We have seen early signs of reflation in China, led by a stronger investment growth impulse. In our view, the potential recovery in investment demand mainly results from the cumulative impact of monetary and fiscal easing since 4Q14, which includes 165bp of lending rate cuts, 300bp of RRR cuts, sizable LGFV loan swaps, accelerated local government financial activities, and a visible step-up in fiscal spending. Consequently, total financing growth1, a reliable leading indicator for aggregate demand, has picked up since June 2015 . More specifically, we are likely to witness a moderate acceleration in infrastructure investment, inventory restocking, and more importantly, property investment2. While the current momentum in infrastructure and inventory investment could wind down somewhat over the next two quarters, the property investment cycle tends to have more legs to run.

We revise up our 2016 real GDP growth and inflation forecast to 6.9% YoY and 1.9% YoY, from 6.8% YoY and 1.3% YoY. Meanwhile, we raise our 2016 nominal GDP growth forecast to 7.5% YoY from 7% YoY. From the GDP by expenditure perspective, stronger YoY growth of fixed asset formation and government spending is likely to be offset by a narrowed trade surplus. On the industry level, stabilization of the manufacturing and construction sector growth may pick up the slack from slower growth of the financial sector value-added. The investment demand–driven reflation may lead to faster recovery of CPI, PPI, and GDP deflator than previously expected. The emergence of inflationary impulse may be more pronounced for supply-constrained products, such as fresh food and quality property in leading cities.

A potential mild reflation indicates less need for further monetary loosening and reduced depreciation pressure for the RMB. We adjust our benchmark interest rate forecast to no cuts in 2016 (from one 25bp cut), and revise up our year-end USD/CNY forecast to 6.76 from 6.87. Less-than-expected narrowing of interest rate differential vs. the USD may provide support for the value of the renminbi. More importantly, growth stabilization may also reduce the depreciation expectation of the currency.

We also reduce our RRR cut forecast to 250bp throughout 2016 (600bp previously). Apart from the potential mild reflation, the notable change in our RRR cut expectation has also factored in a potential shift in monetary policy conduct. In recent research , we have highlighted the policy shift towards boosting money supply growth via more issuance of the base money. If this trend were to continue, the room for further RRR cut may be reduced. Assuming base money grows by 9% in 2016 (base money has already grown 5% YTD) and considering the M2 growth target of 13% YoY, we now see room for only 250bp of RRR cuts for the year, i.e. four more 50bp cuts to go. Mild reflation, coupled with a stable interest rate, may drive further decline of the real interest rate in 2016 and propel a moderate cyclical recovery.

The potential moderate domestic demand reflation in China also has profound implications for the global growth and inflation outlook, as well as corporate profitability domestically and abroad.

1. China’s potential domestic demand stabilization and import growth recovery may boost the incremental demand of China’s global suppliers, especially those that cater towards China’s investment demand. Meanwhile, a moderate reflation in China may help reduce the deflationary pressure worldwide.

2. Secondary industry profitability in China may benefit the most from the investment-led reflation, among which raw material and intermediate goods producers may show the most visible improvement in profit growth and margin.

The sustainability of the moderate reflation hinges on the implementation of efficiency-enhancing reforms in China and the stability of the external demand environment.  Although potential cyclical stabilization is welcome news, as it may create a benign macro environment conducive to the much-needed economic reforms, the sustainability of the cyclical recovery hinges on investment efficiency and private sector confidence. In this regard, structural reforms to tackle China’s supply-side constraints and enhance the efficiency of resource allocation, such as SOE and hukou reforms, may go a long way in extending the investment cycle without generating excessive inflationary pressure. On the other hand, private sector investment sentiment is likely to be vulnerable to external demand volatilities during the early stage of a cyclical stabilization.