China Macro:June data preview,A halt in disinflation and destocking

China’s economy picked up 18 months ago, driven by 3R: reflation, restockingand real estate, then peaked in 1Q17. Since then, reflation and restockinghave turned into disinflation and destocking. However, in June, the trend ofdisinflation and destocking halted, resulting in higher PMI readings. That said,we believe that the improvement in June was a blip, and will not change theoverall downtrend from a 12-month point of view. China will also release 2QGDP growth data two weeks later. We expect a modest slowdown to 6.7%yoy from 6.9% in 1Q17. Looking ahead, we expect 6.6% yoy for 3Q17.

A halt in disinflation and destocking: One of the biggest surprises so far in2017 has been the resilience of the tier 3/4 cities. In the previous propertydown-cycle in 2014, all cities slowed together. This time is different. Accordingto the NBS, Jan-May GFA sales in the top 40 cities were flat, but still grew14% yoy at the national level. The better-than-expected demand causedinventory to fall to a low level (table top left). The changing supply/demandbalance is behind the recent rebound in commodity prices, which was alsohelped by easing liquidity concerns. As a result, we expect PPI inflation to riseto 5.6% yoy after falling three months in a row. CPI inflation should also rise to1.6% yoy in June from 1.5% in May.

External demand as another bright spot: In June, we expect exports togrow 9% yoy and imports to rise 13%, little-changed from May. In June, theNew Export Orders sub-index in the NBS PMI rose to its highest level since2012. Exports from Korea, a gauge for the East Asian supply chain, alsoaccelerated to 17% yoy in 2Q17 from 15% in 1Q17.

Lower production and investment growth on a higher base: Despite astronger-than-expected PMI, note that PMI is about sequential change andimpacted by sentiment. In terms of ‘hard data’ such as industrial productionand FAI, we expect a modest slowdown in June due to a higher base.

Specifically, industrial production growth could edge down to 6.4% yoy from6.5% in May. In 2H17, a rising base could further weigh on growth. Forinstance, power output grew 2% yoy in 1H16 but 8% in 2H16, while auto salesgrew 8% yoy in 1H16 but 19% in 2H16.

Financial regulation to continue on interbank liquidity: Regardingfinancial tightening, policy makers have been very careful to differentiatebetween real economy liquidity and interbank liquidity. Of course policymakers aim to tighten interbank liquidity, but don’t want to hurt liquidity in thereal economy too much. This is behind the recent divergence between loangrowth and M2 growth (bottom left chart). M2 is impacted by financialregulations, as 10% of M2 is deposits by brokers and insurance companies.