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Boston, MA -- (SBWire) -- 03/19/2013 --Core Views

We estimate China's real GDP came in at 7.7% in 2012, marking the weakest growth outturn since 1990. Unlike the situation facing the economy in Q109, when a recovery in exports combined with a fiscal stimulus programme resulted in a V-shaped recovery, this time we expect the ongoing bounce in economic activity to fade in H213 as the country's structural headwinds build. As such, we are sticking with our 2013 growth forecast of 7.5%.

Inflation is beginning to rear its ugly head in China as a predictable consequence of the proliferation in shadow bank lending and the increasingly inefficient allocation of capital. While consumer price (CPI) inflation remains low by historical standards, it has risen sharply in recent months and with the economic recovery gaining momentum, it appears that the only way is up over the coming months. Renewed economic weakness in H213 should cool CPI, however, and we are forecasting an average rate of 2.8%, with an end-2013 target of 2.6%. The main risk comes from further expansionary policies, which we believe could result in the emergence of stagflation.

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The rise of shadow banking activity poses systemic risks to China's financial system as a whole. Risks have been contained thus far thanks in part to explicit government support, and we expect this to remain the case. That said, the potential for a run on the shadow banks, triggering a widespread liquidity crisis, is as great as ever.

Sino-Japanese relations are likely to remain strained in 2013, and could worsen if new Japanese Prime Minister Shinzo Abe takes steps to boost the role of the military or downplay Japanese atrocities in Asia in the early 20th century. The biggest risk is that of an aerial or naval skirmish as a result of an 'incident' in the disputed Senkaku/ Diaoyu islands in the East China Sea.

Major Forecast Changes

We have upgraded our real GDP growth forecast for 2013 from 6.9% to 7.5% owing to the strong rebound in economic activity witnessed in late-2012/early-2013, although our outlook remains below consensus estimates of 8.1%.

We have also upgraded our inflation outlook, calling for consumer price inflation to average 2.8% this year (from a previous forecast of 2.6%) owing to the continued rise in shadow-bank lending.

Key Risks To Outlook

The main downside risk to our economic outlook remains another collapse in external demand, such as the one that occurred at the height of the global financial crisis. This would seriously undermine growth in trade-dependent industries and hasten a fall in the property market, potentially leading to an outright recession. There is also a risk that continued fiscal and monetary stimulus by government and the People's Bank of China could usher in stagflation.

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