The Next Rev of China's Growth Engine

This week, China released statistics showing that August consumer price index rose 4.9% compared with last year, down from the July number of 6.3% and certainly much lower than the 12-year high of 8.7% reached in February of this year. However, the August producer price index remained at a high level of 10.1%.

The milder CPI number indicates that China's tightening policy has taken effect. We believe the government is now in a better position to focus on growing the economy, which has slowed in the past four quarters amid a global economic slowdown and Chinese currency appreciation. China has already taken several actions to try to put the economy back on the growth track. We learned that the lending quota has been expanded to small businesses, and that exporters are seeing a gleam of hope as the Chinese currency remained flat against the dollar since August and as the government cuts export taxes for garment and textile firms. At the same time, however, high CPI remains a key concern for the government, in our opinion. The high August PPI indicates that inflation may flare up again later in the year, requiring the government to stay vigilant. Or, if Chinese firms fail to pass along rising product costs, they will see significantly lower profit margins.

Market Recap
In the past five trading days, the Shanghai Composite Index declined more than 5.6% to 2079.67, briefly touching its 22-month low of 2064. The Shenzhen stock index dropped by 4.5% to 6935. Volumes in both markets remained very low. Despite milder CPI numbers, investors were reluctant to return to the market, with concerns about China's economic outlook. Uncertainties resulting from a series of new regulations governing equity and bond transactions added to their worries.

The oil sector declined by 8.5% as oil prices dropped in the international market. The financial sector dropped by 6.53%, and the real estate sector slumped by 13.06%, as many developers are facing a fund shortage due to China's tightening monetary policy.

Industrial
Industrial Production Grew at Lowest Pace in Six Years
China recently reported that industrial production grew by 12.8% year over year in August, down from the pace of 14.7% in July. We think the slow growth is attributable to weaker demand in major export markets of the U.S. and the European countries, as well as power shortage problems in major industrial provinces such as Liaoning and Hubei. Transportation restrictions and temporary plant shutdowns before and during the Beijing Olympics in August may have also led to lower production.

Real Estate Firms in Tough Spot
Vanke, the largest listed real estate developer in China, said revenue fell 35.2% year-over-year in August 2008. Many developers are slashing prices by 20%-30% in major cities across China to reduce their inventory. The lending restrictions put in place by the central bank caused significant fund shortages for the real estate firms.

Financial
China to Tighten Rules on IPO Underwriting
The new rules drafted by the China Securities Regulatory Commission (CSRC) will focus on defining the due diligence process to ensure that companies seeking public listing are properly vetted. In July, the regulator had announced that it would release a preliminary prospectus online within five days after the commission gave feedback to a prospective IPO firm and its underwriter. Previously, there was no timetable requiring IPO prospects to post updated versions of their prospectus.

Internet
C2C Giant Taobao Blocks Baidu Search Engine from Its Sites
China's leading auction site, Taobao.com, recently announced that it will completely block the search engine of  Baidu (BIDU) and partially block that of  Google (GOOG) and  Yahoo . Taobao says this will reduce fraud caused by online merchants who mislead consumers with search optimization techniques. We think Taobao is taking this action to pre-empt Baidu's plan to enter the C2C (consumer-to-consumer) market leveraging its popular search engine.

Thanks for contributions from Lun Lu, Iris Tan, Peter Liu and Feliz Li.