The fiscal slide will likely bring surprises to both growth and policies. Economic growth is likely to surprise on the downside in H1 2015. Growth of fiscal revenue for local governments as well as total government is likely to fall into negative territory in H1. The government will loosen monetary and fiscal policies but the effect might not show until H2. We believe GDP growth will decline to 6.8% yoy in Q1 from 7.2% in Q4.

Industrial level indicators could surprise more on the downside than GDP growth. Industry production and general material demand should still be weak in H1. We expect the HSBC PMI to drop to 48 sometime in H1 (Figure 60).

Policy easing will have to surprise a lot on the upside to achieve c.7% growth in 2015. We forecast two interest rate cuts and two RRR cuts in 2015. The risk is that there may be more rate and RRR cuts than we forecast.

While investors may not be surprised to see rate and RRR cuts, they may be surprised to see how fast M2 growth will be in 2015. Some news articles reported that the government might set the M2 target at 12% for 2015, vs. 12.6% in November 2014. Most analysts hence forecast M2 growth to be stable at around 12-13%.

?We forecast M2 growth to rise sharply to 14% yoy in 2015, because the fiscal shock is much higher than others expect. Note that M2 growth rose from the trough of 13% in end 2011 to the peak of 14.8% in the 2012 policy easing cycle, and GDP growth slowed from 9.2% in 2011 to 7.7% in 2012 (Figure 61). In 2015 the government aims to allow GDP growth to slow only by around 0.5%, yet the fiscal shock is unprecedentedly high. This means M2 growth will have to rise sharply.

Monetary policy easing alone is not sufficient for delivering 7% growth. Fiscal policy at the central government level might have to loosen significantly in order to offset the fiscal slide facing local governments. The fiscal deficit of the central government was 1.9% of GDP in 2013 and might have moved to 2.1% in 2014. We forecast it might have to rise to 3.0% of GDP.

Eoin Treacy's view

Land sales are an important source of revenue for local governments not least because they need to bridge the gap between government transfers and what they spend on public services. At the present time, government transfers will need to increase in order to help balance regional municipal budgets as the property market cools and demand for land slows. 

As megalopolises such as Beijing, Shanghai, Shenzhen, Guangzhou and Chengdu expand the ability of land sale revenues to meet the demands of an increasing population is questionable. Property taxes will need to be introduced at some point and the sooner the better. They will be especially important in curbing corruption in the planning process as well as in oversight of how the capital raised is spent.

This report from the OECD carries additional information on China’s taxation system and may be of interest.