworryingly， our recent discussions withcompanies suggest that many plan tofreeze wages in 2015 as a result of theslowing economy and already-squeezedprofit margins. If the labour marketweakens further， we could see a secondwave of economic slowdown drivenby slowing consumption in early 2015(Figure 5).

4. Disinflationary pressures arebuilding and pose a threat to theeconomy. CPI infiation could slow toabout 0.5% y/y by Q2-2015 from l.6%in October 2014， based on two leadingindicators we like - the SP globalagricultural price index and China'sconsumer spending sentiment index(Figures 6 and 7). Further disinflationcould undermine corporate profitmargins and， consequently， incomegrowth. We expect average CPIinfiation of2% in 2015.

5. Borrowing costs remainhigh， curbing new investment andconsumption. China's nominaleconomic growth has fallendramatically since the globalfinancial crisis， to less than 8% asof Q3-2014 from 22% in 2008.However， the average lending ratehas failed to adjust sufficiently，declining by only 0.8ppt overthe period. This is partly dueto the incomplete interest rateliberalisation process. The actuallending rate for the private sector，usually for short-term loans， is closet0 21% including all expenses (e.g.，insurance， handling and consultingfees)， as measured by the Wenzhouprivate financial index.

6. There are tentative signs ofa housing-market recovery. Salesin China's 31 biggest cities havebeen recovering gradually since July2014， according to data from Soufun(Figure 8). This is the result oftargeted policy easing and the releaseof pent-up demand. However， newinvestment and construction activitymay not re-accelerate until H2-2015， in our view， as inventories arestill high and land purchases remainlacklustre (Figures 9).

7. New industries are emerging，preparing China for the long run.Investments in green energy， healthcare， education， environmentalprotection and infrastructure haverisen in 2014 (Figure 10). Theseindustries have been selectedby Beijing as part of its plan totransform China into a moreinnovative， environmentally friendlyand consumption-driven economy.For now， they are not yet bigenough to generate much e:onomicgrowth， as they account for lessthan 15% of GDP.The housing andmanufacturing industries remainthe heavyweights， but investmentgrowth in these sectors has beenslowing.

8. Leverage growth hasbeen brought under control， andsystemic default risk is bettercontained. Credit growth hasslowed significantly in 2014，especially for \"shadow banking\"credit， where growth fell t0 17%y/y in October 2014 from 27%at end-2013. New regulationsrolled out in 2014 have reducedsome of the riskier activities inthe shadow banking sector， suchas third-party guarantees andwrite-offs of collateral assets usedin repo transactions. Growth inlocal government debt slowed toabout 3% in 2013 from over 20%in 2009-10， according to the latestfindings by the National AuditOffice. The revised Budget Lawpassed in August and subsequentState Council documents have alsostrengthened the supervision andmanagement of local governmentdebt. Local governments arebanned from additional borrowingthrough financing vehicles， whilethey are allowed to issue municipalbonds to finance local projects andencouraged to participate in PPP(public-private partnership) projects.

9. Another interest rate cut islikely in Q1-2015 to support theeconomic recovery. The PBoC isthen likely to pause to evaluate theeffectiveness ofits rate cuts. We expectit to cut the deposit rate by another25bps and lift the deposit rate ceilingt0 1.3x from l.2x as it moves towardsinterest rate liberalisation. Duringthe transition period (before loanrates are based on SHIBOR ratherregulated benchmark lending rates)，the PBoC may lower the benchmarklending rate by another 40bps. Wealso expect it to take material stepstowards liberalising deposit rates byend-2015， possibly by simultaneouslyremoving the ceiling for deposit ratesand adjusting benchmark rates lower.

10. Mild CNY appreciationand a slightly larger current accountsurplus are expected in 2015. TheUSD-CNY exchange rate is likelyto stay range-bound in the near termdue t0 weak economic growth andthe policy easing stance. We do notexpect material Chinese yuan (CNY)depreciation given that it could triggercapital flight and jeopardise CNYinternationalisation， which couldundermine China's financial stability.CNY appreciation is also unlikely tobe welcome for now given the need tosupport the economic recovery. Weexpect the CNY to strengthen in H2-2015 after the economy stabilises，however. We see the USD-CNY spotexchange rate ending 2015 at 5.95，with China's current account surpluswidening t0 2.8% of GDP in 2015from 2.3% 2014.

(Author: Economists fromStandard Chartered Bank)