Six weeks after Beijing dismissed two senior officials and moved from denial to aggressive measures to tackle the SARS outbreak, the number of daily new infections has fallen sharply (no infections were reported on June 2). There may be new setbacks in the battle against SARS and rural infection remains a worry, but signs of stabilisation have emerged. Meanwhile, we now have better clarity vis-à-vis potential economic losses.

1) Consumption fell more but also rebounded quicker than we first thought. Air travel slumped 80% yoy, while rail travel dropped 60% during the May Labour Day holidays — the busiest travel season outside of the Chinese New Year. We project nationwide spending fell by about 20% yoy due to reduced spending and travel cancellations, with Beijing plummeting 70% during that period. However, the consumer panic appears to have been short lived. By mid-May, sales had recovered by 90% in cities such as Shanghai, while a visible improvement in sentiment has been witnessed in Beijing as well. The consumer behaviour pattern so far is consistent with that seen in Hong Kong; thus, we expect consumers to more or less return to their normal lives in the coming weeks, barring a major set back in the control of SARS.

2) Exporters are estimated to have lost about 10-15% of orders due to SARS, but weak global demand is an even bigger threat, in our view. We have observed that some export orders were diverted to Turkey, India, Mexico and some Southeast Asian countries, as travel restrictions and fear of production interruption undermined buyers’ confidence – these factors should show up in Q3 trade statistics. Still, if SARS is contained by the end of Q2, China will not miss the other two major order seasons of the year – July and September. Besides SARS, weak global demand is also unsettling. Export growth is still expected to slip from 33.4% yoy in the first four months of this year to single digits in Q3. Production interruption does not seem to have been a major hindrance so far.

3) FDI will be affected, but China’s fundamentals should stay mostly intact. We have spoken with some managers of major joint ventures in China, all of whom said that the epidemic would not affect their long-term strategies in China. Still, two types of investors may hold back their investment – new comers who are easily affected by the western press coverage of SARS and those with very high exposure in China who need to diversify risk. Further, travel restrictions will delay the bulk of FDI into next year. We see a US$3bn loss in FDI this year and US$4-6bn next year, compared to the US$52bn figure recorded in China in 2002.

4) Fiscal stimulus to kick in H2. The government has set aside RMB8bn for disease prevention and offered tax breaks to badly hit industries, but also refrained from diluting its focus away from the SARS battle by not concentrating on stimulus measures too early. We think the size of the stimulus could reach RMB50bn or more through SARS bonds in H2. RMB50bn would represent 0.5% of GDP (the current fiscal deficit GDP ratio stands at 6%).

By all means, the repercussions from SARS to the Chinese economy are enormous, and we project 5% yoy growth for Q2. 5% growth would be considered high by US standards, but it is almost half the 9.9% growth recorded in Q1. What is clearer to us now is that most of the shock to domestic consumption is likely to be a Q2 phenomenon. We have lowered our 2003 growth forecast from 8% yoy before the SARS outbreak to 6.9%, but think that other (worse) scenarios now look unlikely to happen.

It is probably premature to claim victory over the SARS outbreak in China, but bringing the virus under control (i.e., it no longer appears in headline news) by the end of Q2 looks increasingly more realistic. More importantly, consumer confidence seems to be recovering quickly after the initial shock. There are three connected but to some extent separate curves linked to SARS: the medical curve, the economic curve and the sentiment curve. The medical curve relates to the infection and outbreak and shows some signs of stability, but the risk of a relapse after the summer must not be ruled out. But this issue is beyond my knowledge. The economic curve refers to the impacts on consumption, investment, trade and FDI. We think consumption dips first, but also recovers first. Trade will see a delayed effect in Q3, while the impact on FDI may show up even later. Our reading is that while the adverse repercussions on trade and FDI will occur later, most of the economic damages will be contained in Q2 through consumption. The third curve is the sentiment curve, which relates to consumer confidence and investor confidence. Consumer confidence deteriorated sharply but is now back on track to recovery. A repeat of the consumer panic seen in late April and early May is unlikely even if another outbreak does occur after the summer. Spending will resume as long as SARS does not dominate the headline news on a daily basis, even if there continues to be new cases in rural areas. The same can be said for equity investment sentiment, as buying opportunities remain the main objective, despite new infections. Share prices of most Hong Kong listed Chinese stocks have moved back to their pre-SARS levels.

The SARS outbreak could have the following long-term implications:

1. FDI diversification: In term of competitiveness, China’s virtually dominates the manufacturing products market. Its rapidly growing middle-income class and domestic market is also attractive to foreign capital. SARS will not deter this money away. However, companies such as Motorola, which produces 60% of its mobile phones in China, or Wal-Mart, which outsources more than US$10bn from China annually, may consider diversifying their production. Still, a balance must be drawn between diversification and maintaining a competitive edge. China’s low cost base remains one of it key advantages. We expect FDI flows to return to normal levels within a 2-3 years timeframe.
2. Fiscal imbalance: China underwent expansionary fiscal policy in 1998. Its public debt GDP ratio stands at 33%. According to S&P estimates, the ratio would surge to 70-80% if contingent liabilities from banking NPLs were included. The Wen administration seemed prepared to slow this burgeoning deficit before the SARS outbreak, but fiscal stimulus now looks very likely to play a major role in China’s growth in H2. An additional few years of deficit spending would not represent a serious problem to China, as long as a) local liquidity remains high and b) the economy sustains its robust growth. Nonetheless, a reversal of fiscal policy does deteriorate China’s fiscal outlook in the medium term. The majority of spending is likely to be in infrastructure works rather than public health.
3. Establishment of the new leadership: SARS represents an unprecedented challenge to the new leadership led by President Hu Jintao and Premier Wen Jiabao. We think the public regards the government’s radical and decisive response after April 20 was the key factor that led to the quick containment of the epidemic. This will help to establish the new leadership in Beijing. On the other hand, other countries and the WHO seem to have mixed feelings about China’s response to SARS – which ranged from government denials amid a lack of transparency in the early stages of the outbreak to the draconian efforts and improved transparency to tackle the disease head-on. The mobilisation of neighbourhood cells, widely used to rally the public in the Mao era, but considered defunct as China moved towards a market economy, was critical in the government’s efforts to control movement of the population (estimated at at least 5 million on daily basis) quickly and effectively.

Implications to the rest of Asia: The SARS outbreak has been largely brought under control throughout Asia, though China and Taiwan (and Toronto) are still on the WHO’s travel advisory list. I would like to make the following assessment:

1. Hong Kong, Singapore and Taiwan were the three economies, with the exception of China, to be badly affected by the outbreak. Retail sales saw a catastrophic collapse in the early stages of outbreak, but consumers gradually returned to their normal lives after the initial pandemic fears subsided, a pattern similar to what is now being seen in China.
2. Korea is arguably the least affected country in East and Southeast Asia under our coverage. It could be negatively impaced by a sharp fall in China, which has replaced the US as Korea’s top export market. For both Korea and Taiwan, production interruption in China is a cause of concern, as it is an integral part of the global supply chain for many joint ventures there. Some provincial governments on the mainland have set up contingency plans to quarantine the whole factory if one worker on the floor is infected. So far, production interruption has been very limited.
3. For Southeast Asia outside of Singapore, the main damaging effect from SARS is from lost tourist receipts. Tourist receipts accounted for 7.5% of Malaysia’s GDP and 100% of its current account surplus last year. They represent 6.1% of Thailand’s GDP and 101% of its current account surplus. The sharp slowdown in tourist flows undermines growth momentum.
4. China has become one of Asia’s main export drivers, so any slowdown in its export orders would be likely to cause a decline in intermediate good exports from Asia ex. China. Further, China’s robust domestic demand has been a huge part of Asia’s export story over the last 12 months. In H2 2002, exports from the rest of Asia to China grew at 23% yoy while Asia’s exports to the rest of the world were up 17%.
5. A substitution effect exists between Chinese exports and the rest of Asia. Anecdotal evidence suggests some buying orders are being diversified away from China to the rest of Asia. Still, this hardly compensates for the lost orders from the mainland.
6. There is evidence that some FDI, especially from Japan, which was originally planned for China, is now heading to Southeast Asia. We estimate that the switch would amount to US$3-4bn. Although this is not a large reduction by China’s standard, it does represent a substantial amount to the rest of Asia.