Once prices fall, the public's expectations will be reversed. Because current property prices are still unaffordable for many, home prices will continue to fall. We estimate that in the next two years, the average home price in China will drop 15-20 percent. Meanwhile, the real estate investment growth rate will plummet considerably. CICC real estate analysts believe that the growth of fixed-asset investments in real estate will fall to 5 percent from this year's 20 percent, directly dragging down GDP growth by 1.3 percentage points. GDP growth will be further dampened by the sluggish construction material industry.

As a result, we expect, if the policy does not change, that China's GDP will grow 10 percent in 2008 and 7.3 percent next year, while the inflation rate will stay at 6.5 percent and 2-3 percent, respectively. This might indicate a soft landing for the Chinese economy that will be maintained within a safe range because of our consumption structure and positive fiscal policies.

In terms of monetary policy, we assume that China will enter a cycle of interest rate cuts. We expect the benchmark loan and deposit interest rates in the next 12 months to be slashed 81-135 basis points and 27-81 basis points, respectively, to encourage investment and consumption. We also expect that the reserve requirement ratio (money that lenders must put into the central bank) to be cut 350-550 basis points; and the renminbi to appreciate by a mere 2-3 percent against a basket of currencies.

But we believe that monetary policy will not make a huge difference. For one thing, the money supply will decline due to a weak economy and a lower trade surplus; for another, banks will become picky for fear that their loans will turn bad in a time of economic slowdown.

However, a readjustment in fiscal policy will actively propel economic growth. We expect that a value-added tax reform will take place as of January 1, 2009, capable of cutting the corporate tax burden by 150 billion-200 billion yuan ($22 billion-$29 billion). The total tax burden on individuals is likely to be further reduced by 50 billion-80 billion yuan ($7.3 billion-11.7 billion) because of a possible increase in the income tax threshold. The government might also issue more bonds to boost infrastructure construction and to offset the fiscal deficit.

We do not believe the government will enact policies to drive up property prices. Many banks previously indicated that if home prices fell by no more than 30 percent, the quality of banks' assets would not be seriously affected. To date, home prices have not dropped that much. The property bubble in China is still big, and a price drop will benefit the majority of the people.

External impacts should not be neglected. The U.S. and European economic downturns will be passed on to China and restrain its economic growth.

After years of rampant expansion, investments in the export-oriented manufacturing and real estate industries will start to retrench. We expect China's economic growth to drop for three years or more and possibly rebound after 2010.

Pushing structural reform

The government's policy adjustment will determine whether China can prevent an economic slowdown from evolving into a meltdown.

China should transform its economy from an export-driven to consumption-driven growth model and from one that relies on highly polluting and energy-consuming heavy industries to one that depends on the hi-tech and service industries.

The cyclical fall in commodity prices offers the best timing for China's energy price reform as well as for increasing its energy efficiency. (Currently, the government decides most of the energy prices; hence cost fluctuations cannot be reflected in the final sales price.) In the 1960s-70s, Japan, Germany, and Latin American countries such as Mexico and Argentina boasted the highest economic growth in the world. But four decades later, the first two edged into developed countries, while Latin American countries are still lingering in the domain of developing countries. This is because they adopted completely different development models after being punched by high oil prices in the 1970s. Japan and Germany adopted favorable policies to encourage innovation in energy efficiency projects, and their energy efficiency levels have doubled in the past 30 years. But developing countries tried to stimulate economic growth by offering subsidies and price caps on energy. At present, the energy problem has increasingly become a bottleneck restricting developing countries' development. China should avoid the Latin American pattern and embark upon a project to refurbish its national energy policies to develop its economy in a more effective way.

Moreover, China should perfect its social security system in a bid to boost domestic consumption. High household deposit rates and low consumer consumption are partly caused by the lack of a sufficient social security system. China's expenditures for social security are far less than the average spent by developed countries. Therefore, its citizens tend to save as much money as possible for their retirement and possible illnesses, thus leading to inefficient consumption. The government should invest heavily in social security, public health and education to reassure its people that it is safe to spend money now.

Apart from the above-mentioned suggestions, the government should continue its land reform program to improve farmers' income, speed up urbanization and enhance intellectual property rights protection to promote innovation.