WE revise down our forecast for China's official 2013 real GDP growth rate to 7.5 percent (from 7.7 percent), and to 7.2 percent in 2014 (from 7.5 percent). We expect GDP growth of 7.5 percent year-on-year in the third quarter and 7.3 percent in the fourth quarter. We therefore believe the economy has not yet reached its lowest gear as far as headline numbers are concerned. This is a cyclically weak patch in the midst of a long-expected structural slowdown.

There is, of course, considerable skepticism about China's official GDP numbers at high and low points in the business cycle. Though one can make brave attempts at estimating what the actual growth rate is, we analysts all sit outside of the official statistical system, and have no serious way of competing with the National Bureau of Statistics to generate a more accurate estimate. We would say, however, that it will likely feel more like a 6 percent growth in GDP.

Second-quarter GDP growth was weak, but bearable. The official headline GDP growth rate slowed to 7.5 percent from 7.7 percent in the first quarter. This was bang on market consensus and, after speculation about a weaker print over the weekend, was greeted with some relief by the equities market.

On a quarter-on-quarter seasonally adjusted basis, the pace of sequential growth was little changed at 1.7 percent. In other words, there appears to have been no significant deterioration or improvement in growth momentum in the second quarter.

Lackluster demand

The GDP deflator slowed to 0.5 percent year-on-year in the second quarter from 1.7 percent in the first. The continued moderation in prices suggests that overall demand remains lackluster and there are ongoing oversupply issues. The GDP deflator is a more comprehensive measurement of overall prices than the consumer price index and the producer price index. We are not in deflationary territory yet, apparently.

On the positive side, private consumption stabilized in the second quarter. In real terms, urban household consumption grew 4.6 percent and rural consumption growth was a solid 9.8 percent. Real disposable income growth for urban households stabilized at 6.5 percent.

In contrast, fixed asset investment and net export growth decelerated. The real growth rate of FAI slowed to 19.9 percent year-on-year in the second quarter from 21.2 percent in the first. Given that real imports grew more rapidly than exports, we think the contribution of net exports to GDP should also have fallen in the second quarter.

Even though the market was relieved by the 7.5 percent growth, we take this opportunity to revise down our growth forecasts for 2013-14. We look for the official target of 7.5 percent to be hit.

Finance Minister Lou Jiwei caused a stir this month when he appeared to reassure a reporter that China's GDP growth will hit the 7 percent target this year. Given that the official target is 7.5 percent, that comment triggered thoughts that maybe he was preparing the ground for a downward revision or even missing the target. We think it is more likely he misspoke. Missing the official target is not impossible - it could be explained by the challenges of dealing with "legacy issues." But even though there is evidently more willingness to bear some pain in order to implement structural reform, everyone in Beijing knows that the agenda can only succeed if there is "enough" growth. Missing the official target could also be seen by some as a black mark for the new economic management team. As one senior economist connected with the National Development and Reform Commission mentioned to us recently, meeting the target is an extremely important "political task."

Really weaker?

Is official growth really weaker?

Using proxies to track growth is a useful and increasingly popular activity in China. We have used factors like electricity and freight traffic a lot in recent years, beginning in early 2008.

Such proxies are, no doubt, useful pointers. But one has to be careful. The two (in addition to bank credit) were reported to have been favorites of Premier Li Keqiang when he was running Liaoning Province and they suggest that the economy has entered a recession.

However, choose different proxies and the story changes. Electricity consumption, road freight traffic, and gasoline production growth show a slow-growing economy, not one that is contracting. Recent PMI readings have (once the services sector is added in) remained positive overall, also suggesting mild growth.

Moreover, it is worth remembering that the proxies available to us cover only industrial and investment-related activity; we have been unable to find any good monthly services sector-related proxies. The non-manufacturing PMI continues to outperform its manufacturing cousin.

We expect the official annual target to be set (at the March 2014 session of the National People's Congress) at 7 percent for next year, and we expect official growth to come in at 7.2 percent.

Premier Li has made it clear that it is necessary to maintain economic growth and employment rates above certain "lower limits" while the country pushes through economic reforms. The labor market still appears to be healthy - a task made easier by the fact that in the past two years, the overall size of the labor market has been declining.

We do not expect any significant stimulus polices to be authorized, or that macro-economic policies will be adjusted. In fact, overall credit growth is now decelerating. We do not expect a dramatic deceleration in growth of total social financing, though clearly the peak in growth has passed. There will be more stories of non-performing loans appearing in the second half. However, given GDP growth is weak, we believe it is likely that Beijing will allow for some targeted supports to be rolled out.

The supports will likely be targeted at small and medium-sized enterprises, "strategic" industries (for example, energy saving, environmental protection, IT) and consumer spending, in line with China's long-term reform goals.

The "Guidance on Finance Supports to Economic Reforms" issued by the State Council this month suggests that one avenue for support is regulatory fine-tuning, which may include:

The risk weighting on loans and the loan-deposit regulation could be adjusted to motivate banks to lend more to certain industries.

Government SME loan insurance funds could play a more active role in offering guarantees on bank borrowing by smaller companies.

Big infrastructure projects will receive government support to raise funds in the bond market.

Banks are being encouraged these days to offer maximum discounts on mortgage loans to first-time homebuyers.

Premier Li has also called to boost low-quality housing reconstruction; supports for the energy saving, environmental protection and IT industries; and investment and consumption.

If the slowdown continues to worsen, Beijing could look to cut banks' required reserves and interest rates, and boost fiscal spending. But on balance, we do not see this happening in the third quarter.

We maintain our Neutral recommendation for onshore China government bonds, although we revise lower our bond yield forecasts to reflect lower growth revisions. We now expect the 10-year government bond yield to remain range-bound around 3.6 percent for the remainder of 2013 (down from 3.8 percent), before rising above 4 percent in 2014.

Tightening unlikely

As we downgrade our GDP growth forecast for this and next year, we believe that policy tightening is unlikely near-term. Macro-economic data is likely to remain weak in the coming months and policy tightening remains remote, which will help anchor 10-year government bond yields at around current levels before they trend higher in 2014.

Meanwhile, the curve is likely to remain flat, although we see some (but very limited) room for short-dated bond yields to decline from here.

We believe a liquidity crunch as seen in June will not be repeated, but that the overall liquidity condition will remain tighter than in the first half of 2013 as the government pushes forward structural reform.

Overall demand for onshore government bonds is likely to remain solid as banks continue to move exposure from "non-standard" to "standard" products (mainly bonds) for their wealth management products (there is a grace period until the end of this year to reduce exposure to "non-standard" credit to 35 percent of overall wealth management products), and as they continue to boost capital ratios to meet the requirements of the new capital rule (the People's Bank of China bills, and policy bank paper are the only eligible bonds that carry zero risk weighting).

However, volatility in China's onshore bond market could increase. Regulators are likely to take bolder steps to reform the domestic bond market in the coming months, making it more ready to serve the real economy.

Such steps could include a further standardization of bond trading and issuance activities, and streamlining the approval and supervision frameworks.