EFSF - Downgraded to AA+

EFSF Downgraded To AA+, Or French Fitch Flunks EFSF Following France Flub 07-15-13 Zero Hedge

Prompted by their FrAAAnce downgrade to AA+, French-owned Fitch has downgraded Europe's last best promise/hope - the EFSF - from AAA to AA+... but the crisis is still behind us - we are assure by such truth-sayers as Juncker, Barroso, and Merkel (pre-elections).

Fitch Ratings-London-15 July 2013: Fitch Ratings has downgraded the European Financial Stability Facility's (EFSF) guaranteed and long-term debt Long-term rating to 'AA+' from 'AAA'. The EFSF's short-term (less than 12 months contractual maturity) guaranteed debt instruments' Short-term rating has been affirmed at 'F1+'.

KEY RATING DRIVERS

High Weight

The rating actions were prompted by Fitch's downgrade of France's Long-term Issuer Default Ratings (IDRs) to 'AA+'/Stable and the affirmation of its Short-term rating at 'F1+' on 12 July 2013. EFSF's ratings rely on the irrevocable and unconditional guarantees and over-guarantees provided by euro areas member states (EAMS). These commitments are governed by an international agreement dated in June 2012 by the 17 EAMS - the EFSF Framework Agreement (FA) - and by a Deed of Guarantee. The downgrade of France's IDR had a high weight in Fitch's rating actions.

The original version of the FA ensured that all payments due on EFSF debt are covered by guarantees provided by EAMS, pro-rata based on their contribution key in the European Central Bank, which could be extended to 120% of their initial amount. Subsequent amendments to the FA and Deed of Guarantee, applicable to all debt issued since October 2011, reduced the credit enhancement through cash buffers and extended the percentage of over-guarantee percentage to 165%.

Following the downgrade of France's IDR, the EFSF's long-term debt issues are not fully covered by 'AAA' guarantees and over-guarantees and, for debt issued before October 2011, by the cash reserve. However, short-term debt issues remain entirely covered by guarantees and over-guarantees issued by EAMS rated 'F1+'.

RATING SENSITIVITIES

As of 12 July 2013, 100% of the long-term debt issued by the EFSF is covered by guarantees and over-guarantees rated 'AA+' and 'AAA'. In the event that one or more of the 'AAA' and 'AA+' guarantors, namely Germany (AAA/Stable), France (AA+/Stable), Netherlands (AAA/Negative), Austria (AAA/Stable), Finland (AAA/Stable), and Luxembourg (AAA/Stable), are downgraded below 'AA+', and if the coverage by 'AA+' guarantees falls below 100%, Fitch would also review the Long-Term rating assigned to EFSF debt issues.

KEY ASSUMPTIONS

Fitch assumes there will be progress in deepening fiscal and financial integration at the eurozone level in line with commitments by euro area policy makers. Fitch also assumes that the risk of fragmentation of the eurozone remains low.

FRANCE - Loses its Coveted and NEEDED AAA Rating

French-Owned Fitch Downgrades FrAAAnce To AA+ 07-12-13 Zero Hedge

On the even of Bastille Weekend and the 100th anniversary of the Tour de France, you know it must be bad when the French-company-owned ratings agency Fitch is forced to remove its AAA rating from France. Key drivers include Debt-to-GDP projections rising and substantially weaker economic output and forecasts.

Fitch Ratings-London-12 July 2013: Fitch Ratings has downgraded France's Long-term foreign and local currency Issuer Default Ratings (IDR) to 'AA+' from 'AAA'. The Outlook is Stable. At the same time, the agency has affirmed France's Short-term foreign currency IDR at 'F1+' and the Country Ceiling at 'AAA'.
 
KEY RATING DRIVERS
 
The downgrade of France's foreign and local currency IDRs reflects the following key rating drivers and their relative weights:
 
High
 
- Fitch now forecasts general government gross debt (GGGD) to peak higher at 96% of GDP in 2014 and decline only gradually over the long term, remaining at 92% in 2017. This compares with Fitch's previous projections in December 2012 of GGGD peaking at 94% (and 92% when it first revised the Outlook to Negative in ecember 2011), and declining more rapidly to below 90% by 2017.
 
- The agency commented at the time of its previous rating review that this was the limit of the level of indebtedness consistent with France retaining its 'AAA' status assuming debt was firmly placed on a downward path from 2014. Its projections for France's GGGD ratio are significantly higher than the 'AAA' median of 49% and 'AA' median of 27%. The only 'AAA' country with a higher debt ratio is the US (AAA/Negative), which has exceptional financing flexibility and debt tolerance afforded by the preeminent global reserve currency status of the US dollar.
 
- Risks to the agency's fiscal projections lie mainly to the downside, owing to the uncertain growth outlook and the ongoing eurozone crisis, even assuming no wavering in commitment to fiscal consolidation. A debt ratio that is higher for longer reduces the fiscal space to absorb further adverse shocks.
 
Medium
 
- Economic output and forecasts are substantially weaker than when Fitch revised the Outlook to Negative. The unemployment rate has also jumped to a 15 year high of 10.9% in May 2013. The weaker economic outlook is the primary factor behind increases in the budget deficit and France remaining in the EU's Excessive Deficit Procedure for a year longer. Fitch expects the French economy to recover less quickly then official projections, owing to headwinds from subdued external
demand, weaker competitiveness, high unemployment and fiscal consolidation. Its latest forecasts are for GDP to contract in 2013 before growing by 0.7% in 2014.
 
- As well documented by organisations such as the OECD, IMF and European Commission, the French economy faces a number of structural challenges, including gradually declining competitiveness, weak profitability and rigidities in the labour, goods and services markets, which weigh on the medium term outlook. Fitch's projection for long term potential growth is broadly unchanged at around 1.5%.
 
- France's current account was in a deficit of 2.3% of GDP in 2012. Although that is not especially high, it has deteriorated steadily from surpluses a decade ago, reflecting a steady loss of competitiveness and export market share. This evolution has been mirrored by the rise in net external debt which has risen to 25% of GDP, compared with the 'AAA' median of 20%.
 
Despite the loss of its 'AAA' status, France's extremely strong credit profile is reflected in its 'AA+' rating with a Stable Outlook, which reflects the following main factors.
 
- France's wealthy and diversified economy and political stability entrenched by strong and effective civil and social institutions. 

- Fitch judges financing risk to be very low reflecting an average debt maturity of seven years, low borrowing costs and strong financing flexibility underpinned by its status as a large benchmark eurozone sovereign issuer.
 
- France has a track record of relative macro-financial stability including low and stable inflation. It also benefits from moderate levels of household indebtedness and a high household saving rate.
 
- Since coming into office last year the Socialist government has set out and started to implement a wide-ranging programme of structural reforms, including the "National Compact for Growth, Competitiveness and Jobs" and recent labour market reforms. This may help improve the long term growth and current account position. However, the quantitative impact of the new measures is uncertain and reforms are subject to implementation risk.
 
- The recent structural reform of the budget procedure through the organic law that transposes the EU Fiscal Compact into national law will strengthen the confidence in the outlook for French fiscal policy. As part of the reforms an independent body, the High Council of Public Finances was created with the role to give an opinion on the growth forecasts underpinning budget forecasts. It will also monitor the government's compliance with the multi-annual planning law and will be charged with identifying and making public any major budget slippage.
 
- Risks in the French banking system have eased as asset quality, funding and capitalisation have improved, though exposures to Italy remain significant.
 
- The intensity of the eurozone crisis has eased over the past 12 months reflecting progress with country fiscal and reform plans and policy enhancements at the EU level, including the ECB's OMT and gradual steps towards banking union. Nevertheless, in Fitch's view the eurozone crisis is not over and contingent liabilities arising from the crisis remain material. France has already incurred commitments totalling EUR48.1bn (2.4% of GDP) as the second largest guarantor of the EFSF. France's paid-in capital contribution to the European Stability Mechanism (ESM) is EUR16.2bn with a further EUR126.4bn in callable capital.

SPAIN - Clear Signs of Desperation from a Growing Collateral Contagion

Spanish Banks Petition To Convert Historical Losses Into Bank Capital 07-12-13 Zero Hedge

In what has to be the most insane level of desperation, the Spanish banking system is lobbying to turn its deferred tax 'assets' into fungible capital to meet new stricter Basel III requirements. In other words, the Spanish banks believe that capitalizing historical losses provides a fungible 'stash' of capital against future losses... Following this morning's round of incredulity from the Spaniards, we have no words...

Via Reuters,

Spanish banks are lobbying the government to turn more than two thirds of their 50 billion euros ($65 billion) in deferred tax assets into state-backed tax credits that would boost their capital but add to the state's debt, three banking sources said.

The so-called deferred tax assets (DTAs) are created when a bank makes losses or writedowns that it can offset against future tax bills when it returns to profit.

Under stricter Basel III rules on capital, being phased in as of January 2014, most forms of DTAs will no longer be allowed to count towards capital, while tax credits will be.

Spanish banks are asking the government to convert between 15 billion and 30 billion euros of their DTAs into tax credits, the banking sources said.

SPREADS - Widen in Peripherals and Significantly in Portugal and Greece

European Peripheral Bonds Plunge Most In A Year As Portugal Risk Flares 07-12-13 Zero Hedge

Following a handsome bounce driven by Draghi, Carney, and various Fed officials promising moar, peripheral European bonds and stocks are having a bad day (and week). Greece, Portugal, Spain, and Italy are all ending the week lower (after solid performance mid-week) with Germany's DAX seeing the benefits of a rotation from high-beta momo with a 5.1% rise on the week (the best week in 20 months!).

Safe-haven flows dominated in bonds; Bunds rallied slightly more than Treasuries on the week but once again Peripheral nations collapsed. Spanish bond spreads jumped the most in a year. Italy was notably weak, but Portugal has seen spreads jump 28% in the last 2 weeks (the worst in over 3 years!).

EURUSD had its best week in 5 weeks - and despite the peripheral collapse, Europe's VIX had its best (drop) week in 4 months ending at 19%.

A huge divergence in Europe this week... (seems evident that Spain, Portugal, and Italy are being traded as one entity...)

but bonds were the big news... (in percentage terms, Portugal's move was the owrst in 37 months)

Meanwhile, in Greece, the stock-market has dropped 7 of the 8 weeks and is dramatically underperforming the supposed reality that the bond market represents... Charts: Bloomberg

PORTUGAL - Presidential Warning Spikes Yields To 8 Months Highs

Portugal's Presidential Warning Spikes Yields To 8 Months Highs 07-12-13 Zero Hedge

UPDATE: 5Y now +126bps (biggest jump in 19 months - snce the record highs) and rest of Europe is catching their systemic risk flu

Bond Spreads...

Stocks red in the periphery now...

Amid all the fun and games of the last few days that have seen everyone buy everything everywhere, we noted that the President of Portugal has 'warned' his politicians that if they don't find a coalition solution in a "very short period" then he will call early elections (throwing the Troika-imposed austerity program into shambles). It seems the 'time-bomb' was on a long fuse - thanks to Bernanke - and the reaction is very evident today as Portuguese bonds implode. Spreads are 76bps wider on the day, breaking above 600bps for the first time in 8 months. The 5Y yield on Portuguese debt is now at 7.5% (up 109bps today!) - and yet still they discuss the expectation of coming to market soon for new issuance. Europe remains very un-fixed and every now and again, when the domestic buyers are overwhelmed by some real liquidity, we get a glimpse.

SPAIN - The Government's 'Bad Bank' Scam

Spanish "Bad Bank" Fairy Tales 07-12-13 Zero Hedge

Submitted by Mark J. Grant, author of Out of the Box,

The Lords of Chaos are
 
The enemies of Logic,
 
The jugglers of Truth
 
                -Michael Moorcock
 
Whether it be the plains of Asgard, the fields of Mordor, the yellow brick road in Oz; I can recognize and appreciate fantasy. I take delight in meandering off in my mind when emerging myself in one of these pieces of fiction. This morning I can share with you that a new and quite imaginative fairy tale has been told and it has been spun by the government of Spain.
 
Spain, as you know, and no matter how the story is fabricated, was bailed out by the European Union. The money was lent to the banks so that Spain does not have to count it as sovereign debt even though the country guaranteed the loans. A nod to magicians and the clever use of a sleight of hand trick but the truth is readily apparent. Then, having mastered that trick they are on to new and grander schemes.
 
Madrid tells the truth in the same manner as a sardine naturally climbs mountains.
 
Spain has set up a "bad bank" known as Sareb (Sociedad de Gestión de Activos procedentes de la Reestructuración Bancaria). This operation has $66 billion of Real Estate loans and property as their assets we are told. So far they have sold 700 properties and they claim they can achieve an annual return on equity of 13%-14% over its fifteen year tenure.
 
You see, I was not joking; Spain is out with a wonderful new fantasy competing with the Hobbits, "he who cannot be named" and the land of the Munchkins. Who knew, besides the Portuguese, that the Spaniards could be so inventive? Madrid has outdone itself and Don Quixote has returned to the capital.
 
Sareb has roughly 107,000 properties and 90,000 loans they tell us. The loans are collateralized by about 400,000 pieces of Real Estate. This all sounds fine as presented but then Sareb started looking at what they actually owned. "Oh no Pancho," 150 loans were all collateralized by the same apartment building. "Oh no Rodrigo," six banks had all lent money to one downtown building and each bank had the same collateral. "Oh no Manuel," we are holding a deed as collateral on a building that does not exist. The problem is that each example that I have presented is not an isolated instance. Such a good tale; invisible buildings, documents relating to non-existent people, collateral shared by everyone and held at face value at Sareb.
 
What to do, what to do? So Spain turns once again to Clifford Chance. This is the same firm that assured us of the health of the Spanish banks. Another fairy tale please. One more story told around the campfire to engage the investors. One more piece of Pulp Fiction.
 
If there was a Pulitzer Prize for fiction Spain would be the sure winner.
 
"Take care, your worship, those things over there are not giants but windmills."
 
    -Miguel de Cervantes Saavedra

CHINA - Stampeding into Gold

The Asian Giant Stampeding into Gold 07-10-13 Frank Holmes CEO and Chief Investment Officer U.S. Global Investors

I recently discussed how traders were stampeding out of gold as a result of rising interest rates and the threat of evaporating monetary fluid that was lubricating markets. Hovering around $1,200 at the beginning of July, the gold price has completely disconnected from the precious metal's fundamentals, in my opinion. Prices have fallen too far out of fear, but the drivers for gold are still in place.

My friend and highly respected analyst, Gregory Weldon, highlighted an important point about rising rates in the U.S. As interest rates rise, debt will be rolled over at a higher rate, making the burden even greater than it already is. This suggests a likely tipping point for Treasuries. Will the Federal Reserve suppress yields at that "line in the sand?"

In this environment, gold should remain attractive. However, as the West flees the precious metal, another set of gold buyers has come forward with the aim to preserve wealth. Take a look at the chart below which shows total gold production compared to the gold deliveries on the COMEX and the Shanghai Gold Exchange. In May, gold imports into the Asian giant rose to the second-highest level ever. While mining production is around 1,134 tons so far this year, gold delivery on the Shanghai Gold Exchange is 918 tons. This is strikingly in contrast to the gold delivery on the COMEX, which stands at only 103 tons year-to-date as of the end of May.

China may be devouring even more of the supply in the future if the price of gold remains subdued. I've been talking with several gold company executives, who tell me they are seeing squeezed margins because of lower grade finds, as well as governments raising taxes or increasing royalty rates.

The top priority for these miners today is cost control, focusing their efforts on viable projects that have all-in costs of less than $1,000 per ounce of gold. If spending is too expensive, exploration is cut and production is halted.

This is an extremely conservative amount, as some gold mining projects in certain countries come in significantly higher. The CEO of Gold Fields recently indicated that the average all-in cost in Africa is $1,500!

This is a similar phenomenon to the supply of natural gas recently. When there were huge discoveries in the commodity, companies immediately halted drilling. There's a notable difference in drilling gas versus mining gold, though: The natural gas cycle is shorter and measured in months, so there can be a relatively quick recovery in supply. When gold companies cut production, the restart cycle can take decades.

To me, these supply and demand drivers point to a sustained higher gold price.

A PARAMILITARY POLICE - Tools of Statism (i.e. German 'Brownshirts' & Gestapo)

The Psychotic Militarization of Law Enforcement 07-15-13 BATR.org

JAPAN - Structural Problems a "Canary" for Western Developed Economies

JAPAN - Shinzo Abe Hasn't the Stomach for the Heavy Lifting Needed to Accomopany ABE-nomics.

Here Comes The Hardest Challenge Yet For Abenomics 07-15-13 BI

Prime Minister Shinzo Abe is likely to win a mandate on Sunday for his three-part recipe to end stagnation in the world's third-biggest economy, but anyone expecting him to use it to push a "Big Bang" reform agenda may need a reality check.

Abe's Liberal Democratic Party-led bloc is expected to win a hefty majority in a July 21 upper house election, ending a "twisted parliament" in which the opposition controls the upper chamber. Media surveys published on Monday showed the LDP maintained a substantial lead over rival parties. That stalemate has hampered policies for most of the past six years since Abe, then in his first term as premier, led the LDP to a humiliating 2007 upper house defeat. He resigned two months later and was followed by a string of short-term leaders. Abe, who returned to office in December for a rare second chance, will have few excuses for shying away from reforms including deregulation that many see as vital to generating growth - but his commitment to doing so remains in doubt.

"What's required is the kind of thorough-going reform that Mr. Abe doesn't seem to have the vision or stomach for," said Jun Okumura, a senior advisor for Eurasia Group and former bureaucrat at Japan's trade and industry ministry.

"Just because he wins an election doesn't mean vested interests will be any more amenable to changes that would affect them negatively," he said. "A leader can do a lot with the ability to appoint and dismiss cabinet members and ultimately, the right to call a general election. "But I don't see Mr. Abe as that kind of leader."

Hopes for his "Abenomics" prescription of hyper-easy monetary policy, big spending and steps to promote growth pushed up Tokyo share prices and weakened the yen even before his LDP-led bloc won a December poll for the powerful lower house.

"ENRICH THE COUNTRY, STRENGTHEN THE ARMY"

Business executives and economists welcomed his decision in March to join talks on the U.S.-led Trans-Pacific Partnership (TPP) free trade pact despite fierce opposition from the farm lobby, a traditional backer of the LDP.

Advocates say joining the pact would open Japan's economy to competition and boost momentum for deregulation to spur growth.

"TPP is not about agriculture reform, it's about whether Japan sits at the table when global rules are made and doing whatever it takes to be a first-rate power," said Jesper Koll, head of equities research at JP Morgan in Tokyo. "That's what fires them up."

Abe has also backed reform of the energy sector that would break up regional utility monopolies, also powerful LDP supporters - although a political scuffle just before parliament ended in June prevented the reform bill from passing.

Optimists argue the desire of Abe and like-minded nationalists for a strong economy to ensure Japan's place on the global stage will keep up pressure for reform - a sort of 21st century version of the "Enrich the Country, Strengthen the Army" slogan of the late 19th century reformers who modernized Japan.

"I think he sees a genuine challenge to the sovereignty and power of the country," said Robert Feldman, chief economist at Morgan Stanley MUFG in Tokyo. But reaction to Abe's "Third Arrow" of structural reforms unveiled in June has been tepid, prompting the premier and his aides to promise that more is in store after the upper house election.

Among the areas where critics want bolder steps are

1. Agrarian land reform,
2. Labor market measures to make it easier for firms to exit loss-making business and shift to growth sectors,
3. Cuts in the corporate tax rate and
4. An easing of barriers to immigration to cope with Japan's ageing, shrinking population.

ACHILLES' HEEL ON HISTORY?

Reform advocates also worry about potential backsliding on promised steps such as energy market reform. "The LDP might change some part of the (utilities reform bill) so it doesn't have so much impact on incumbent utilities," said Hiroshi Takahashi at Fujitsu Research Institute, who sat on an advisory panel that recommended the reforms incorporated in the bill.

A split among Abe's growth strategists between those who see a big role for government in picking and backing new growth sectors, and those who want government to get out of the way to allow innovation, also clouds the outlook for reform.

Ironically perhaps, too big a victory on Sunday could make it harder for Abe to push through the sort of reforms that would harm traditional LDP supporters. Such a win would increase party complacency along with the number of MPs with ties to vested interests.

Some media forecasts give the LDP a shot at winning an upper house majority on its own for the first time since 1989. With no national poll required until 2016, LDP members keeping quiet now ahead of the election are likely to become more vocal afterwards. "Are we dealing with Japanese politics" the answer is 'yes'. Will there be compromise? You bet. The risk of compromise moving to the forefront gets bigger the bigger they win," said Koll, who nonetheless argues Abe is intent on meaningful reforms.

Abe will also face a tough decision in autumn on whether to give the go-ahead for a plan to raise the 5 percent sales tax to 8 percent next year, the first stage in a scheduled doubling by October 2015 to help curb Japan's huge public debt.

Some LDP members fear a tax hike would derail a recovery, but postponing it could cause havoc in financial markets, where the move would be taken as a signal of reneging on fiscal reform.

The International Monetary Fund (IMF), while giving a cautious OK to "Abenomics", has warned of downside risks if Japan doesn't both

1. Cut its debt - already twice the size of its $5 trillion economy - and
2. Enact structural reforms.

Concerns have eased a bit that the deeply conservative Abe might shift attention after the election from the economy to pet projects such as revising the pacifist constitution, drafted by U.S. Occupation officials after Japan's defeat in World War Two. The LDP's junior partner, the New Komeito, is wary of such changes and media forecasts suggest the LDP and small parties that also favor constitutional revision will fall short of the two-thirds majority needed to submit changes to a plebiscite. But Abe may find his Achilles' heel in questions relating to Japan's wartime history, which he wants to recast with a less apologetic tone. Abe visited Tokyo's Yasukuni Shrine, where wartime leaders convicted as war criminals by an Allied tribunal are honored with war dead, after becoming LDP leader in September. He has declined to say if he will do so as premier, but could face pressure from supporters to go on the August 15 anniversary of Japan's defeat or at an annual autumn festival. A pilgrimage to Yasukuni would outrage China and South Korea, which suffered from Tokyo's wartime aggression.

Tokyo's relations with Beijing are already strained by rows over rival claims to tiny, uninhabited isles. Abe may also have trouble refraining from comments on history that spark ire in Beijing and Seoul, in turn upsetting security ally Washington and potentially undermining his support at home.

"It is going to be very tempting for Abe to speak his mind that seems like an endorsement of what he stands for as a politician," said Sophia University professor Koichi Nakano.

CHINA - "Will introduce some measures to arrest the slowdown of growth in the next couple of quarters"

Chinese Q2 GDP Rises 7.5% But Industrial Production Misses 07-14-13 BI

Chinese Q2 GDP climbed 7.5% in line with expectations. This is down from 7.7% growth in the first quarter. Economists had been cutting their GDP forecasts leading up to the data release.

Chinese GDP grew 1.7% quarter-over-quarter, slightly below expectations for a 1.8% rise. China's GDP is up 7.6% in the first half of the year. The official government target is for 7.5% growth in 2013.

The cash crunch in June is also expected to have impacted economic growth. We also had other economic data out tonight.

Chinese industrial production was up 8.9%, below expectations for a 9.1% rise. Industrial production was up 9.3% in the first half of the year. The 10.8% rise in crude oil output, following the rise in crude oil imports suggests some improvement in investment activity.

All important year-to-date fixed asset investment (FAI) climbed 20.1%, missing expectations for a 20.2% rise. A breakdown showed that railway FAI slowed to 15.7%, from 24.2% in May, manufacturing FAI slowed to 15.2%, from 16.5%, and property FAI was up 19.4%.

Retail sales were up 13.3%, above expectations for a 12.9% rise. In real terms however, retail sales were up 11.7% in June, down from 12.1% the previous month. Retail sales were up 12.7% in the first half of the year.

Chinese electricity consumption was up 6.3% YoY in June to 438.4 billion kilowatt hours, and up 5.1% in the first half of the year.

National Bureau of Statistics spokesman, Sheng Laiyun, said that China is creating jobs despite the slowdown in the economy, according to Bloomberg.

"We’d like to reiterate our call of “Li Keqiang Put”, which means that in the first couple of years of Premier Li’s term, he may try to prevent a growth hard-landing and a financial crisis," wrote Bank of America's Ting Lu following the release.

"That’s why we expect Li’s cabinet will introduce some measures to arrest the slowdown (in yoy term) of growth in the next couple of quarters."

Markets will be watching to see if policymakers move to support their 7.5% growth target.

CHINA - Slower Growth In the Cards & Endorsed by New Leadership

NOMURA: Chinese Growth Will Fall Below 7% Next Year 07-15-13 Nomura via BI

Following last night's China's GDP figures (which indicated slowing, but which came in line at 7.5% for Q2) Nomura is slashing its 2014 growth forecast to below 7%, which is kind of major threshold.

Economist Zhiwei Zhang gives three reasons for reducing the firm's 2014 GDP forecast to 6.9%.

First, we believe the government may lower its annual growth target to 7% for 2014. While this decision will not be made until the Central Economic Working Conference in December, the government has made it clear to the public that it is less concerned about the growth rate and more about the quality and sustainability of growth. We believe lowering the growth target would be a sound policy to adopt.

Secondly, we believe China has likely entered a prolonged period of deleveraging, which will last well into 2014. Clear signs of systemic financial stress have seen the new government acting to rein-in credit growth since it took office in mid-March and we believe it is determined to bring down leverage. That said, a sharp deleveraging process is to be avoided as that would cause a disruptive slowdown in the economy; the liquidity squeeze in June illustrating just how easily a tightening could lead to unintended consequences. We therefore believe a gradual and prolonged deleveraging is the most likely scenario (see China may enter a prolonged period of policy tightening, 24 June 2021).

Thirdly, potential growth continues to slow and may drop below 7% in 2014. The size of the working-age population fell in 2012 – for the first time in at least 20 years – and will likely continue to slide in 2014 and beyond. Progress on structural reforms has been slow. The government has announced guidelines twice in the past five years to encourage private investment, but concrete action has been limited. When the Central Committee of the Communist Party meets in October, it is expected to lay out the reform agenda for the next five to 10 years. We expect some positives to help growth recover modestly in H2 2014, but do not expect reforms to fully offset the negative effects of deleveraging and the demographic trends through H1 2014.