CHINA'S economy probably bottomed in the third quarter last year. Although headline gross domestic product growth registered only 7.4 percent year on year, 19 out of 27 provinces reported GDP growth in excess of 10 percent in the third quarter last year. Some areas such as Tianjin, Chongqing and Guizhou registered GDP growth of almost 14 percent year on year. Provinces in the central and western parts of China were relatively unscathed by the trade demise. Meanwhile, export-oriented provinces such as Guangdong and Zhejiang dragged down the overall level of GDP growth.

The current recovery is also assisted by re-stocking. The end of a de-stocking cycle is naturally followed by the need to replenish stock. The recent mild rebound in iron ore, copper and crude oil imports partially reflected this emerging trend. It also mirrored the inter-temporal increase in infrastructure spending as a result of China's highly directed fiscal spending. That in turn translated into improving readings of Purchasing Managers Index.

On the consumption front, retail sales have remained steady. They have improved in nominal terms since July, and in real terms as early as May. After all, consumption in the short term is dictated by sentiment and the level of consumer confidence, which should fare slightly better for the rest of the year.

The current recovery momentum should justify real GDP to advance 8 percent in the fourth quarter last year to conclude annual GDP growth at 7.8 percent.

Keeping status quo

The new Chinese leadership has not introduced any major stimulating policies hitherto - not even the single 50 basis-point cut in the reserve requirement ratio widely expected by the market. Keeping the status quo is a wise strategy.

If China could resist credit loosening during the slowdown from the fourth quarter of 2011 to the third quarter of 2012, it does not make sense to stimulate the economy by monetary loosening when signs of improvement are already apparent.

Fixed asset investment growth has revived somewhat recently. FAI is set to conclude the year at around 21 percent. In fact, the new construction component of FAI has already charged up in a straight line from 20.9 percent (year-to-date) in March to 25.3 percent in October - back to growth rates seen just before the global financial crisis.

Given the likelihood of gigantic fiscal stimulus is low, headline FAI growth will at most grow 25.0 percent in 2013 (compared with 30.5 percent in 2009). This has already taken into the account of the fact that investment bias is usually strong after leadership transition is completed.

If China is not going to make massive investments in infrastructure everywhere this time around, there must be a new and comprehensive strategy to spearhead investment growth. This strategy will be urbanization. China's urbanization rate has exceeded 51.3 percent as of the end of 2011, meaning more than half of China's population is now living in urban areas. The aim is to bring the ratio up to 60 percent by 2020.

A recent study by the Asian Development Bank and the National Development and Reform Commission estimates that cities in China will grow by about 15 million people each year and by a total of about 230 million over the next 15 years. That's equivalent to adding nearly the entire current population of Indonesia.

Big theme

Since urbanization will be a big theme in 2013, growth impetus should be strong once momentum picks up.

To be specific, we should look for the following type of policies to promote urbanization in 2013:

1. Policies affecting rural-to-urban migration;

2. Policies affecting the size distribution of cities and the relative concentration of people in major metropolitan centers;

3. Policies affecting the development of urban infrastructure; and

4. Policies that impinge on the availability of and access to public services and social safety nets.

That means new FAI will have to be made in accordance with urban planning.

This is a lot more micro-centric and yet diversified in nature (urban renewal planning touches subject matters ranging from electricity, water sewage, transportation, housing and even hygiene-related investment).

The next phase of China's urbanization will focus on small and medium-sized cities instead of metropolitan areas. The aim is to urbanize rural areas, generate demand for road construction, telecommunications services and other essential infrastructures. In order words, urbanization will be able to create demand from a "needs" perspective for people moving into urban areas.

If urbanization begins to boost domestic demand in the second half of 2013, demand-pull inflationary pressure should follow through gradually. The pattern will likely be an uneven distribution because the pace of urbanization will vary from city to city. Our view entails upward bias on inflation measured by the Consumer Price Index (CPI) over the medium term. For the time being, inflation is not a prevalent threat as CPI has been consistently advancing below 2 percent in recent months. Factors such as cold weather and stronger food demand during the Chinese Lunar New Year holiday may spike up the reading of CPI in the first quarter of 2013 back above the 2 percent threshold. Still, such seasonal factors are largely transient in nature.

Asset inflation

The risk of asset inflation, however, is very much alive. Tier I/II/III cities showed property price increases of 9 percent/19 percent/-7 percent, respectively. Year-to-date daily average sales volume is 25 percent higher than the fiscal year 2011's average. Average selling prices of 17 major cities have continued to register 1.5 percent month-on-month and 0.5 percent year-on-year price increases. According to Soufun, an authoritative real estate website, the average selling price of 100 key cities registered month-on-month increases for six straight months in spite of austerity measures.

That's why stringent administrative controls on the property market nationwide have remained largely intact. Should China lift those administrative restraints, the impact on prices could be explosive given the magnitude of pent-up demand accumulated over almost 24 months. Yet, real GDP of 19 provinces were able to grow more than 10 percent even without the property fever.

That explains why the market is unlikely to see more reserve requirement ratio or interest rate cuts.

The interest rate outlook is neutral for the first three quarters of 2013 with a high likelihood of a 25 basis-point hike in the fourth quarter of 2013.

Recently, authorities in China have allowed the Chinese currency to be more responsive to market forces. In line with empirical evidence, capital inflows into China usually intensify during the US Federal Reserve's quantitative easing programs. This time is no exception. Appreciation of the currency sped up in spite of a subdued export outlook. Another line of thought could be the fact that the Chinese yuan has merely been responding to a larger trade surplus which amounted to US$180 billion by the end of October, already larger than the annual trade surplus of US$155 billion in 2011.

As a result, the current account surplus as a share of GDP in 2012 is expected to rebound to 3.8 percent from 2.7 percent in 2011.

Assuming export/import growth will both advance 15 percent in 2013 from 7 percent/4 percent in 2012, the trade surplus will likely reach US$262 billion this year. The current account surplus as a share of GDP will remain around 3.8 percent. As the yuan appreciation has been well correlated with the current account surplus as a share of GDP, it makes sense to project that the yuan will appreciate by at least 2 percent in 2013.