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China economy
GLOBAL ECONOMICS AND STRATEGY November 2011
China risks
Research analysts
November 2011
We attach a one-in-three probability to China experiencing a hard economic landing commencing before the end of 2014. We define hard landing as an abrupt slowdown in real GDP growth to an average of 5% y-o-y or less over four consecutive quarters. We discuss six key reasons why the risk of a China hard landing happening in the next three years appears to have increased. We launch Nomuras China Stress Index (CSI), which uses 18 indicators to summarize the macro risks in a single measure. Our global strategy teams conduct a what if exercise, discussing trading recommendations and stock ideas for this non-trivial risk scenario.
Any portion of this report that has been prepared by a trading desk analyst is not a product of the Fixed Income Research Department and is not covered by the Research Analyst certification provided in Appendix A-1. For additional information concerning the role of Trading Desk Analysts, please see the important conflicts disclosures beginning at page 101 of this report.
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Foreword........................................................................................................... 3 Executive summary ......................................................................................... 4 Introduction Six reasons to worry .............................................................. 5 Defining a hard economic landing ................................................................. 8 Defining a hard landing ................................................................................ 8 Triggers and timing ........................................................................................ 8 Policy responses ............................................................................................ 8 Perceived likelihood ..................................................................................... 10 Nomuras China Stress Index (CSI) ............................................................. 11 1. Overinvestment and excessive credit ..................................................... 13 Box 1: Fuzzy numbers .............................................................................. 14 Box 2: Chinas challenging GDP arithmetic .............................................. 17 Box 3: Lessons from Japan on the return and cost of capital .................. 19 2. Rudimentary monetary architecture ........................................................ 22 Box 4: Shadow banking in the US and China compared ......................... 26 3. The privileged state-owned enterprises .................................................. 28 Box 5: Investment is high, but savings are even higher ........................... 30 Box 6: The Akerlof market for lemons problem applied to China ............. 31 4. Unintended consequences of financial liberalization ............................ 33 Box 7: A chronology of Chinas capital account liberalization .................. 34 Box 8: Risks associated with financial liberalization: lessons from Japan38 5. The Lewis turning point ............................................................................ 39 6. The setting in of growing pains ............................................................... 43 Demographic challenges .............................................................................. 43 Box 9: Chinas hukou household registration system .............................. 46 Rising inequality and an aspiring middle class ............................................ 46 Resource and environmental strains ........................................................... 51 Pricing a China hard landing Strategy perspectives .............................. 56 Global macro perspectives ........................................................................... 59 Global equity perspective ............................................................................. 64 Asia-ex Japan FX perspective ..................................................................... 67 Implications for Asia regional equities69 China equities the risk.......73 Chinese credits already reflecting the risks of a China hard landing ........ 91 References...................................................................................................... 94 Appendix: The Construction of Nomuras China Stress Index ....................... 97
November 2011
Foreword
We are pleased to present Nomuras Anchor report on China, in which our economists, strategists, equity and political analysts assess the medium-term risk of a hard landing a critical issue for todays global economy. At Nomura, we pride ourselves in producing research of the highest standard. Historically, we have had a strong presence across Asia, and in recent years we have increased our footprint in Europe and the United States to become Asias leading global investment bank. Our roots in Asia allow us to see firsthand the breakneck speed at which the regions economies are emerging and contributing over half of global GDP growth. China leads the world in the growth stakes, but the risks in our view have risen and should no longer be ignored. Our base case is that China's economy will average growth of about 8.5% in 2012-14, but we judge that the risks of a temporary interruption that pushes growth far below potential are rising. We define a so-called hard landing as an abrupt slowdown in real GDP growth to average 5% or less for at least one year. This report discusses six key factors that lead us to attach a one-in-three likelihood that Chinas economy commences a hard landing before the end of 2014. How would this non-trivial risk of a hard landing in China impact global financial markets? Our global and Asian equity, FX, rates and credit strategy teams assess the macro implications and present trading recommendations and specific stock ideas to this risk scenario. How can investors calibrate the risk of this hard landing scenario? In this report we launch Nomuras China Stress Index (CSI) which we will update quarterly. The exact probability of a hard landing is necessarily a matter for investor judgment, but the CSI will give investors an important indication of risk. Nomuras Anchor series of reports underscore our dedication to produce thematic, long-term studies, involving cross-region and cross-division collaboration among our global markets research teams. We welcome your feedback as we continue our tradition of collaborative work to deliver unique investment insight and ideas to our clients.
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Executive summary1
This study takes Chinas still enormous economic development potential as a given and focuses on the risks and challenges that lie ahead for the economys meteoric rise has been associated with a build-up of fundamental imbalances. We define a hard economic landing in China as an abrupt slowdown in real GDP growth to an average of 5% y-o-y or less over four consecutive quarters. While our base case is that China's economy will average growth of about 8.5% in 2012-14, we discuss six compelling reasons why the risk of a hard landing has increased. We attach a one-in-three likelihood that a hard landing commences before the end of 2014. Overinvestment and excessive credit. China's investment is almost half of GDP, while domestic credit is nearly 1.5x GDP, or 1.8x if the shadow banking sector is included. Empirical literature shows that investment booms are more likely to trigger a crisis if they are associated with credit booms. China ticks both of these boxes. A rudimentary monetary architecture, centered on controlling the exchange rate is not very effective in managing an economy that is rapidly becoming more open and sophisticated, and has resulted in a cost of capital that is too low and a financial sector that is repressed. The privileged state-owned enterprises receive preferential government subsidies and bank financing, yet they are capital intensive, inefficient and crowd out smaller private enterprises. Unintended consequences of financial liberalization. Internationalization of the renminbi is adding pressure for China to accelerate financial liberalization, but this is not without risks, such as falling credit standards as banks overly compete with one another. The Lewis turning point, associated with a dwindling supply of surplus labour from the countryside, is likely upon China, which could trigger a serious outbreak of inflation. The setting in of growing pains from worsening demographics and increasing strains on natural resources and the environment. These growing pains will almost certainly cause the economy's growth potential to slow over this decade, making it more challenging to implement structural reforms and address high income inequality. China's economy is now so big and complex that many of its structural problems are becoming more interrelated. Also, many of its critical reforms are becoming unavoidably connected, making it more difficult to continue undertaking individual reforms gradually and in isolation. The government would no doubt do all in its power to respond, but the question is how large, quick and effective a policy stimulus would be. On all three counts, we judge that it would be less than in 2008. We are well aware that picking the exact timing of a hard landing is devilishly difficult. The key will be whether the risk of a hard landing rises or falls in the future. Enter Nomura's new proprietary tool, our China Stress Index, which uses 18 indicators to summarize the macro risks in a single measure. Please refer to the summary pages 56-58 for strategy perspectives, trading recommendations and stock ideas should the non-trivial risk of a China hard landing impact global financial markets.
The authors of particular parts are accredited in their respective sections, but specific mention should be made of Zhiwei Zhang, Chi Sun, Alastair Newton, Simon Flint, Pradeep Mohinani, Michael Kurtz, Ian Scott, Chien-hua Chen and Qilong Zhang. We are grateful to Candy Cheung and Wendy Chen for data analysis; David Vincent and Kenneth Persing for editing; and Jay Chandrasekharan for coordinating the equity analysts. We are also indebted to Zhiwei Zhang, Paul Sheard and Paul Norris for providing helpful comments on early drafts.
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China's economy still has lots of room to develop, but fundamental problems have built up
35,000 30,000
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Japan
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-30 1950
1960
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1980
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2010
This study takes Chinas still enormous economic development potential as a given and focuses on the macro risks and challenges that lie ahead. Our base case is that China's economy will average growth of about 8.5% in 2012-14, but we judge that the risks of a temporary interruption that pushes growth far below potential are rising. We define a so-called economic hard landing as an abrupt slowdown in real GDP growth to an average of 5% y-o-y or less over four consecutive quarters. Six factors lead us to attach a one-inthree likelihood that a China hard landing commences before the end of 2014. 1. 2. 3. 4. 5. 6. Overinvestment and excessive credit Rudimentary monetary architecture The privileged state-owned enterprises (SOEs) Unintended consequences of financial liberalization The Lewis turning point The setting in of growing pains
Six factors lead us to attach a one-in-three likelihood that a China hard landing commences before the end of 2014
2 3
To compare the sizes of economies we convert nominal GDP into USD at market exchange rates. GDP per capita in constant prices is a more appropriate yardstick to compare real purchasing power, but such data on a consistent basis are only available back to 1960. World Bank data show that in 1960, Japan's real GDP per capita (USD7,241) was still higher than China's real GDP per capita (USD2,423) in 2010, suggesting that China's current real average standard of living is more on par with Japan's before the 1960s.
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While there may be many tell-tale warning signs that a hard landing is coming, the trickiest part is getting the timing right. The conventional wisdom seems to be that, because of political incentives, a hard landing, should there be one, would not occur until after the transition to Chinas fifth generation of leaders in 4 early 2013. The analysis of Eichengreen, Park and Shin (2011) adds some support to this view. They analyse a sample of 41 fast-growing economies over the period 1957 to 2007 and find that on average these economies slow significantly when GDP per capita on a purchasing power parity basis hits 5 USD16,740 which China is unlikely to reach until 2015, at the earliest. However, they also show that a low consumption-to-GDP ratio, higher and more volatile inflation, a rising old-age dependency ratio and an undervalued exchange rate are important features that typically increase the chances of a sharp slowdown and China has all of these. While we are well aware that picking the exact timing of a hard landing is devilishly difficult, we find some compelling reasons why the risk of it happening in the next three years should no longer be ignored. The empirical literature on the causes of financial crises offers some pertinent lessons to China. The first is that an extended period of high GDP growth can mask the build-up of underlying financial problems, in part because the most robust leading indicator of financial crises the debt-to-GDP ratio is flattered. Lesson number two is that investment booms are more likely to trigger a crisis if they are associated with credit booms. China ticks both of these boxes: investment (public and private) comprises nearly half of GDP and domestic credit is almost 1.5x GDP, or 1.8x if the shadow banking sector is included. The second reason relates to China's stage of economic development the economy has become so big and complex that many of its structural problems are becoming more interrelated. For example, a rudimentary monetary architecture, centering on controlling the exchange rate, has resulted in a cost of capital that is too low and a financial sector that is severely repressed. The too-low cost of capital has fueled overinvestment, while the financial repression has given rise to a flourishing shadow banking sector. Another example is the generous government and bank support given to the less efficient and capital-intensive state-owned enterprise (SOE) sector, which leads to wasteful investment of scarce resources, environmental degradation and credit rationing to private small to medium-sized enterprises (SMEs). Rather than any one of these factors alone, we believe it is the combination of various imbalances and interactions among them that increases the likelihood of a major setback. Third, increasing strains on natural resources and the environment, together with demographic changes rapidly turning unfavorable, are causing growing pains to set in that will almost certainly cause the economy's potential growth to slow over the course of this decade and inflation to be structurally higher. In an environment of slowing trend growth and higher structural inflation, structural problems festering below the surface can bubble up to the surface, and implementing reforms can be more challenging. For instance, removing the generous government subsidies to SOEs, can become politically more divisive as power and economic privilege needs to be wrested from local governments, the SOEs and the banks. Fourth, historically the government has implemented reforms incrementally. However, China has reached a stage of development at which many of its critical reforms are unavoidably connected, making it more difficult to undertake individual reforms gradually and in isolation. For example, internationalizing the renminbi and moving to a more flexible exchange rate
4
The empirical literature on the causes of financial crises offers some pertinent lessons to China
Chinas economy has become so big and complex that many of its structural problems are becoming more interrelated
Increasing strains on natural resources, the environment, and demographics are causing growing pains to set in
For example, according to a Bloomberg global survey on 29 September 2011, 1,031 of its subscribers were asked about the chances of Chinas economy slowing below 5% growth: 12% of respondents believed it will happen within the next year, 47% within the next 2-5 years and the remainder thought longer than 5 years, or that it would never happen. 5 Specifically, the authors identify 43 cases where rapidly growing economies slow significantly that is, real GDP growth shifts down by at least 2 percentage points and calculate that, on average, the tipping point is when GDP per capita (on a purchasing power parity basis) is USD16,740.
November 2011
regime are adding pressure on China to press ahead with capital account liberalization and interest rate deregulation. But without adequate safeguards, financial deregulation can pressure banks to engage in overly aggressive competition, lowering overall credit standards. Another example is Chinas shrinking supply of young, rural surplus labour which is starting to accelerate wage growth. One proposed reform is to relax the rigid hukou household registration system, giving city migrants the same rights as locals so as to encourage greater labour mobility and faster urbanization. But without other reforms this could exacerbate other problems, such as environmental degradation and social tensions. We see the pressure building to make more broad-based wholesale reforms, but given growing inter-linkages of various reforms, big changes will carry greater risks. Politically, it is hard to envisage substantial change before the next generation of leaders takes the helm in March 2013.
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Policy responses
In response to the global financial crisis China implemented a RMB4trn (13% of 2008 GDP) fiscal stimulus; put the steady appreciation of the CNY/USD exchange rate, that has been in train since July 2005, on hold; cut the bank
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reserve requirement ratio (RRR) by 250bp; and cut the benchmark 1yr lending rate by 216bp. We have no doubt that the government would again do all in its power to respond to signs of a hard landing, but the question is how large, quick and effective a policy stimulus would be. On all three counts, we judge that it would be less than in 2008. On monetary policy, we would expect aggressive cuts in the bank RRR and CNY/USD appreciation to once again be halted (if there were to be large net capital outflows rather than allowing CNY/USD depreciation, we would expect the PBC to drawdown its USD3.2trn of FX reserves to keep CNY/USD stable). On the other hand, we see a higher hurdle than in 2008 for the PBC to cut the benchmark 1yr lending rate aggressively. One reason is because of greater inflation pressures today, with CPI inflation currently much higher (6.1% y-o-y in September 2011) than the 2.5% in 4Q 2008. Moreover, core CPI inflation, which excludes food and energy items, has also risen steadily over the past two years to 2.4% y-o-y in Q3 2011, the highest since the government began publishing the data in 2005, suggesting that a structural inflation problem is emerging (see Asia Special Report, China: The case for structurally higher inflation. 21 September 2011). Another reason is what we believe is growing recognition among Chinas policymakers that interest rates were set fundamentally too low in the past, and that this cheap cost of capital contributed to overinvestment. As such, we would expect to see greater official resistance to rate cuts than in the past. On fiscal policy, we would expect another stimulus package and, to avoid the economy becoming more unbalanced, there would likely be more focus on consumption-boosting measures. However, fiscal stimulus aimed at consumption tends to be less effective than public investment, because any increase in household income can be saved rather than spent. Therefore, we would expect a fiscal stimulus package to again be dominated by public investment, but again believe it would be less effective than that seen in 2008-09, for three reasons. First, while China certainly has room for fiscal stimulus, it has less room than it did before. Central government debt is still low at around 20% of GDP, but the build-up of local government debt in recent years has lifted general government debt (central plus local) to around 50% of GDP. On top of this are the governments contingent future liabilities, including future losses related to NPLs and unfunded pension liabilities which, if all were to be recognized in 2011, would lift the general government debt to 85% of GDP, according to the IMF (2011a, p.47). Second, the speed of implementation would likely be slower than in 2008-09. Before the global financial crisis, the economy was overheating, forcing the National Development Reform Commission (NDRC) to turn down a large number of new investment projects by SOEs and local governments. So when the global financial crisis hit, China had many large off-the-shelf investment projects ready to go and so could boost investment quickly. This is no longer 6 the case. Third, given that government-influenced investment comprises about one-third of total investment, to avoid a fall in total investment public investment must grow by twice as much as any decline in private investment growth. The government doubling up with another public-led investment boom could heighten concerns over misallocated, wasteful investment, increasing fears of an even bigger hard landing further out the private response could be to pull back investment even more.
China still has room for fiscal stimulus, but less than in 2008 We see a higher hurdle than in 2008 for the PBC to cut the benchmark 1yr lending rate aggressively
Another public-led investment boom could heighten concerns over misallocated, wasteful investment
The growth of newly started fixed-asset investment projects was 28.7% y-o-y in 2007, but the NDRCs rejection of new projects caused the growth rate to plunge to -2.9% y-o-y in Jan-July 2008; the NDRC reversed course after the global financial crisis hit, and the pent-up demand caused the growth rate to rebound to over 80% y-o-y in Jan-Oct 2009. The growth of newly started fixed-asset investment projects was 23.1% y-o-y in Jan-Aug 2011, and there is now much less pent-up demand.
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Perceived likelihood
Drawing together the strands of the analysis we have done on the six main macro risks in China, our overall assessment is that the chance of a hard economic landing has increased in recent years. We attach a one-in-three probability of real GDP growth falling to an average of 5% y-o-y or less over four consecutive quarters sometime between now and the end of 2014. While our baseline modal (i.e., most likely outcome) forecast to which we attach the residual two-third probability is for Chinas real GDP to grow by an average of 8.5% in 2012-14. We are aware of the non-trivial tail risk of a much worse outcome which, as we explain in the final chapter, would have severe repercussions for the global economy and financial markets. Interestingly, this year there has been a significant sell-off in Chinas equity and credit markets, yet most China economists have not significantly downgraded their GDP forecasts. For example, the latest 10 October survey of 18 market economists by Consensus Economics Inc. shows that the consensus forecast of Chinas real GDP growth is 8.5% in 2012 and 8.4% in 2013, while the IMFs latest forecast (released in September) is 9.0% in 2012. The way we would reconcile this gap is that economists forecast the modal, or most likely, outcome, whereas the financial market tends to take a weightedaverage probability of different possible outcomes. If we apply our baseline and hard-landing probabilities to the market method {(8.5*0.66)+(5.0*0.33)}, it gives a weighted-average GDP growth forecast of at most 7.3% in 2012-14. In other words, like-for-like, our forecasts are probably not that dissimilar to what the market is pricing in the key will be whether the risk of a hard landing rises or falls going forward, which brings us to Nomuras new proprietary tool our China Stress Index (CSI).
We attach a one-in-three probability to our definition of a hard landing commencing sometime between now and the end of 2014
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Note: The last data point is September 2011. Source: PBC; National Bureau of Statistics and Nomura Global Economics. For details of construction, see the Appendix: The construction of Nomuras China Stress Index
A closer look at the components reveals that rapid increases in residential housing starts relative to sales, residential property prices, gross capital formation, property loans and domestic credit have been the main recent drivers (Figure 4). We are under no illusions that the CSI has its limitations and needs to be treated with caution. The results of the CSI, which we will update on a quarterly basis, should always be open to interpretation, and used as a tool among many others for analysis of China macro risks.
Housing starts relative to sales, property prices, gross capital formation, property loans and domestic credit have been the main recent drivers
Fig. 4: The five biggest drivers of the CSI over Jan 2007-Sep 2011 (contribution to the increase in the CSI index over this period)
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Residential housing starts less sales Residential property price deviation from long-run linear trend
0.05
0.1
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Note: Unit is percentage point. Source: PBC; National Bureau of Statistics and Nomura Global Economics. For details of CSI construction, see Appendix: The construction of Nomuras China Stress Index.
Fig. 1
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Household consumption 12
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In international and historic terms, China is now an outlier: no other large economy has had such a high investment-to-GDP ratio for so long. The highest investment ratio in the US since 1929 was 26.2% in 1941. Surveying Japan, Korea, Singapore and Thailand, four Asian countries that have experienced rapid economic take-offs, their highest investment ratios typically lasted seven to eight years and none ever reached the levels seen in China (Figure 7). 2011 will be the ninth consecutive year that Chinas investment ratio has been over 40%. Undoubtedly there are questions marks over the quality of Chinese data some claim that Chinas official investment ratio is overstated because the services sector and hence consumption are likely underestimated; on the other hand, aggregating the investment data for Chinas 31 provinces suggests that the official national investment-to-GDP ratio could be 7pp too low (see Box 1: Fuzzy numbers).
China is now an outlier: no other large economy has had such a high investment-to-GDP ratio for so long
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China, 2002 -11e Japan, 1966 -75 Korea, 1988 -98 Singapore, 1978 -88 Thailand, 1989 -98 t t+1 t+2 t+3 t+4 t+5 t+6 t+7 t+8 t+9 t+10
Note: t=numbers of years from the starting year, eg. For China, the starting year is 2002. The data are in nominal terms and investment is the sum of public and private gross capital formation. Source: China Statistical Yearbook; CEIC and Nomura Global Economics.
Fig. 2
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The recent jump in China's investment ratio to almost half of GDP was driven by a conscious policy response to the global financial crisis, but the fundamental reason why the investment ratio has been so high for so long has more to do with serious factor cost distortions. The high priority on internal rebalancing of the economy that is, lowering the investment ratio and raising the consumption ratio is not a new initiative; in fact it was a key goal of the 11th Five-Year Plan (2006-10) unveiled in early 14
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2006. However, the global financial crisis of 2008 was a huge unexpected shock, causing Chinas export performance to swing from 23% y-o-y growth in Q3 2008 to a 24% y-o-y contraction in Q2 2009. Fearing major knock-on effects to the domestic economy from firms cutting jobs and capex, the authorities gave the go-ahead to a credit-financed investment boom. China's real estate developers, SOEs and local governments took heed, ramping up investment in property and infrastructure, putting rebalancing efforts in China firmly on the back burner. However, the more fundamental reason for China's persistently high investment-to-GDP ratio is the large difference between the return on, and cost of, capital. The bank lending rate has historically been artificially controlled far below the return on capital needed to support an industry-led, export-orientated growth model. A simple approximation of the return on capital is nominal GDP growth, which averaged 18.5% in the 1990s and 14.6% in the 2000s, compared with the benchmark 1yr bank lending rate of 9.4% in the 1990s and 5.8% in the 2000s. This large gap gave producers a big incentive to invest. To more formally estimate China's return on capital, we follow a similar methodology to the Bank of Japan (2011) and Bai et al (2006). Qualitatively, the results are similar to that of using nominal GDP growth, indicating the large wedge between the return on, and cost of, capital of over 10pp over the past three decades (Figure 9). Even five years ago, Aziz (2006) found that Chinas low cost of capital was quantitatively an important factor in explaining why the investment-to-GDP ratio was high, and back in 2006 the 7 ratio was only 42%.
The fundamental reason for the high investment-to-GDP ratio is the large difference between the return on, and cost of, capital
Fig. 9: The difference between the return on, and cost of, capital
% 30 25
20 15 Difference (percentage points) Return on capital Cost of capital
10 5 0
Note: The aggregate return on capital is measured using approximated data on the share of capital in total income, the capital stock-to-output ratio and the depreciation rate of capital. The cost of capital is estimated using the 1yr bank lending rate. Source: CEIC; China Statistical Yearbook; Development and Research Center under the State Council; and Nomura Global Economics.
The big question is not if, but when, Chinas investment and consumption ratios re-balance and will it happen in a gradual, policy-controlled way, or will the process involve one or more episodes that are abrupt and beyond the control of policymakers, causing major disruptions to the economy and markets? International experience shows that rebalancing is never easy, as it usually means redistributing income and power from vested interests that have benefited from the old model in China, notably large SOEs and local governments (see chapter: The privileged state-owned enterprises). Of all the main components in GDP, investment is typically the largest swing factor and in most Asian countries it usually contracts at least one year each decade. Yet
7
At almost half of GDP, Chinas investment is now so large that were it to stop growing it would cut real GDP growth in half
The flipside of China's high investment-to-GDP ratio is a low consumption-to-GDP ratio, which is partly because Chinese households have a high motive for precautionary saving, but also the share of wages in national income is low relative to profits. SOEs historically provided generous social welfare benefits to their workers, so the downsizing of SOEs in the late 1990s meant that workers needed to save more of their income to pay for their own healthcare, education and pensions. Also, while urbanization has boosted incomes of rural migrant workers, the stringent hukou household registration system has provided them with scant social welfare benefits in the cities where they live, increasing their precautionary savings. The very low or negative real interest rate on bank saving deposits has also forced households to save more than they otherwise might have.
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China's investment has not fallen since 1990 in volume terms and not since 1976 in value terms (Figure 10). At almost half of GDP, Chinas investment is now so large that were it to stop growing, let alone turn negative, it would cut real GDP growth in half (see Box 2: Chinas challenging GDP arithmetic). The timing of rebalancing is also now less favourable for China, as besides investment and consumption, the third engine of growth exports is unlikely to be firing on a full cylinder given the crisis-scarred economies of the US and Europe.
Fig. 10: Identifying the years when real gross capital formation contracted
China Nominal Real* Hong Kong Real 1940s n.a. n.a. n.a. 1950s 1955: -2% 1955:-2% n.a. 1960s 1967:-25% 1960-62:-95% 1967-68: -27% 1960-62:-109% 1966-68: -38% 1970s 1976:-7% 1972:-3% 1976: -9% 1972: -2% 1980s 1990s 2000s
1990: -1% 1998-99: -32% 1996: -3% 1996: -1% 1991: -16% 1998-99: -62% 1998-99: -16% 1992-94: -10% 1997-98: -32% 1992: -1% 1998-99: -47% 2008: -1% 2005: -1% 2001: -5% 2008: -6% 2000-01: -6% 2002: -4% 2008-09: -23% 2001-03: -13% 2009: -13% 2008-09: -17% 2005: -2% 2003: -2% 2001: -9% 2009: -9% 2006: -15% 2004: -2% 2009: -19% 2001-03: -57% 2007-09: -30% 2001: -24% 1997-98: -73% 2009: -25% 2006: -4%
1981: -4% 1988: -5% 1983: -3% 1980: -1% 1980: -17% 1985-87: -32%
n.a. n.a.
n.a. n.a.
Philippines
Real
1956: -1% 1952: -3% 1949-50: -30% n.a. n.a. n.a. n.a. 1955: -15% n.a.
1970: -4%
1984-85: -69% 1980: -4% 1988: -3% 1985-86: -18% 1985: -8% 1982: -5% 1985-86: -8% 1982: -7%
n.a.
n.a.
Source: CEIC and Nomura Global Economics. Note: The shaded areas are decades when real gross capital formation falls. For China, official data on real gross capital formation are not available and so Nomuras proxy is nominal gross capital formation deflated by the fixed-asset investment deflator back to 1990 and before that, deflated by the GDP deflator.
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As Japan's experience shows, the large positive gap between the return on, and the cost of, capital does not last forever
The phrase Chinas challenging GDP arithmetic was coined by Paul Sheard, Nomuras global chief economist, back in 2009 (see the Global Letter, Chinas challenging GDP arithmetic in the Global Economic Weekly Monitor, 25 September 2009). 9 A good micro example is China building in just three years the worlds longest and fastest high-speed rail network, which according to data from the International Union of Railways extends to 6,300km, an achievement that had produced considerable national pride. The collision of two new high-speed trains outside the city of Wenzhou on 23 July, which killed 40 and injured 191, stoked public anger and a media frenzy that the breakneck development of high-speed rail had cut corners indeed, Chinas Railways Ministry is the manufacturer, operator and regulator of the network. As a result, Beijing has suspended approvals of new high-speed lines and its original ambitious program of having a further 4,339km of high-speed rail under construction by 2012 more under construction over this period than that of the rest of the world put together is now unlikely to be achieved.
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unwind generous subsidies to SOEs and to stop underpricing factor inputs such as land, water and energy; and a likely continued multi-year surge in food prices (see our Special Report, The coming surge in food prices, 8 September 2010). Higher interest rates would also be a natural result of accelerating the evolution of China's monetary policy framework, from administrative measures to more market-price-based instruments (see chapter: Rudimentary monetary architecture). A key risk is policy errors, for example falling behind the curve in fighting inflation and needing to catch up via aggressive rate hikes, leading to a sharp rise in the cost of capital at a time when the return on capital could be 10 falling.
10
Firms should adjust their capital stock so that its marginal productivity equals its user cost. As interest rates increase, firms scale back investment for which the expected return is insufficient to cover the higher financing costs. Using micro data on listed Chinese firms over 2002-07, Conway, Herd and Chalaux (2010) found empirically that capital spending is negatively influenced by higher interest rates.
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Consumption
Fig. 12: Japans difference between the return and cost of capital
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What accentuates the macro risks of China's investment boom is the credit boom associated with it. One of the relatively few robust findings to emerge from the empirical literature on leading indicators of banking crises is that rapid domestic credit growth increases the likelihood of a problem (Kaminsky and Reinhart, 1999). In a survey of credit booms in 28 emerging market economies during 1970-2002, the IMF (2004) estimates that about 75% of the credit booms were associated with a banking crisis. More pertinent to China, Borio
What accentuates the macro risks of China's investment boom is the credit boom associated with it
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and Lowe (2002) use annual data since 1960 for 34 countries to show empirically that an investment boom by itself may pose little threat to the stability of the financial system. Rather, it is the combination of various imbalances, in particular the simultaneous interactions of rapid credit growth, rapid increases in asset prices and an investment boom rather than any one of these alone that increases the likelihood of problems. Analysis of China's recent credit boom has tended to focus on local government borrowing, where the data are opaque. Local governments are not allowed to directly incur debt, and so finance infrastructure projects by borrowing from banks. To do so, they set up over 6,500 Local Government Financing Vehicles (LGFVs). The latest official estimate of local government debt outstanding was RMB10.7trn, or 27% of 2010 GDP, as at June 2011 by 11 the State Audit Office, although some private estimates are much higher. Whatever the true figure of local government debt is, a broader analysis can be gleaned from IMF data which show that total domestic credit (private and government) surged from 121% of GDP in Q4 2008 to 147% in Q2 2011, a level that is not far from the peak in 2003 (Figure 13). Moreover, China's credit-to-GDP ratio stands as an outlier compared with other countries of a similar income level (Figure 14).
China's credit-to-GDP ratio stands as an outlier compared with other countries of a similar income level
Cyprus
Fig. 4
Fig. 5
China's credit boom over 1998-2003 led to a banking crisis. As far as we know, the earliest official data on the NPL ratio of the major commercial banks was 23.6% in 2002, but this excludes a large volume of bad loans, of over 15% of GDP, that were carved out and transferred to newly created asset 12 management companies a few years earlier. Since 2002, the official NPL ratio has steadily declined and by June 2011 stood at just 1.0% for all commercial banks. However, given that China's credit-to-GDP ratio has surged to just shy of the record high in 2003, there is little doubt that the NPL ratio will rise again the question is by how much. Reflecting the paucity of data and the uncertainties involved, estimating how high NPLs may rise and the potential fiscal cost of recapitalizing the banks can 13 vary widely. To be sure, compared to a decade ago Chinas banks today are better capitalized, have higher loan-loss provisioning and face more stringent
There is little doubt that the NPL ratio will rise again the question is by how much
Chinas banks today are better capitalized, have higher loanloss provisioning, but
11
In July 2010, the China Banking Regulatory Commission (CBRC) first estimated total local government debt outstanding at RMB7.7trn but raised its estimate in November 2010 to RMB9.1trn. The latest estimate in June 2011 by the State Audit office was even higher, at RMB10.7trn, or 27% of 2010 GDP albeit still far short of the RMB20trn projected by Professor Victor Shih at Northwestern University. 12 Before the establishment of asset management companies, unofficial estimates put the peak NPL ratio in 1999-2000 at about 40%, or higher. The OECD estimates that the total cost to the government of recapitalizing the banking sector in the early 2000s was some 30% of GDP (OECD 2005). 13 The State Audit Office sent a warning in June 2011, when after a lengthy audit of the five major banks it found that RMB58bn, or 17% of total loans outstanding, violated regulations, such as new loans granted for unapproved projects or used to repay existing debt. Rating agency Moodys expects Chinas NPL ratio to rise to 8-12% in coming years. In July 2011, the official auditor of Liaoning province reported in a speech that 85% of LGFVs in Liaoning had insufficient income in 2010 to cover debt-servicing payments.
20
November 2011
regulations and supervision. But on the other hand, we see two important reasons for concern: 1) a big and largely unregulated shadow banking sector has emerged in recent years, estimated to be almost as large as the official banking sector (see chapter: Rudimentary monetary architecture); and 2) this time, both local governments and property developers are heavily indebted, which raises the risk of a vicious spiral if there is a major correction in property prices given that 30-40% of local government revenue is made up of proceeds 15 from land sales and other property-related activities. According to official data, nationwide property prices have risen 60% since the end of 2006 (IMF 2011c). This has fueled speculative property investment and an ominous sign is the large gap that has opened up between the combined floor space of residential, office and commercial property that builders have started work on, 16 compared to the floor space sold (Figure 15). In a back-of-the-envelope exercise simply to illustrate how much estimates can vary, if we assume that China's NPL ratio rises from 1% to 10% and that 70% of these loans could be recovered, then the cost to the banking sector or failing that, the government would be RMB1.6trn, or 3.6% of 2011 GDP (Figure 16). However, under more drastic scenarios of higher NPLs and lower recovery rates, it is possible that the total cost could be over 30% of 2011 GDP.
a big and largely unregulated shadow banking sector has emerged in recent years
Fig. 15: Difference between floor space started and floor space sold:
Millions of Sq. meters, 12m rolling sum 2,500
Fig. 16: Assessing the cost of potential financial sector problems, % of GDP
Loan recovery rate, % 30 40 7.1 14.2 21.3 28.4 35.5 50 5.9 11.8 17.8 23.7 29.6 60 4.7 9.5 14.2 18.9 23.7 70 3.6 7.1 10.7 14.2 17.8
2,000 1,500
1,000
ratio,
500 0 Dec-96
Dec-99
Dec-02
Dec-05
Dec-08
Dec-11
Note: % of estimated 2011 GDP. Source: CEIC and Nomura Global Economics.
14
In May 2011, the CBRC ordered systemically important banks to have bad-loan provisions that are no less than 2.5% of total outstanding credit by the end of 2013 and 150% of non-performing debt. 15 This year, tighter credit conditions have led property developers to seek other, more expensive, forms of financing in the shadow banking sector, notably new entrusted loans. Lucy Fung, Nomuras China Bank analyst, estimates that of the RMB702.8bn of new entrusted loans in Jan-Jun 2011, 46% were granted to property developers at an average interest rate of 15.8% and at an average duration of 11.3 months. Stress tests by ratings agency Standard & Poors (2011) estimate that the property developers could absorb a 10% decline in property sales in 2012. But if property sales fell by 30% in 2012, more than half of the 30 developers rated by S&P would have weak liquidity, which according to S&Ps definition means overarching credit risk and an issuer credit rating at the B level or lower. 16 The increasing use of desperate sales gimmicks by property developers is one micro-level sign that property supply has moved ahead of demand. For example, at this year's Shanghai Autumn Property Exhibition, to exploit the law which prohibits the purchase of more than two residential apartments, so-called Soho apartments offices equipped with private bathroom and kitchens have been marketed as they are not classed as homes (South China Morning Post, 6 October 2011).
21
November 2011
Chinas monetary policy is losing its effectiveness in managing an economy that is rapidly becoming more open and sophisticated
While the PBC is successfully sterilizing its FX intervention, it is repressing the freefunctioning intermediation role of the banking sector
20 15
10
5 0 Oct-91
Oct-95
Oct-99
Oct-03
Oct-07
Oct-11
17
The massive accumulation of FX reserves to USD3.2trn is not necessarily costless. The larger the stock of FX reserves the greater the potential quasi-fiscal cost if the return earned on the foreign assets is less than the interest paid on the PBCs sterilization bills. The PBC could also incur substantial capital losses on its balance sheet if USD was to crash, leaving it with negative capital. The PBC could try and recapitalize itself by earning profits from increased seigniorage, i.e. printing more currency; or it could be recapitalized by the government but at the cost of losing some of its monetary policy independence and heightening the risk of a major inflation problem. 18 Combining these two sterilization measures, we estimate that the PBC has effectively "locked up" nearly onequarter of total bank deposits that otherwise could have been used for more profitable commercial business, such as lending.
22
November 2011
Fig. PBCs sterilization operations impose considerable cost on the banking The 6
sector. China maintains an interest rate ceiling on bank deposits, which currently ranges from 3.50% for 1yr savings deposits to 5.50% for 5yr deposits. So, the requirement that 21.5% of deposits for large banks be reserved at the PBC earning only 1.62% interest is akin to an implicit tax on the banking sector, restricting banks from allocating a larger portion of their portfolios to higheryielding loans and investments. One way to help ease this financial repression is to allow a wide margin between the benchmark bank lending and deposit rates, which traditionally is what China has done. In the last decade, the spread between the 1yr bank lending and saving deposit rates averaged 3.4% substantially higher than the 1.4% average in the 1990s. However, fat margins simply shift the cost of financial repression from the banks to depositors, which means most households given a lack of alternative investment opportunities. This has been particularly onerous on depositors in the past year because of the sharp rise in inflation. For a third time in the past eight years (after 2004 and 2008) the real rate of return on 1yr bank saving deposits has sunk deep into negative territory, averaging -2.5% in Jan-Sep 2011 (Figure 18). The IMF (2011a, p.34) finds that a 1pp increase in the real rate of return on bank deposits lowers the urban household saving rate by 0.6pp.
One way to help ease this financial repression is to allow a wide interest rate margin, but this shifts the repression from the banks to depositors
Fig. 7
It should come as no surprise then, that despite waves of macro-prudential tightening measures, it has proved difficult to cool speculation in the property market. Moreover, with negative inflation-adjusted returns, banks have been finding it more difficult to attract deposits and so are turning to wealthmanagement products, which typically are loans repackaged as short-term investment vehicles and are held off-balance sheet. These products are typically short term, maturing within one month, and can offer annualized returns of about 8%, more than double that on 1yr bank deposits. According to Xinhua news agency, by mid-2011 China had RMB7trn in outstanding wealth management products, triple the amount at the end of 2010. With bank assets mainly tied to longer-term loans, there is a growing problem of duration mismatch between bank assets and liabilities. Perhaps in response, in this latest tightening cycle the PBC has hiked interest rates on longer-term bank deposits by a larger magnitude, which has shifted some of the costs of financial repression back to the banks. For example, since September 2010 the 1yr bank deposit rate been increased by 125bp, and the 5yr rate by 190bp, while the benchmark 5yr or longer lending rate has been increased by only 114bp. Interestingly, this seems to be forcing banks to price credit risk more actively by charging borrowing rates that are higher than official benchmark rates on more of their loans: in June 2011, a record-high 61.2% of loans were priced above benchmark rates, versus 44.3% in
Negative real bank deposit rates have contributed to property market speculation and the explosion of wealthmanagement products
23
November 2011
September 2010 (Figure 19). Yet with an obligation to lend to large SOEs, banks are increasingly rationing credit to private companies, forcing them to borrow in the shadow banking sector at punitively higher interest rates (see chapter: The privileged state-owned enterprises).
Fig. 19: Proportion of new bank loans charged above the benchmark lending rate
% share 65
60 55 50
45
40 35
30 Jun-05
Jun-06
Jun-07
Jun-08
Jun-09
Jun-10
Jun-11
Fig. 8
Financial repression is also encouraging off-balance sheet bank activities, disintermediation and other less-regulated activities outside the official banking system. In an attempt to monitor informal financing activities, the PBC introduced a new statistic in February 2011 called total social financing, which in addition to net new bank loans includes net new trust loans, bank acceptance bills, corporate bonds, non-financial corporate equity and funding from insurers (see Box 4: Shadow banking in the US and China compared). The total social financing statistic likely still does not capture all informal financing activities, but even so, the results are revealing. Outside net new bank loans, the sum of other forms of financing more than tripled from RMB1.9trn in 2008 to RMB6.3trn in 2010 although the annualized rate in Jan-Sep 2011 had eased to RMB5.5trn. Add on net new bank loans, which totaled an annualized RMB7.6trn in Jan-Sep 2011 and total social financing was RMB13.1trn, with the shadow banking sector comprising a stunning 42% of the total. A sign of the costs of financial repression, movements in the bank RRR are closely correlated with the aggregate data on net new non-bank financing activities (Figure 20).
Financial repression is also encouraging off-balance sheet bank activities and other lessregulated activities outside the official banking system
Fig. 20: Bank RRR and net new bank loans and other forms of financing
RMBbn 18 15
12
% 25 20 15 10 5
0
9
6
3
0
2002
2003
2004
2005
2006
2007
2008
2009
Note: Jan-Sep 2011 is an annualized figure. Source: CEIC and Nomura Global Economics.
19
On 1 January 2004, the PBC deregulated commercial bank lending rates, allowing banks to charge 0.9-2.0x the benchmark 1yr lending rate. On 29 October 2004 the ceiling on commercial bank lending rates was scrapped altogether (except for credit cooperatives).
24
November 2011
Utilizing the new social financing statistics, which is a net flow of funds concept (new issuance less redemptions and write-offs), we have attempted to tally the stock of total funds outstanding in Chinas economy; that is the official banking and shadow banking sectors combined. Data are available on outstanding RMB bank loans, which nearly doubled from RMB26.2trn at the end of 2007 to RMB52.9trn by September 2011, and outstanding corporate bonds, which increased more than five-fold from RMB0.8trn at the end of 2007 to RMB4.5trn by September 2011. To gauge total funds outstanding in the shadow banking sector, we simply accumulate the other components of the social financing statistics, of which the data first began in 2002, and assume that the outstanding amount before 2002 was zero for each component. The result is a more than four-fold rise in total funds outstanding in the shadow banking sector, from RMB4.5trn at the end of 2007 to RMB18.2trn by September 2011. Summing up outstanding bank loans, corporate bonds and funds in the shadow banking sector gives a grand total of RMB75.6trn, or 177% of GDP, as at September 2011 a 57% of GDP increase since the global financial crisis in 2008, revealing just how explosive the growth in 20 economy-wide financing has been (Figure 21).
We estimate that total banking and shadow banking funds outstanding totaled 177% of GDP as at September 2011
Fig. 21: Our estimate of total banking and shadow banking funds outstanding
RMBtrn 80 70 60 50 40
30 20 10 0 % of GDP 180
Shadow banking, lhs Corporate bonds, lhs RMB loans, lhs Total as a % of GDP, rhs
2002
2003
2004
2005
2006
2007
2008
2009
2010
Sep-11
100
Fig. 9
20
FitchRatings (2011) arrives at a similar number, estimating that total economy-wide financing would increase to 185% of GDP by the end of 2011. These estimates are also more in line with the broad money supply, which in September 2011 equaled 175% of GDP.
25
November 2011
Figure. 22: Illustrative examples in the US of the steps, entities and funding techniques involved in shadow credit intermediation
Function Step (1) Loan origination Step (2) Loan warehousing Step (3) ABS issuance Step (4) ABS warehousing Step (5) ABS CDO issuance Step (6) ABS intermediation Step (7) Wholesale funding Shadow banks Finance companies Single and multi-seller conduits SPVs, structured by broker-dealers Hybrid, TRS/repo conduits, brokerdealers' trading books SPVs, structured by broker-dealers LPFCs, SIVs, securities arbitrage conduits, credit hedge funds 2(a)-7 MMMFs, enhanced cash funds, securities lenders, etc. Shadow banks' funding* CP, MTNs, bonds ABCP ABS ABCP, repo ABS CDOs, CDO-squareds ABCP, MTN, repo $1 NAV shares (shadow bank "deposits")
Source: Shadow banking, Federal Reserve Bank of New York Staff Report No. 458, July 2010.
Fig. 10
The growth of shadow banking presents new challenges for Chinas policymakers. One is that the bank RRR, loan quotas and other quantitativebased monetary policy instruments aimed at the official banking sector are becoming less effective as they target what is a shrinking share of the overall financial system. Another is that, almost by definition, the different types of offbank balance sheet or non-bank financial activities are less regulated, heightening the risk of too much credit being generated and of credit being misallocated. Adding to these challenges is the opaqueness of the data, suggesting that Chinas shadow banking sector could be a lot larger than the official social financing statistic suggests. FitchRatings argues that the official social financing statistic fails to fully capture some RMB3.5trn of shadow banking activity, including letters of credit from domestic trust companies, lending by domestic non-bank financial institutions and financial claims on mainland 21 entities by Hong Kong-based banks. The latter has mushroomed in recent years as Chinese companies and banks seek cheaper funding overseas. We estimate that Mainland China-related exposure of Hong Kong financial institutions has nearly tripled from HKD1.1trn in 1Q 2009 to HKD3.7trn in Q2 2011, equivalent to 27.2% of the total assets of Hong Kong banks (Figure 22 23).
The growth of shadow banking presents new challenges for Chinas policymakers
21
A micro example of the flourishing "underground market" for loanable funds can be gleaned from the advertisements on the back pages of city newspapers, often listing only a single mobile phone number next to names such as "Easy Heaven Investments" and "Treasure Beautiful Gold Credit", Financial Times, 10 October 2011. 22 To put this surge in Hong Kong bank mainland-related claims into perspective, from 1Q 2009 to 2Q 2011, domestic property-related lending by Hong Kong banks rose by HKD410bn to HKD1.7trn, or 13% of the total assets of Hong Kong banks.
26
November 2011
25
20
15 10
5 0
Fig. 11
27
November 2011
Fig. 24: The SOE share of total urban employment and stock of fixed assets
% share 90 80
70 60 50
40 30 20 10
0 1950
Share of total stock of assets of industrial enterprises 1960 1970 1980 1990 2000 2010
Fig. 12
The performance of Chinas SOEs is puzzling in two respects. One is that labour productivity, or output per worker, in the SOE sector has been much stronger than in the private sector, whereas in most other countries it is the opposite. In 1999 to 2007, labour productivity averaged 5.6% per year in the SOE sector, versus 3.6% per year in the private sector (OECD, 2005, p.110). However, the SOE sectors high labour productivity is misleading, as it is driven by: 1) large declines in employment and 2) massive capital accumulation (Figure 25). By contrast, growth in total factor productivity (TFP) measuring output gains over and above increases in inputs of labour and capital has been relatively weak in Chinas SOE sector, at less than two-thirds of that in the private sector (OECD, 2005, p.111). TFP is driven by innovation by new technologies and managerial skill and is a better gauge than labour productivity of real efficiency gains.
The SOE sectors high labour productivity is misleading, as it is driven by: 1) large declines in employment and 2) massive capital accumulation
The SOE sectors growth in total factor productivity has been relatively weak
28
November 2011
Source: Product Market Regulation and Competition in China - OECD Economics Department Working Papers No. 823, 2010
Fig. 13
A related puzzle is that, despite relatively low TFP, the SOE sector as a whole has remained profitable, with high retained earnings to plough back into new investments. This is because after almost 30 years of economic reforms, while nearly all product markets have been liberalized, the factor markets remain heavily distorted through a raft of generous government subsidies to SOEs (see Box 5: Investment is high, but savings are even higher). Subsidies include low effective tax rates; under-pricing key inputs, such as energy, water, 23 land, and capital; keeping the RMB undervalued; allowing low or no dividend payouts; charging little or no royalties on resource extraction; barriers to entry in some industries; and only lightly enforcing environmental protection, 24 workers rights and work place safety (e.g., coal mines). One study estimates that these factor market distortions could be costing the economy almost 10% of GDP in terms of lost efficiency (Huang 2010). Another study of a sample of over 3,000 firms shows empirically that private firms, where managers have complete de facto autonomy in corporate decisions from the state, do indeed have better operating efficiency under various metrics (Gan et al, 2008). In contrast, despite preferential treatment, many of the smaller SOEs still make losses or barely break even in 2007, one in five SOEs earned a negative return (Conway, Herd, Chaalaux, 2010, p.19). Government support for the massive yet inefficient use of capital by SOEs is likely contributing to wasteful investment of scarce resources and environmental degradation, and goes completely against efforts to rebalance GDP growth from investment to consumption (see chapter: The setting in of growing pains).
Despite relatively low total factor productivity, SOEs as a whole have remained profitable due to a raft of generous government subsidies
Government support for the capital-intensive goes completely against efforts to rebalance GDP growth from investment to consumption
23
The latest estimates of the IMFs Consultative Group on Exchange Rates indicate that the RMB is undervalued by 3-23%, IMF (2011a, p.18). 24 In China, all land belongs to the state and local governments who have the discretion to sell industrial land use rights to companies for up to 50 years. In many cases the industrial land is provided cheaply or even free to companies in order to attract investment. The price of water in China is about one-third of the global average, while the cost of electricity is also relatively low (IMF 2011a, p. 20).
29
November 2011
Chinas potential output growth looks set to slow this decade, increasing the urgency to boost total factor productivity
A more enduring challenge to reforming Chinas industry structure relates to an asymmetric information problem in the banking sector
Chinas four largest banks, which are still majority stateowned, maintain a strong bias to lend to SOEs, largely irrespective of credit risk
From the accounting identity, gross domestic savings is equal to gross domestic investment plus the current account balance. Hence Chinas savings are higher than investment because of a current account surplus of 5.2% of GDP in 2010. 26 Until 2004, interest rates set by commercial banks were not permitted to be more than 10% above the benchmark lending rate, but the band has been progressively widened and commercial bank lending rates are now only subject only to a floor, while deposit rates are subject to a ceiling.
30
November 2011
the past as banks are more actively starting to price credit risk. Yet at the grassroots level, Chinas bank loan officers still lack the skill and experience to properly assess credit risk a task compounded by opaque company 27 reporting data. This is creating a serious asymmetric information problem for Chinas lenders who are under increasing pressure not to make bad loans. As a result, creditworthy SMEs are being charged too high borrowing rates in relation to what they perceive to be their credit risk, thereby encouraging them to opt out of the loanable funds market and hence lowering the overall credit standard of the non-SOE loan market. This can have a snowballing effect. Nobel Prize laureate George Akerlofs famous market for lemons effect is starting to appear in Chinas non-SOE loans market (see Box 6: The Akerlof market for lemons problem applied to China).
A growing number of SMEs have been denied bank credit altogether and have to turn to the less regulated shadow banking sector
27
Perhaps the most publicized Chinese company accounting fraud case this year was Sino-Forest, which listed on the Toronto stock exchange in 1994, overstating its forestry holdings in Yunnan province by some USD900m. But this is one example of more than two dozen listed Chinese companies that have shown accounting discrepancies or seen their auditors resign so far this year, according to an article by David Pilling in the Financial Times, 1 September 2011. 28 According to the PBC's Wenzhou branch office, underground banking in the city is estimated to have reached RMB110bn by June 2011, equivalent to 18% of formal bank loans outstanding, see http://zj.people.com.cn/GB/15228039.html.
31
November 2011
Fig. 26: Informal lending rate in Wenzhou vs. official benchmark lending rate
% p.a. 30
Wenzhou informal lending rate
25
20
15 10 5
0 Sep-07
Sep-08
Sep-09
Sep-10
Sep-11
Fig. 14
The segmentation of Chinas credit market, through priority lending to large SOEs at the expense of SMEs, poses serious risks to the economy. For not only are the SMEs, on average, more productive than SOEs, they are also in many ways the life and blood of the economy: in 2009, Chinas 431,000 SMEs generated two-thirds of total industrial output, paid two-thirds of tax revenues and employed over three-quarters of the workforce (Figure 27). In recent months, the government has urged banks to relax credit standards to SMEs 29 but the quid pro quo could be higher bank NPLs.
The segmentation of Chinas credit market, through priority lending to large SOEs at the expense of SMEs, poses serious risks to the economy
*Note: SMEs are classified on the official definition which is based on employment, revenue and total capital size, which varies by industry. For example, SMEs by employment size are defined as <2,000 persons for industry, <3,000 for construction, < 200 for wholesale, <500 for retail sales, <3,000 for transportation, <1,000 for postal service and <800 for accommodation and catering. Source: China Statistical Yearbook 2010.
Fig. 15
29
In late September 2011, the city government of Wenzhou set a ceiling on the interest rate of loans made by non-bank financial institutions at 4x the benchmark lending rate (6.56%), while for banks the ceiling for the interest rate on loans to SMEs was set at 1.3x the benchmark lending rate. More significantly, the State Council on 12 October 2011 ruled that nationwide bank loan growth to small enterprises should not be lower than overall loan growth; bank loans of RMB5m or less to small enterprises can be treated as retail loans in determining credit risk weights and can be excluded from the banks aggregate loan-to-deposit calculation.
32
November 2011
China seems to have made a clear policy shift to accelerate the use of the renminbi in international trade and finance
30
For instance, firms can move capital to China by overstating export receipts and/or understating import expenses. Expectations of CNY/USD appreciation can also fuel speculative hot-money capital inflows.
33
November 2011
2010
Note: * These planned measures were announced by Vice Premier Li Keqiang during a special visit to Hong Kong on 17 August 2011, but have yet to be fully implemented. Source: Nomura Global Economics.
34
November 2011
Over the past year, the offshore use of the renminbi has grown tremendously. Renminbi trade settlement has surged from almost zero in 2009 to 10% of Chinas total trade in June 2011 (Figure 28), while trade settled in renminbi through banks in Hong Kong has increased 35x from RMB27bn (USD4bn) in H1 2010 to RMB953bn (USD146bn) in H1 2011, comprising one-third of total trade between Hong Kong and China (including offshore trade). At the same time, renminbi deposits in Hong Kong have grown exponentially from RMB103.7bn (USD15bn) in July 2010 to RMB609bn (USD95bn) in August 2011, equivalent to 6.8% of total deposits in Hong Kong (Figure 29).
Renminbi deposits in Hong Kong have grown exponentially from USD15bn in July 2010 to USD95bn in August 2011
RMB bn 800
600
4 3 2
1 0
400 200
0
Jun-10
Sep-10
Dec-10
Mar-11
Jun-11
Fig. 16
Fig. 17
However, the range and accessibility of renminbi financial instruments outside China is still small relative to the volume of renminbi that is building up offshore, leaving much of the renminbi being deposited at the Hong Kong clearing bank earning a low return. As a result, internationalization of the renminbi is adding pressure for China to accelerate capital account liberalization. Chinas government has allowed about RMB50bn (USD7bn) in Hong Kong to be invested in Chinas interbank bond markets, a similar amount to return as inward FDI and plans are underway to launch an RMB-based QFII (Qualified Foreign Institutional Investors) scheme of RMB20bn (USD3bn) to invest in Chinas capital markets (IMF, 2011a, p.14). However, if the renminbi is to become truly an international currency, Chinas capital controls will have to be eliminated so that foreign investors can freely invest in RMBdenominated assets and easily repatriate their capital and income. Yet even following the best practice of carefully sequencing capital account 31 liberalization , the lessons from other emerging markets, including those in Asia in the late 1990s, is that foreign capital can come pouring in, whether it be foreign portfolio investment or China's banks and companies stepping up borrowing from overseas. Without a strong regulatory infrastructure and appropriate safeguards, capital can be misallocated, fueling rapid credit growth, asset price bubbles and an overheated economy. The economic boom can then turn to bust, through diminished competitiveness, a worsening current account, rising NPLs and a loss of investor confidence triggering capital flight. With a war chest of FX reserves and a large current account surplus, China is not, in our opinion, vulnerable to a balance of payments crisis, but that does not rule out the possibility of large net capital outflows and a drawdown in FX reserves particularly given that China's M2 money supply has swelled to 175% of GDP as of September 2011. Indeed, a freer capital account amid severe financial repression can increase the incentive for China's savers to flee negative real bank deposit rates in favour of higher returns abroad.
Internationalization of the renminbi is adding pressure for China to accelerate capital account liberalization
Based on international experience, if capital account liberalization happens too fast, without appropriate safeguards, it can cause financial crises
31
Although certain rules about sequencing capital account liberalization for example, countries should liberalize long-term flows before short-term flows, and foreign direct investment before portfolio investment have the appeal of simplicity, the fungibility of capital makes their practical application difficult.
35
November 2011
Faster capital account liberalization can also speed up domestic financial deregulation. With freer capital movement it will become more difficult for the PBC to both manage the exchange rate and have autonomy over monetary policy. With the exceptions of small and very open economies, like Singapore and Hong Kong, the conventional macro policy approach under a freer capital account is to gradually relinquish control over the exchange rate and focus instead on setting domestic interest rates. Indeed, quantitative-based monetary policy instruments, such as credit quotas, are easier to circumvent under a freer capital account (for example, by companies increasing borrowing from overseas), undermining their effectiveness. However, if the primary instrument of monetary policy is to be the policy interest rate, to be effective in influencing the price of money and credit it 32 becomes necessary to deregulate bank deposit and lending rates. China still imposes a floor on bank commercial lending rates (0.9x the benchmark 1yr lending rate) and a ceiling on bank deposit rates. While deregulating these interest rates should increase the efficacy of monetary policy, it is not without risks. Without strong regulatory and supervisory frameworks, interest rate deregulation can pressure banks to engage in overly aggressive competition to 33 attract customers and maintain market share. By raising deposit rates and cutting lending rates it can shrink the profit margins of banks; worse still, it could also encourage them to start taking on riskier loans to compensate for the drop in profits. The overall loan quality in the banking system would decline, heightening the risk of a financial crisis. Another risk related to financial liberalization can stem from developing the local private debt markets. Until 2004, Chinas private debt market was small and heavily regulated, but since then regulations have been relaxed and debt issuance by non-finance firms more than tripled to RMB1.5trn (USD226bn) in 2010 (Figure 30). There are a number of advantages in deepening the debt market in tandem with capital account liberalization and interest rate deregulation. Deeper debt markets can: 1) help absorb larger capital inflows; 2) develop a yield curve and increase the potency of monetary policy; and 3) diversify credit risks away from the banks. However, developing the private bond market can increase competition between banks, as large companies choose to increase borrowing directly from investors by issuing debt. Without adequate supervision, losing market share of high-grade corporate customers to the bond market could pressure banks to lower their credit standards to attract new customers. This happened in Japan in the 1980s and contributed to its unprecedented asset price bubble (see Box 8: Risks associated with financial liberalization: lessons from Japan).
Faster capital account liberalization can also speed up domestic financial deregulation
Interest rate deregulation can pressure banks to engage in aggressive competition, leading to a drop in credit standards
Another risk related to financial liberalization can stem from developing the local private debt markets
Losing market share to the bond market could pressure banks to take on riskier loans to attract new customers
32
In China's current credit tightening cycle there has been a surge in mainland institutions borrowing from Hong Kong banks and debt issuance in Hong Kong's bond market. 33 Rather than interest rate deregulation, the risk could stem from other forms of financial deregulation, such as relaxing controls on the issuance of new lending products which can be counterproductive when complimentary factors such as commercially orientated loan officers and consumer familiarity with the risks of new financial products are lacking. For example, domestic financial liberalization in Korea resulted in a crisis in 2003 when credit card debt as a share of GDP more than tripled between 1999 and 2002, and the average number of credit cards for every adult in the country rose from one to three.
36
November 2011
1,800 1,600
1,400
1,200 1,000 800 600 400 200
2004
2005
2006
2007
2008
2009
2010
Jan-Sep 2011
Note: Commercial paper issuance was allowed from May 2005 for maturities of 1yr and below. Issuance of so-called medium-term notes was allowed from April 2008. Source: China Government Securities Depository Trust & Clearing Co. Ltd.
Fig. 18
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Yen trn
20 Bond with Warrants (overseas) Convertible Bonds (overseas)
18
16 14 12
10
8 6 4 2 0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Interest rate deregulation Deregulation of interest rates made for another source of aggressive bank lending behaviour. Bank deposit rates had long been set at low levels by the authorities to provide banks with sufficient interest rate margins. The interest rate deregulation schedule started by removing the interest rate ceiling for large deposits of JPY1bn or more in October 1985; for deposits of JPY500m or more in April 1986; for deposits of JPY50m or more in April 1988; and for deposits of JPY10m or more in October 1989. Interest rates for certificates of deposit were also rapidly deregulated in the 1980s. Abolishing the interest rate restrictions sparked fierce competition among banks to raise deposit rates to attract new customers. To reduce interest rate margin pressure, financial institutions started to seek out riskier customers that were willing to pay higher borrowing rates.
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Labour supply
D2
D1
Labour pool
Fig. 19
Surveying the recent literature, empirical studies have reached no firm 34 conclusions on whether China is at the LTP. Taking a different approach, we find an interesting pattern in countries that have already passed the LTP. In Japan it was in 1965 when employment in the secondary sector (manufacturing and construction) overtook that in the primary sector (mostly agriculture) that real manufacturing wages started to surge (Figure 33). A strikingly similar phenomenon happened in Korea in 1987. In China, employment is still largest in the primary sector, but on current trends it will be overtaken by employment in the secondary sector in 2015.
Empirical studies have reached no firm conclusions on whether or not China is at the LTP
34
Knight, Deng and Li (2011), Zhang, Yang and Wang (2010) and Cai and Wang (2008) conclude that China is at, or near, the LTP. On the other hand, work by Minami and Ma (2010), Du and Wang (2010), Wang (2010) and Garnaut (2010) conclude that the LTP has yet to be reached.
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Fig. 33: Primary, secondary and tertiary employment and real wage growth Japan
Employment, Mn 60 50 40
South Korea
% y-o-y 20
15 10
China
% y-o-y 25 20 15 10 5 0 -5 -10 -15 -20 2010
Employment, Mn
30
20 10
5
0 -5
ent, Mn
0 1954
1968
1982
1996
-10 2010
% y-o-y
F
450
400 350
25
20 15
10 5 0
-5 -10
2002
Secondary, lhs
Tertiary, lhs
Source: Japans Ministry of Internal Affairs and Communications and Ministry of Health and Labour; CEIC and Nomura Global Economics.
Fig. 20
At first glance it would appear that China is near, but not yet at, the LTP, and it is true that lower-end manufacturing is moving inland to areas where labour is more plentiful and cheaper. However, we believe that most of the recent empirical studies have ignored three critical factors that, taken together, suggest to us that the LTP is upon China. The first is demographics (see chapter: The setting in of growing pains). Based on projections by the United Nations, Chinas 15-24 year-old age cohort1986 will 1962 1970 1978 fall from 16.8% of the total population in 2010 to 14.6% in 2015 and 12.8% in 2020, resulting in there being fewer young, productive workers willing to leave the countryside to work in factories. In contrast, the 15-24 age cohort was 20.3% in Japan in 1965 and 21.1% in Korea in 1985. Second, the focus should be on total labour benefits, not just wages. Chinas wages are growing strongly: in 2010, the average wage grew by 13.3% and the average minimum wage jumped 22.9% and by a similar magnitude in 2011, but other components of labour compensation have surged even more. As in Japan in the early 1970s, there are signs that Chinas workers are becoming increasing aware of their fair share of entitlements from social welfare benefits to better working conditions as evidenced by the surge in the 35 number of labour disputes. It is intriguing that there was a structural break in Chinas labour disputes in 2008, and the same pattern happened in Japan in 36 the early 1970s, coinciding with the wage surge there (Figure 34).
We believe that most studies have ignored three factors that, taken together, suggest to us that the LTP is upon China
2002
35
According to research by Huang (2010), if companies strictly follow policies on social welfare contributions, commonly the payrolls of migrant workers would have to rise by at least 35-40%, including contributions to pensions (20% of payroll), medical insurance (6%), employment benefit (2%), work injury insurance (1%), maternity benefit (0.8%) and housing entitlements (5-10%). 36 In the early 1970s Japan experienced an outbreak of inflation, in part driven by the 1973-74 oil crisis, but also the flow of surplus rural labour moving to the cities started to diminish in the 1960s, leading to increased worker bargaining power, as evidenced by the surge in labour disputes, not only for higher wages but also better working conditions the so-called Lewis turning point (Minami, 1973).
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No. of labour disputes in Japan in thousands, lhs No. of labour disputes in China in 100 thousands, lhs Japan's real wage growth, rhs
% y-o-y 12
9
6 3 0 -3 -6 2010
Source: Bank of Japan; Chinas Ministry of Human Resources and Social Security and Nomura Global Economics.
Fig. 21
This may have been triggered in part by Chinas new labour laws in 2008 and the exponential increase in user-penetration of the internet and mobile phones. The new labour laws have empowered low-paid workers by making it mandatory to have written labour contracts, enforcing the payment of overtime, paying salaries on time, and being enrolled in a social security program. It is also now easier for workers to file complaints against employers in the arbitration tribunals or courts. If we aggregate data measuring compensation of labour in Chinas 31 provinces, which is based on the income measure of GDP, it shows that this broader measure of firms labour costs grew much faster than average national wages in 2008-09, although both series returned to a similar rate of still-fast growth of around 16-17% last year (Figure 35).
This may have been triggered in part by Chinas new labour laws in 2008
15 10
5 0 1994
1996
1998
2000
2002
2004
2006
2008
2010
Fig. 22
The third reason is the rising opportunity costs of migrating from the agricultural sector, if food prices keep rising, lifting incomes in the countryside. Food prices have soared in recent years and we expect them to continue to climb, underpinned by burgeoning demand from the worlds rapidly developing and most populated economies. In these economies, diets are changing towards a higher calorie intake, while agricultural supply faces many constraints and uncertainties, such as greater use of biofuels, global warming and increasing water scarcity (see Special Report, The coming surge in food prices, Nomura Global Economics, 8 September 2010). The rigid hukou household registration system, by making it extremely difficult for rural migrants to obtain a permanent urban resident permit and thereby gain the same access to the deepening social welfare systems as locals, could also become a growing constraint on urbanization, as costs in the cities rise.
The third reason is the rising opportunity costs of migrating from the agricultural sector
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A surge in wages is no doubt positive for household consumption and helps facilitate internal rebalancing, but if it happens too fast, particularly if productivity growth fades, then it can eat into profit margins, erode export competitiveness and, if passed on to consumers, trigger a serious outbreak of inflation. Indeed, because of the LTP, but also due to the need to deregulate the government's underpricing of key natural resources and a likely multi-year surge in food prices, our base case is that CPI inflation will average around 5% from 2011 to 2015, compared to 2% over the past decade, see Asia Special Report, China: The case for structurally higher inflation. 21 September 2011.
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China is facing growing pains from worsening demographics and increasing strains on natural resources and the environment
Demographic challenges
China is in the midst of a huge demographic shift. A rapidly ageing population, a shrinking labour force and a sex ratio heavily skewed toward males are 37 creating new challenges (Figure 36). The one-child family policy was introduced in 1978 and has brought the fertility rate down to about 1.6. Because of low fertility and rising life expectancy, the UN projects the share of people aged over 60 in the total population to rise from 12.3% in 2010 to 15.1% in 2015 and to 17.4% in 2020, increasing the number of 60+ year-olds over this period by 76m. Meanwhile, the share of 15-24 year-olds in the total population is projected to fall from 16.8% in 2010 to 14.6% in 2015 and to 12.8% in 2020, decreasing the number of 15-24 year-olds over this period by 47m. Chinas age pyramid is projected by the UN to change shape dramatically in the next two decades (Figures 37 and 38), while the World Bank (2011a) expects total employment to start to shrink from around 2015.
China faces a rapidly ageing population, a shrinking labour force and a sex ratio heavily skewed toward males
Fig. 36: Key demographics indicators and projections for China, by the United Nations
Population, millions Working age population, millions Median age, years Young population aged 15-24, % total Elderly population aged 60+, % total Old age dependency ratio - aged 65+, % 15-64 Child dependency ratio - aged 0-14, % 15-64 Total dependency ratio - aged 0-14 and 65+, % 15-65 Fertility rate, child births per woman Net reproduction rate, No. of daughters per woman Population sex ratio, males per 100 females Sex ratio at birth, No. of male births per one female 2000 1269 857 29.7 15.5 10.2 10.4 37.7 48.1 1.80 0.78 107.5 1.18 2005 1308 923 32.2 17.0 10.9 10.7 31.0 41.7 1.70 0.73 107.8 1.21 2010 1341 971 34.5 16.8 12.3 11.3 26.9 38.2 1.64 0.71 108.0 1.20 2015 1370 996 36.2 14.6 15.1 13.0 24.5 37.5 1.56 0.69 108.0 1.18 2020 1388 989 38.1 12.8 17.4 16.8 23.5 40.3 1.51 0.68 107.8 1.16 2025 1395 981 40.1 11.7 20.2 19.9 22.3 42.2 1.53 0.69 107.5 1.15 2030 1393 960 42.5 11.4 24.4 23.9 21.2 45.1 1.58 0.72 107.1 1.14
Fig. 23
37
Chinas one-child policy officially restricts married, urban couples to having only one child, although it allows exemptions in several cases, including for rural couples, ethnic minorities and parents without any siblings themselves.
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Female
Male
Female
Male
70 60 50 40 30 20 10 0 10 20 30 40 50 60 70 Millions
70 60 50 40 30 20 10 0 10 20 30 40 50 60 70 Millions
Fig. 24
Fig. 25
Chinas rapidly ageing population will increase the strain on the countrys relatively undeveloped health and pension systems, and could increase tensions in society (see section in this chapter: Rising inequality and an aspiring middle class). Young urban couples, many of them without siblings, will find themselves with four parents to look after and will themselves have only one child (known in China as the 4-2-1 phenomenon). Perhaps the more alarming concern for population sustainability is the large imbalance between baby girls and boys. Women are bearing only 0.71 girls over their lifetime, well below the replacement figure of just over unity. In 2010, there were 51m more men than woman in the country. The sex ratio among newborns is 120 boys for every 100 girls, the highest in the world (Figure 39). At this rate, there will not be enough brides for as many as one-fifth of todays baby boys when they get to marrying age, heightening the risk of social tensions.
The rapidly ageing population will increase the strain on the relatively undeveloped health and pension systems, and could increase tensions in society
Fig. 26
As a result of Chinas ageing population, potential output growth looks set to slow, possibly quite sharply in the next 5-10 years. The contribution of labour to Chinas potential output growth is estimated by the World Bank to have declined from an average of 3.3pp in 1978-94 to 1.0pp in 1995-2009, and is projected to decline further to -0.5pp in 2016-20 (Figure 40). In the past two decades, the decreasing contribution of labour to Chinas potential output growth was not a major concern as it was offset by capital deepening, with capital accumulation adding a hefty 5.8pp to potential growth in 1995-2009. But capital deepening has lifted the investment-to-GDP ratio to an extraordinarily high level of almost 50%, limiting the scope for further increases in the contribution of capital to potential output growth. The implication is that Chinas potential output growth, which has been remarkably stable in the last three decades, could slow abruptly this decade unless total factor productivity (TFP) can be boosted, i.e. unless China uses its labour and capital more 44
China Korea India Hong Kong Greece Ireland Singapore Australia Czech Denmark Germany Italy Japan Malaysia Netherlands New Zealand Philippines Poland Portugal Russia Spain Sweden Thailand Brazil Canada Colombia Egypt Finland France Iceland Indonesia Mexico Norway Pakistan Switzerland Turkey UK US Vietnam Argentina Sri Lanka Saudi Arabia South Africa
The prospect of a shrinking workforce means that Chinas potential output growth is likely to slow, possibly quite sharply in the next 5-10 years
November 2011
efficiently. The World Bank is not optimistic, projecting Chinas potential output growth to slow from an average of 9.6% in 1995-2009 to 8.4% in 2010-15 and to 7.0% in 2016-20. If potential growth slows too sharply, excess demand 38 could fuel runaway inflation and/or swing the current account into deficit.
Fig. 40: Estimates of potential output growth past and future
% y-o-y Potential output growth Employment growth Labour productivity growth - From total factor productivity (TFP) growth - From capital deepening 1978-94 9.9 3.3 6.4 3.0 3.4 1995-2009 9.6 1.0 8.6 2.7 5.8 2010-15 8.4 0.2 8.2 2.3 5.9 2016-20 7.0 -0.5 7.5 2.3 5.2
Source: Kuijs, L., China Through 2020: A Macroeconomic Scenario, World Bank, China Research Working Paper No. 9, June 2009.
To try to avoid a shrinking workforce, new policies could be implemented. For example, Chinas hukou household registration system, which discriminates against the social rights of migrant workers, could be relaxed (see Box 9: Chinas hukou household registration system). Relaxing the hukou system, which links most health and education benefits to the area where the person is registered rather than living, should help ease the wide income inequalities and encourage more labour mobility and faster urbanization. In turn, this could boost TFP given that productivity in agriculture is about 6x less than in the rest of the economy. Urbanization also creates larger cities, which generate economies of scale due to specialization, information spillovers and clustering. In the countryside, it would also facilitate the much-needed consolidation of farmland holdings, providing economies of scale and greater scope for modernization, hence boosting agriculture productivity. However, the challenge is that these reforms, while helping to encourage urbanization and labour mobility, risk generating other negative externalities. Already, with half of the 1.3bn population living in urban areas, the strain on the bigger cities is intensifying in terms of resource constraints, environmental concerns and social tensions. A good example is Beijing, the capital city, where the population has soared from 15.4mn in 2005 to 19.6mn in 2010, a cumulative increase of 27.5%, dwarfing the 2.5% increase in the nationwide population over this five-year period (Figure 41). No surprise the authorities in Beijing are introducing stringent measures to limit motor vehicle ownership, and in August 2011 shut down 23 schools for migrants across the capital.
China could relax the hukou household registration system to encourage urbanization, but at the risk of generating other negative externalities
38
As economies develop it is common for the initial high rates of TFP growth to slow, as productivity catch up and the flow of surplus labour from the less productive agricultural sector to the more productive manufacturing and services sectors starts to ease. More specifically for China, the recent investment boom has been led by public infrastructure projects, of which the return on capital tends to be relatively lower than private investments and can take longer to be realized. One hope to lifting Chinas TFP is from a boost in human capital. The number of university graduates rose more than 6x between 2000 and 2010 to 384mn, although a large share are struggling to find jobs.
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National
Jiangxi
Heilongjiang
Shandong
Zhejiang
Jiangsu
Mongolia
Chongqing
Ningxia
Gansu
Liaoning
Fig. 27
Rising living standards have so far satisfied the aspirations of Chinas growing middle class
However, rising inequalities within China could spur increasing civil unrest
46
Guizhou
Xinjiang
Shaanxi
Qinghai
Shanxi
Jilin
Sichuan
Yunnan
Fujian
Guangxi
Hunan
Hainan
Henan
Hubei
Hebei
Anhui
Tibet
November 2011
39
Chinas most charismatic politician. Certainly, he has proved himself to be adept at striking a chord with ordinary Chinese through a combination of his crackdown on corruption in Chongqing since he assumed his current post in 2007 and his media-savvy skills. So, it is in our view safe to assume that with his July 2011 public statement in support of greater social equality dividing the cake up well in addition to making the cake bigger he was again striking a chord with many Chinese which, while arguably populist, nevertheless has a firm foundation in contemporary China. Indeed, President Hu Jintao seemingly made a similar point during his joint press conference in Washington with President Barack Obama in January 2011. Asked about human rights in China, he placed great emphasis on economic rights, highlighting the fact that China still has over 250mn citizens living close to the poverty line despite the tremendous strides it has made in poverty alleviation over the past three decades or so. The data support these concerns. Notably, in a study published in 2002 not long before the handover of power to the current (fourth generation) leadership, Newton and Subbaraman (2002) noted that Chinas Gini coefficient a common measure of income inequality rose from 28.8 in 1981 to 38.8 in 1995, and has risen further to 39.0 in 1999, close to internationally recognised danger levels. According to the United Nations 2010 Human Development Report, as we look forward to the handover of power to the fifth generation leadership a year or so from now, Chinas Gini coefficient has risen 40 still further to 41.5 in 2005 (latest data available). By a widely recognised yardstick, inequality is therefore now at a level where it may pose a significant risk to social stability. On simpler but more timely yardsticks of income inequality, Chinas average household income in urban areas has increased to more than three times that in rural areas; and within urban areas, average income of households in the top 20% income decile have risen to more than eight times that of households in the bottom 20% income decile (Figures 42 and 43).
and standard measures support the view that there may be some risk to social stability
Fig. 43: A gauge of urban household income inequality: the ratio of highest and lowest income deciles
Ratio 10
Ratio 3.5
3.0
2.5
2.0
1.5 1978 1982 1986 1990 1994 1998 2002 2006 2010
Fig. 28
Fig. 29
Calls for more redistributive policies in response do not enjoy universal support
One way of addressing this issue would be through the adoption of more redistributive policies which some commentators (e.g. the Economist Intelligence Unit (EIU) in an article published on 30 September 2011) have suggested Bo Xilai (who is experimenting with a property tax in Chongqing) was advocating as part of what has become known as the Chongqing model, marrying leftist rhetoric/policies with a strong anti-corruption drive. This approach is widely seen as an alternative to the so-called Guangdong model promoted by, among others, Wang Yang, head of the CCP in Guangdong
39
Bo Xilai, China's most charismatic politician, makes a bid for power by Clifford Coonan, The Independent, 8 March 2010. 40 The Gini coefficient ranges theoretically from 0, when everyone has exactly the same income, to 100 when a single individual receives all the income of a society.
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province and Bo Xilais predecessor in Chongqing, which adopts a more liberal approach both politically and economically but one which, in our view, has the potential to generate greater public dissatisfaction. In effect, with both Bo Xilai and Wang Yang widely seen as potential candidates for promotion to the Politburo Standing Committee next year, these contrasting approaches can be viewed as a de facto election issue. Furthermore, with others, including Premier Wen Jiabao and his predecessor Zhu Rongji (calling, respectively, for bolder political reform and faster economic reform) recently weighing in, this appears to be an ideological struggle which may be a key determinant in the make-up of the fifth generation leadership and the policies it pursues. But how extensive is social unrest in reality? Gauging the true extent of social unrest in China is far from straightforward. The international press frequently cites numbers from 80,000 upwards per year for mass incidents the majority historically revolving around environmental issues (where the Green movement has emerged over the past decade as the most notably organised manifestation of civil society in China). However, the definition of mass incident is not clear-cut and official reporting may not be entirely reliable; furthermore, the Ministry of Public Security has not published data since it cited 87,000 incidents of public order disturbances (a broader category than mass incident) in 2005. However, as Will Freeman of GaveKal Dragonomics noted in an article published last year: Anecdotal evidence over the last five years suggests a rise in angerventing mass incidents large-scale, often violent, riots that erupt from seemingly minor incidents and reflect general discontent rather 41 than specific rights violations. Although we agree that there is no reason to believe that even the upper estimates of social unrest pose an immediate threat to the CCPs grip on power, we also accept that no government can be sure of its longevity in the face of increasing unrest and a failure to address the underlying causes. Stress in the city According to Chinas 2010 census, around 670mn people now live in towns and cities almost exactly half the total population. History (including recent events in the MENA) teaches us that it is urban, rather than rural, unrest to which regimes are especially vulnerable. However, the continued existence of the hukou household registration system (see Box 9: Chinas hukou household registration system) means that in todays China there is a significant overlap between rural and urban citizenship. The hukou system officially restricts labour mobility thereby effectively discriminating against farmers moving to work in the city. According to the OECD (2011, pp.163-165), Chinas 2005 census estimated the total number of rural-to-urban migrants without a local hukou at 74mn and unofficial migrants in urban areas at 39% of the urban labour force in 2005 (Figure 44). Total labour compensation of migrant workers without a hukou is sometimes only half of that of urban residents, even if they perform the same job functions, according to research by Huang Yiping (2010).
We believe that the hukou system helps perpetuate inequality in the cities but we see no reason to believe that the CCPs grip on power is currently under threat Gauging the true extent of social unrest remains difficult
41
The accuracy of Chinas mass incidents, Will Freeman, Financial Times, 2 March 2010.
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45.2 61.7 106.9 4.9 15.0 19.9 50.1 76.7 126.8 As % of population or employment living in an area 13.1 2.4 7.0 16.5 1.0 6.6 22.5 3.1 11.4 22.6 3.1 10.1 9.4 0.7 4.4 39.1 4.1 16.7
Fig. 30
If the status quo persists, the tensions to which these inequalities inevitably give rise look set to deepen. According to a report published early in 2011 by Chinas National Population and Family Planning Commission, the next decade will see a further 100mn Chinese migrate from rural to urban areas. Indeed, another recent report this one by the Hong Kong-based China Labour Bulletin claimed that the so-called new generation workforce, i.e. workers born since 1980 who account for nearly half of the total number of internal migrants, is the driving force behind increasing labour unrest and strikes in an at least a partly successful quest for better pay and conditions. In response, as the EIU notes in its May 2011 Risk Briefing on China, the authorities have adopted a range of policies which are broadly supportive of workers, at least in part to try to address discontent arising from socioeconomic inequality. These include: raising the minimum wage, improving labour regulation and permitting local unionisation and a degree of collective bargaining. There is some recent evidence that, despite the authorities efforts to prevent a mass labour movement from developing, modern communications are facilitating wider cooperation (e.g. the recent case of industrial action by cab drivers which spread to a number of cities). However, the EIU continues to place only a moderate probability on a labour movement emerging in the foreseeable future which could pose a significant challenge to the government. No taxation without representation? On the other hand, reform of the status quo whatever its direction stands to run into headwinds from constituencies which benefit from, and therefore favour, the current system. Notable among these is Chinas burgeoning middle class, whose aspirations to date have been satisfied without political reform. Indeed, it has long been our view that the implicit understanding between Chinas leaders and its citizens is that political reform would be a nettle to be grasped by the fifth generation leadership, but not until the second half of its expected period of office, i.e. from 2017 onwards provided, that is, that the latters expectation of continuing economic betterment is fulfilled. That said, as The Economist pointed out in its June 2011 special report on China, the introduction of new and higher taxes on the middle classes e.g. as part of an overall more redistributive shift may stir demands for a say in how their money is spent.
and that persisting with it risks increased labour and wider unrest
Any reform of the status quo is likely to run into headwinds from vested interests
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Stepping stones prevail for now For the time being at least, just as is the case with labour policy, we believe that Deng Xiaopings famous analogy of crossing the river one stepping stone at a time is likely to prevail. In particular, as The Economist put it in its June 2011 special report on China: For now the party would rather deal with angry underdogs than with an embittered bourgeoisie. This may in part at least account for the recent boost in spending on internal security which, according to the 2011 annual budget unveiled on 5 March 2011, is now higher and growing faster than defence spending. Another reason behind this could be Chinas demographics, discussed in the previous section. A recent book by science journalist Mara Hvistendahl (2011) examining the implications of the gender imbalance in China (and in India) pointed to a possible link with the expansion over the past several years of the paramilitary Peoples Armed Police, military service being a safety valve historically for the pressures which surplus male populations can create. Ms Hvistendahl goes on to suggest that such imbalances can be as destabilising as climate change, potentially sparking crime, cross-border trafficking and even wider conflict. Indeed, she finds statistical evidence that crime, including violent crime, is 42 rising already in cities in China where the gender skew is greatest. As the EIUs May 2011 Risk Briefing reflects, local protests over a whole range of issues notably inflation, pay, factory closures, environmental issues and corruption are set to continue. Especially with no official channels such as elections through which citizens can register their opinions, these can and do act as a valuable safety valve. Furthermore, as with labour disputes, modern communications (which already facilitate the organisation of social unrest at the local level) bring with them a greater risk of copycat action and even the emergence of a regional or national protest movement of some sort. Nevertheless, as the EIU concludes rapid economic growth and the lack of a figurehead make a national uprising unlikely for the time being. Less haste, more speed All that being said, an accident (attributed by the head of the official inquiry to an as yet unspecified design flaw) near the eastern city of Wenzhou on 23 July 2011 involving two high-speed trains, in which 40 people were reportedly killed, may have significant consequences on the aspirations of the middle classes in particular (as well as being something of a set-back to Chinas highspeed rail (HSR) programme). HSR is a high prestige project which has enjoyed the full backing of the top leadership and which is supposed to showcase Chinas ability to absorb and improve imported technologies. Compounded by what is widely perceived as the authorities clumsy handling of the aftermath of the crash, both the press (including the state-controlled media), despite official warnings to desist from negative reporting, and Chinas weibo networks (i.e. the domestic equivalent of twitter) have repeatedly and strongly challenged official statements and even openly criticised the government. Some commentators have suggested that the slow official response may reflect high-level disagreement over how to handle the matter; and even that this could, in turn, spill over into the selection process for the fifth generation 43 leadership. If that is correct, it may, in turn, bear on the speed with which the fifth generation feels able or obliged to initiate some sort of political reform process. Quite how China will evolve politically is far from clear. But what is clear is that, compounded by growing inequalities, the status quo looks increasingly unsustainable in the medium-term and that evolution there will have to be if something more wrenching is to be avoided.
42
Overall, however, a national uprising remains unlikely, for the time being at least
Nevertheless, political reform may come more quickly than previously expected
Unnatural Selection: Choosing boys over girls, and the consequences of a world full of men, Mara Hvistendahl (Oxford University Press, 2011). 43 See, for example, Curiouser, The Economist, 6 August 2011.
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That is not to contradict our earlier suggestion that the Arab Spring was unlikely to spread to China: indeed, far from it. But the chatter on the weibo networks does appear to have been of a very different nature to the established patterns of social unrest. It is, therefore, not impossible that the 23 July train disaster will be looked back upon in due course as a benchmark moment in accelerating Chinas socio-political evolution.
44
Furthermore and directly related to the issue of food security analysis of the composition of cereal production reveals that since the 1980s growth of output of corn (at 3.5% pa) the key crop for the biofuel industry (as well as animal feed) has been significantly faster than is the case for wheat (2.5%) and rice (1.2%). However, this growth in corn production has been achieved not simply through improved productivity but also through the reallocation of land out of rice and wheat into corn. Based on the experience of Japan, experts such as Robert Ash (2011) believe that China could be approaching a plateau in rice productivity and that switching
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52
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south (which is prone to flooding, although the incidence of drought is also increasing in some parts) and too little in the North China Plain in particular, a major cotton and wheat producing area where both surface and ground water is being depleted to dangerous levels. The practical implications of this can be illustrated by the fact that China went from being a net exporter of 1.9mn tons of wheat in 2003 to a net importer of 6.5mn tons in 2004 due to drought (Figure 45).
Crude petroleum, 10m tons Soybean, 10m tons Cereals, m tons Copper, m tons Coal, 10m tons
Balancing priorities In 2008, China consumed 43% of the worlds coal (meeting 70% of its energy demands) and 10% of its oil; it remains on target to overtake the US as the worlds largest consumer of energy within the next few years and is already the worlds largest emitter of carbon (in volume terms, but if measured per head of population, it is far from being the largest). Sustaining economic growth without compromising the environment requires leapfrogging to a low-carbon urbanisation model which focuses on clean energy supply, compact city design, enhanced public transport, green buildings and clean vehicles. Since anecdotal evidence consistently points to environmental issues (which include air quality, water pollution and food standards) as the biggest single cause of civil unrest throughout the past decade, this also matters in terms of social stability. In response, China needs to continue to increase energy efficiency and lift the share of low-carbon technologies. China already has the worlds largest installed wind energy capacity, yet how successful China is in meeting these challenges is of tremendous importance both domestically and globally, a fact which is fully recognised by the leadership notably, as long ago as 2006 President Hu Jintao proposed a new energy security concept at the G8+5 summit in St Petersburg noting the need for sustainable development of human society. Evidence from China itself over the past five years underlines that this is not merely rhetoric. Good progress has been made toward a more resourceefficient and environmentally friendly economy, and most targets are on track. The efficiency of water use has increased; forest cover is expanding and the long-standing uptrend of both SO2 and CO2 emissions has finally started to reverse. However, with rapid economic growth, immense environmental challenges remain. According to the World Bank, China accounts for 13 of the worlds 20 most polluted cities (admittedly down from 19 out of 23 in 2001). Energy efficiency (the amount of energy per unit of output) has been improving, but not by enough to achieve the targeted 20% reduction over 2006-10. According to a study by the World Bank (2008), if Chinas economy grows by 7.2% pa and the average energy intensity remains around current levels for the next 25 years, as experienced by other large economies during their early
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stage of industrialisation, Chinas energy consumption would reach around 12,750 million tonnes of coal equivalent by 2030 about 87% of the worlds 47 energy demand today. Entering international markets Chinas impact on hard commodity markets over the past decade, especially energy, is well documented. If the 95% self-sufficiency target does indeed prove increasingly unattainable, a similarly dramatic impact on international trade in food and global food prices over the course of the next decade 48 cannot, in our view, be ruled out. In an essay published earlier this year, Robert F. Ash concluded: The Chinese government will find it increasingly difficult to continue to fulfil its long-held target of maintaining 95% self-sufficiency in the provision of basic foodstuffs. As this target is abandoned, China's engagement in international grain markets will increase. This will prove to be a watershed for China, which has previously never wavered in its pursuit of basic food self-sufficiency. It may also prove to be a watershed for international food security through the impact on world cereal prices and supplies of China's emergence as a significant player in world cereal markets However, the cereal whose imports are likely to rise most sharply is corn. It is true that since 1996 China has, remarkably, been a net exporter of corn. But it is striking that the scale of such exports has contracted dramatically (from 16.4 million tons to a mere 0.05 million between 2003 and 2009). Accelerating demand for corn for both feed and biofuel is almost certain to outstrip domestic output growth in the coming years, thereby forcing China to resort to purchases from overseas especially from Latin America and the United States as a permanent feature of its agricultural trade.
Resource security and conflict Throughout history, resource security has been a major source of conflict and it is one to which we are certainly not immune today. Peter Gleick (2008) st identified over 50 occasions since the start of the 21 century where water had been an issue in some form of, often violent, conflict ranging from Afghanistan to Yemen. Without wishing to dismiss the importance of the conflict in the Darfur region of Sudan, which has been described by UN Secretary General Ban Ki-moon as the first climate change war of the 21st century, the impact of climate change on already stressed and/or disputed water resources may pose even bigger challenges for the international community as a whole in the foreseeable future. Notably, in his recent book Water: Asias New Battleground, Brahma Chellaney (2011) notes that China and India between them account for 37% of the worlds population but command only 10.8% of its water resources. Furthermore, much of Indias water comes from the (China-controlled) Tibetan plateau (which is, in fact, a key source for all the countries in an arc from Afghanistan to Vietnam). Combined with the gender imbalance common to India and China, one has to be concerned about the possibility that, exacerbated by climate change, water could indeed be the cause of a literal battleground between Asias two emerging superpowers in the not too distant future.
Historically, both climate change and resource security have caused violent conflict
47
The World Bank (2011a) estimates that if business as usual continues with respect to Chinas economic growth and energy efficiency, then by 2030 China is expected to import 75% of its oil and half of its gas. 48 A second and related trend is Chinas purchasing and leasing of large tracts of farmland in, in particular, subSaharan Africa. Accurate data on the scale of such investments are hard to come by, but a 2009 study prepared on behalf of the FAO and the UN estimated that nearly 2.5mn hectares of farmland had been allocated to foreign-owned entities in the five-year period since 2004 in just five African countries which the study considered. See Land grab or development opportunity? Agricultural investment and international land deals in Africa, by Lorenzo Cotula, Sonja Vermeulen, Rebeca Leonard and James Keeley (IIED/FAO/IFAD, 2009).
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Not that the definition of conflict should be restricted to acts of violence and/or war. Ronald Findlay and Kevin ORourke (2008) in their book Power and Plenty note a close correlation historically between the end of hegemon and rising protectionist pressures. While the economic justification including any possible link to competition for resources to rising protectionist pressures in the US is, at best, tenuous in our view, the recent passage through the US Senate of the Brown-Schumer bill seeking to punish China for its alleged currency manipulation clearly highlights the risk that history will 49 repeat itself.
49
US presidential and congressional elections on 6 November 2012, which could encourage the House of Representatives to follow through on the Senates recent action to pursue punishment of China over its alleged currency manipulation and especially if US unemployment remains sticky.
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The key conclusions for strategy from the economic discussion are: The size of the growth decline a true growth recession. The nature of the growth slowdown capex-led and balance-sheet constrained. The ineffectiveness of policy no rapid recovery. The persistence of some of the causes true change may be required on a number of fronts.
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57
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Chinese HY industrials would likely underperform the large cap HY property credits, impacted by significantly weaker earnings and credit profiles. Expect significantly more scrutiny over the default risk of the smaller cap property credits. The Hong Kong banks that have extended their balance sheets to Chinese banks and SOEs would likely be dragged to wider spread levels once again, though we believe some of these issues could be unfairly penalized.
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wholly reliant on the vague benefits of QE-style balance sheet expansion. Thus, the multiplier effects of a China hard landing could be bigger than one may initially think for short- and medium-term Western growth forecasts. 2. Supply chains and inflation A demand shock for China is also a supply shock for the countries it supplies. While measures of economic slack would increase as Chinese demand slows, leading to markets pricing in medium-term disinflationary pressures, a faster impact would be felt through lower consumer commodity prices i.e., oil, and by extension food prices, and the potential for inventory dumping into the EU and US. This happened during the Asian currency crisis and led to quite rapid durable goods price declines. While this softens the growth blow for Western consumers it is only temporary and it squeezes some corporate margins. We would expect headline CPI inflation expectations, in any event, to fall across developed markets initially from the fall in global traded goods and commodity prices.
Fig. 46: OECD measures of economic slack
10
8 6
4
2 0
-2
-4
-6 1Q90 1Q93 1Q96
What is more difficult to gauge is the medium-term impact on supply chains from a China shock of this scale and duration. Investors would naturally fear inventory dumping turning into competitive devaluations across the region in an effort to take a larger share of a slower growing global demand pie. This would no doubt increase investor concern about protectionist measures and tariff increases. It would be natural to expect investors to predict an initial increase in Chinas trade surplus in this scenario, adding to global imbalances rather than helping to close them. At the same time, we should probably expect capital outflows from China by both domestic and foreign investors. To keep the currency peg intact, as our scenario suggests, would require a slower pace of reserve accumulation, although perhaps by not as much as might be priced in if the trade balance improves. Nevertheless, reserve accumulation globally would be expected to slow, which could prove crucial to funding of Western government deficits in capital account deficit economies. 3. Balance sheets Which brings us on to balance sheet considerations. Slower growth in the OECD would naturally imply higher unemployment, slower profit growth and lower income and consumption tax revenues The result would be forecasts of larger government deficits at the same time as smaller trade surpluses, or larger trade deficits. If this is a 2012 story, the timing really could not be much worse. Countries that have already undertaken substantial fiscal tightening would see headline deficit improvement stall or even reverse. And those taking on responsibility for joint fiscal support in the euro area for example would see their own fiscal accounts deteriorate, thus undermining market confidence in their ability to support further periphery or bank sector needs.
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Of course, this increase in government bond supply expectations would apply equally well to the US, UK, Canada, Sweden and Australia. However, the starting points for debt are substantially different for example, compare and contrast Australian and Canadian government debt. One could imagine the political complications of a widening US federal deficit during an election year, especially if another debt ceiling increase had to be passed. Combine this backdrop with slower reserve accumulation and one has a perfect set of conditions to drive term risk premia higher on weaker fiscal countries. By extension, one also sees markets price in a higher cost of capital for weaker corporate and financial balance sheet entities. Without doubt, more central bank activism would be priced in, leading to the belly of curves flattening along with weaker BEIs from lower commodity prices. Wider credit spreads in investment grade and high yield would seem probable. Financials would remain a source of pressure in this environment. Chinas official data for external USD borrowing has increased quite substantially since the 2008 crisis and most of the increase is short-term debt. Part of this is in the form of trade credits, but by no means all. Naturally, markets would consider which entities are most exposed to China credit risk from these loans and would price accordingly.
Fig. 47: China external debt (USDbn)
500 External Debt - Short term 450 External Debt - Long and medium term 400 350 300 250 200 150 100 50 0 1Q03 1Q04 1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11
4. Risk and uncertainty premia While the growth and inflationary implications of a China hard landing are reasonably clear, the bigger uncertainties will be around future policy regime changes and therefore supply chain risks. One might call this a distinction between business-cycle risk and business-model risk. Clearly the global imbalances that have grown over the past 15 years are contributing and have contributed to domestic imbalances in the US, China and the euro area. A China hard landing would raise legitimate questions about what sort of global architecture for trade and currencies will hold after the event. This, we would argue, will only add to heightened levels of macroeconomic uncertainty already in place, with the result that high risk premia and uncertainty premia should be attached to risky cash flows. A hard landing would only increase those risks.
Strategic conclusions
Modeling can only get one so far in terms of predicting returns. But in circumstances such as this it can at least give some guidance on what to focus on. A very simple VAR (vector auto regression) model of changes in Chinas PMI index, total returns for US Treasuries, US IG, US HY, a commodity index, G7 and EM equities, the EMBIG index and changes in the VIX index, produces results that fit with ones priors as to how changes in Chinese growth might influence and feed back on those asset classes. The cumulative six-month
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change in annual returns (or changes in terms of the VIX index) is shown in Figure 48.
Fig. 48: Six-month cumulative response to a 1sd negative shock to Chinese growth
15 10 5 0 -5 -10 -15 -20 -25 -30 -35
VIX
USD Index
UST Index
US IG Index
EMBIG
Now, one should not place too much emphasis on the numerical outcomes of this it is an extremely nave and simple model. However, the hierarchy seems fairly sensible: EM equities (in USD terms) and commodities underperform the most. G7 stocks are half as bad, US high yield and EMBIG bond returns are similar to each other, but are both outperformed by IG. The USD index does well, or put another way, our Nomura C10 index would be a sell, and implied vol as proxied by the VIX rises by 10 points or so. Interestingly, the UST index does not do very much, a result that we do not put too much emphasis on. In any event, this provides a starting point to think about positioning for a China hard landing, that we believe is not too controversial. More specifically, our global fixed income strategists provide the following colour: Government bond curves would flatten as forward monetary policy rate expectations are reduced and BEI expectations fall. Weaker government markets, however, may see higher embedded risk premia leading to underperformance relative to the peer group. Principal safe havens are JGBs, AUD, SEK and NOK bonds. Certainly USTs also benefit despite open issues around future funding costs as reserve growth slows, or flow of funds change (perhaps offset by QE3?). Bunds naturally receive a safe-haven bid, but again open issues would be raised about fiscal union and support of peripheral bonds. European credit markets would experience broad-based weakness within a more macro risk-off environment, but decent balance sheet health and low refinancing risks generally should help credit to outperform equities in such a scenario. That said, the effect on equity valuations could still particularly weigh on the more levered issuers and levered products, which would see high yield/leveraged loans underperform Investment Grade corporates and Financials. On a more micro level, the greatest impact in terms of sectors will, we believe, be felt in the spreads of the more cyclical corporates, especially those directly affected such as Mining and Oil, which in turn would also impact Shipping (a sector already under pressure). Indirect impacts would be felt by sectors and issuers which have been offsetting the weak recovery in Europe thus far with growth in Emerging Markets, such as Luxury Goods companies or some of the Chemical companies for example, but the effect on spreads could differ markedly depending on a wide range of balance sheet health profiles luxury goods companies, for example, tend to have relatively strong balance sheets which would help absorb some of these pressures from a credit perspective, whereas the credit metrics of chemical companies, say, could be more vulnerable. 62
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The impact on Japan would be felt mostly through the economic channel (a weaker economic outlook and further monetary easing) than the financial channel. Chinese buying of JGBs has been increasing but is still too small to affect the JGB market directly and Japanese bank lending exposure to China is relatively small in their balance sheets. As such, we believe any negative effects should be felt more by the equity market. As a result, banks capacity to buy the long- and super-long end of the curve would be hampered by valuation losses on their equity holdings, so we would expect the yield curve to bull steepen, kinked around the 7yr sector (=JGB futures). Australia offers a particularly popular angle to address this risk. We would expect AUD to take the first hit and is the most obvious trade, in our opinion. After that, confirmation of a slowdown and the follow on effects of this should cause the curve to steepen. More generally, USD, JPY and CHF all outperform in the initial phase of a hard landing scenario, with the Nomura C10 index suffering commensurately.
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700
600
500
400
300
200
100 0 Oct-01
Oct-03 Oct-05 Oct-07 Oct-09 Oct-11
*Versus FTSE World Developed (US$). Source: FTSE, Nomura Strategy research
Fig. 31 This underperformance has not been matched by a similarly poor earnings trend so that the market has been heavily de-rated to the point where the discount now being applied to the Chinese market is the largest since late 2005.
Fig. 50: Chinese market multiple relative to global developed market multiple*
Ratio 1.9
1.7 1.5 1.3 1.1 0.9 0.7 0.5
0.3 Oct-01
Oct-03
Oct-05
Oct-07
Oct-09
Oct-11
*12 month forward PE. Source: IBES, FTSE, Nomura Strategy research
Fig. 32 Compared with other emerging markets, the Chinese market is also trading on a sizeable 28% discount, as Figure 51 demonstrates.
Oct-03
Oct-05
Oct-07
Oct-09
Oct-11
*12 month forward PE. Source: IBES, FTSE, Nomura Strategy research
Fig. 33 64
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That said, there is little doubt that a hard landing in China would have far reaching consequences for global equities. Firstly, there are the stocks and sectors with direct exposure. Here we would highlight Consumer Goods, where stocks have been re-rated relative to their historic valuation norms partly as a result of their exposure to China and other fast growing EM economies.
Fig. 52: Global Consumer Goods sector 12M forward PE relative to market
The global consumer goods sector has been re-rated relative to historic norms, partly as a result of exposure to Chinese growth
1.4 1.2
1
Oct-93
Oct-96
Oct-99
Oct-02
Oct-05
Oct-08
Oct-11
Fig. 34 Elsewhere, commodity producing sectors have been the beneficiaries of strong Chinese demand. Although the valuations attached to these commodity producers are not as demanding as the global sectors exposed to the consumer, there is little doubt that a hard landing in the Chinese economy would have a detrimental impact on them.
Fig. 53: Relative performance of global oil and mining sectors
31 Dec 99 = 100 280 240
200
Of the commodity producers, mining companies have shown the highest sensitivity to developments in China
160 120
80 Oct-01
Fig. 35 Mining stocks have the most to lose, in our opinion. Mining companies have invested heavily in recent years to expand capacity and if demand from China is not forthcoming, those investments are unlikely to prove profitable. That said, recent demand trends in China remain intact (Figure 54).
$/Ton 12000
10000
8000 6000
4000
40 30 20
10 0 Oct-93
2000 Oct-96 Oct-99 Net imports in tons*(LHS) Oct-02 Oct-05 Oct-08 Copper price per ton (RHS)
0 Oct-11
*Imports of copper ore and concentrate. Source: Datastream, Nomura Strategy research.
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In the Oil sector, demand from China remains relative inelastic to movements in the world price, so a hard landing would likely have much less impact on the Oil sector than the miners. Lastly, from a regional perspective, the Japanese market has the lowest historic correlation to Chinese equities, typically acting as something of a safe haven. US equities are the next least likely to be impacted, with European stocks the most highly correlated of the developed markets outside Asia to movements in Chinese stock prices. Figure 56 shows the relative performance of a group of European companies heavily exposed to Chinese demand. Until recently, the poor performance of Chinese stocks had little impact on the relative performance of these China-linked companies. However, in recent weeks they have become more closely correlated to the news flow from China.
Fig. 56: Relative performance of European stocks exposed to Chinese demand and the relative performance of Chinese equities
Index, Oct 2007 = 100 150 130 110
90
While Japanese stocks are lowly correlated with developments in China, European stocks show the highest sensitivity of any developed market outside Asia
70
50 Oct-07 Oct-08 Oct-09 Asia Exposed European Stocks performance relative to Asia
Oct-10
Oct-11
Fig. 36 their recent underperformance, the stocks described in Figure 56 also Despite trade on a substantial 24% premium to the wider European market. There is little doubt that a hard landing in China would have far reaching consequences for stocks well beyond the country itself.
Fig. 57: PE relative for Europes Chinese exposed stocks*
Ratio 1.6 1.5 1.4 1.3 1.2 1.1 1 0.9 0.8 0.7 0.6 Sep-95
European companies with strong links to China would be especially vulnerable since they trade on a significant premium to the European market
Sep-99
Sep-03
Sep-07
Sep-11
* PE for selected European stocks with high exposure to China relative to the European market Source: IBES, FTSE, Nomura Strategy research
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Note: As per the latest data available. Source: CEIC, Bloomberg, Nomura.
That said, it is worth having a sense of the relative Sino-Asian linkages, in the unlikely event that the shock is non-systemic and/or a Chinese hard-landing occurs while G3 prospects are improving. The schema gives very different
50 51
As gauged by FX reserves owned as a percent of countrys GDP. The ranking is based on the average of the basic balance and FX reserves as a percent of GDP. The order is from least vulnerable to the most vulnerable economy.
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results, indicating that INR (for example) would be least effected, whilst TWD would be most vulnerable (see Figure 59, which shows Chinese exports/GDP for each Asian country).
Fig. 59: Asia rolling 12m exports to China / GDP
20%
Latest 15% 2004
10%
5%
0% TW KR MY SG TH PH ID HK IN
Given a weaker-than-expected recovery and potential downside risk in developed countries, external demand as a driver of Chinas growth now has less of a boosting effect. Meanwhile, there are more domestic risks growing as well, from local government debt issues to funding of micro, small and medium-sized enterprises (MSMEs) and the property market. China IRS curves (deposit IRS, SHIBOR IRS and repo IRS) have all started to invert and price in the potential for rate cuts for example, the 5yr IRS indexed to the 1yr deposit rate implies an average 1yr deposit rate in five years is 3.27%.
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Research analysts:
Michael Kurtz
+852 2252 2182 michael.kurtz@nomura.com
Mixo Das
+852 2252 1424 mixo.das@nomura.com
Yiran Zhong
+852 2252 1413 yiran.zhong@nomura.com
determinant in projecting the degree to which a collapse in top-line revenues would transmit through to bottom-line profits. In the Figure below we rank the Asia-Pacific markets in terms of aggregate OL:
Fig. 1: Asia-Pacific operating leverage and gearing
Asia Pacific India China Malaysia Australia HK Japan Singapore Korea Taiwan Indonesia Thailand Philippines Vietnam Operating Leverage* 3.9 7.1 5.7 4.6 3.8 3.4 3.3 3.1 2.7 2.0 2.0 1.9 1.8 1.3 Net Debt / Equity (%) 39.1 34.0 24.6 28.4 27.0 18.7 54.4 25.5 43.9 12.0 28.0 48.6 34.9 34.7
* Note: Operating leverage calculated as (Revenue - COGS) / (Revenue COGS - SG&A). Aggregated for all members of the respective MSCI index ex banks/insurance/diversified financials. Source: Bloomberg, Nomura Strategy research
1 In assessing the scope for damage to valuations, it is useful to keep in mind Fig. 1 ex-Japan Asian stocks are already discounting an extraordinary degree of that
risk, as illustrated by the equity risk premium (i.e. the differential between the consensus 12-month forward earnings yield and the available risk-free cost of / opportunity return on capital in the 10-year US Treasury market).
At currently 8.0%, this compensation for equity risk-bearing is fully 2.5
standard deviations above its long-term mean of 4.3%. While this by no means would alone insulate regional stocks from further volatility, it does suggest the degree to which Chinese structural concerns have already embedded themselves into asset values.
Fig. 2: MSCI Asia ex-Japan: Equity Risk Premium
10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0%
May-01
Oct-01
Oct-06
Nov-03
Dec-05
Nov-08
Dec-10
Aug-02
Sep-04
Aug-07
Sep-09
Feb-05 Jul-05
Jun-08
Jan-03
Jun-03
Jan-08
Feb-10 Jul-10
2 Fig. 2
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May-11
May-06
Mar-02
Mar-07
Oct-11
Apr-04
Apr-09
November 2011
Similarly, Chinas sovereign credit default swap (CDS) spread, at currently 137bp, stands fully 62bp above its 75bp January 2010-July 2011 average suggesting China investor perceptions have already grown substantially more cautious.
Fig. 3: China Credit Default Spread
(bps)
210 190
170 150
130 110
90 70
50 Jan-10
Apr-10
Jul-10
Oct-10
Jan-11
Apr-11
Jul-11
Oct-11
3 Still, comparing current Asian equity index multiples to trough levels of the Fig. 3 decade does suggests particular markets would still be quite vulnerable past
(Figure below). Because earnings themselves become less reliable in times of greater demand uncertainty, the results below are ranked according to the more tangible Price-to-Book Value measure:
Fig. 4: Asia ex Japan market valuations versus historical trough
PER (since 2001) Current % to Trough 9.9 -21% 11.8 13.4 9.3 12.6 12.1 8.4 13.1 11.5 7.7 12.2 -69% -38% -40% -24% -32% -29% -28% -29% -14% -26% Trough 7.8 3.7 8.4 5.6 9.5 8.2 6.0 9.5 8.2 6.6 9.0 Date of Trough Oct-08 Apr-01 Oct-08 Oct-08 Aug-04 Oct-08 Mar-03 Oct-08 Oct-08 Oct-08 Oct-08 PBV (since 2001) Current % to Trough 1.6 -25% 3.9 2.6 2.0 1.7 2.5 1.3 2.1 1.5 1.5 1.2 -79% -67% -50% -37% -36% -35% -34% -28% -21% -21% Trough 1.2 0.8 0.9 1.0 1.1 1.6 0.8 1.4 1.1 1.2 0.9 Date of Trough Sep-01 May-01 Jan-03 Nov-08 Jan-09 Sep-01 Dec-01 Jun-01 Feb-09 May-03 Feb-09
MSCI Asia ex-Japan Indonesia Philippines Thailand Taiwan India Korea Malaysia Singapore China HK
4 Fig. 4
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Asia ex-Japan Fd/Staples Rtl Cons Svs Health Care Equip & Serv Auto & Compo Software & Services Div Fin Household & Pers Prod Pharmaceuticals Cons Dur/App Materials Retailing Commerical Serv & Supp Fd/Bev/Tob Energy Transpt Tech Hardware & Equip Cap Goods Media Real Estate Utilities Semiconductors Banks Telecom Insurance
A look at recent years statistical correlation between Asia-Pac indexes and Fig. 5 H-shares also offers insight into where the risk of equity market contagion China may be greatest. In most cases these correlations also comport with our fundamental sense as to how the real and financial effects of a China rollover would propagate through the rest of the Asia-Pac region.
Based on US$-denominated weekly returns since 2007, Korea and Indonesia
exhibit the Asia-Pac regions two highest-beta relationships with China Hshares. This is interesting given the substantial disparity between these two economies and markets: the former largely a high-value-added manufacturer of capital goods and consumer durables, vs the latter predominantly a provider to China of primary goods such as coal, natural gas, and ore. Yet in both cases, the risks appear justified by Chinas rapidly increasing role in recent years as a key export growth market. Indonesias broader sensitivity to any presumptive downdraft in global energy and commodity prices also places it squarely atop the endangered list.
Fig. 6: Asia-Pacific Country Index Correlations w/ China H-shares
vs. HSCEI R^2 0.56 0.52 0.48 0.53 0.74 0.65 0.45 0.50 0.38 0.37 0.46 0.36 Slope 0.80 0.74 0.66 0.63 0.60 0.60 0.60 0.54 0.48 0.42 0.37 0.34
MSCI Korea MSCI Indonesia MSCI India MSCI Australia MSCI Hong Kong MSCI Singapore MSCI Thailand MSCI Taiwan MSCI Philippines MSCI New Zealand MSCI Malaysia MSCI Japan
Source: DataStream, Bloomberg, Nomura Strategy research
6 Fig. 6
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Although India offers the third-highest beta relationship with China over the
2007-11 period, this strikes us more as coincidental (based on generalized BRICs risk tolerance/aversion) than fundamentally driven. Indeed, we would be inclined to see India as comparatively more resilient in the Asian-regional context to a China rollover, given still-modest trade linkages between the two economies, and given prospective relief both on Indias chronic current account deficit / terms of trade, as well as on its recently problematic inflation front if commodity prices were to recede.
Also noteworthy as a potential comparative safe haven is Japan. Not only do
Japanese stocks exhibit the lowest-beta relationship with China H-shares among the Asia-Pac markets, but Japans domestic consumption-heavy GDP composition may help insulate it from a Chinese demand slowdown. Additionally albeit tragically the impact of 2011s Miyagi earthquake forced markets already to substantially downgrade expectations for Japan.
Among the riskiest markets in terms of historical return correlations are also
Australia and Hong Kong (i.e. the pure Hong Kong ex-China H-shares as found in MSCI HK). Unlike in Indias case, these seem explainable in terms of direct real-economic (and in Hong Kongs case, also financial) linkages between those geographies and China. Of note, Asian equity China correlations are generally stronger at the sector level than the country level (Figure below). Given Chinas predominant role as a driver of global marginal demand for energy and commodities (as discussed above in the Global context), within Asia-Pac it is the Energy, Materials and Industrials sectors (at the GICS-1 level) that exhibit the strongest correlations with H-shares.
By contrast, lower-beta relationships (i.e. vs. H-share returns) are generally
found among the classically defensive sectors (e.g. Utilities, Staples, Telcos). In other words, positive China-share performance should tend to be associated with outperformance in riskier assets (as seems intuitively logical); but a China-driven rollover could best be sidestepped within the Asian-regional equity space through exposure in low-cyclical names (Staples, Health Care), steady high dividend yielders (primarily among Asias Telcos), and Utilities where softer energy costs would offer the prospect of margin relief.
Fig. 7: Asia-Pacific Sector Correlations w/ China H-shares
vs. HSCEI R^2 0.79 0.71 0.75 0.82 0.81 0.63 0.48 0.70 0.62 0.59 Slope 0.83 0.80 0.79 0.72 0.66 0.59 0.54 0.51 0.48 0.38
Energy Material Industrial Financials MSCI Asia ex Japan Consumer Disc IT Telco Consumer Staples Utilities
Source: Bloomberg, Nomura Strategy research
7 Fig. 7
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Research analysts:
Michael Kurtz
+852 2252 2182 michael.kurtz@nomura.com
Mixo Das
+852 2252 1424 mixo.das@nomura.com
tied to China's investment cycle: Commodities and Basic Materials (e.g. Metals & Mining incl. Steel, Cement, etc.) as well as the Capital Equipment names and, possibly, the Construction Companies, depending on whether policymakers saw room to expand infrastructure project spending as a counter-cyclical tool as they did in 2008-10 (which we see as less feasible a second time, as discussed elsewhere).
A dramatic slowdown in Chinas aggregate growth alongside the credit
Yiran Zhong
+852 2252 1413 yiran.zhong@nomura.com And the China Research Team
constraints and rising real cost of capital discussed elsewhere would also undermine the quality of assets in the domestic financial system. This would hurt asset-rich balance sheets, not least in China's large, state-owned Banks; and as such, composition of individual institutions loan books and breakdown of their lending activity would be a key differentiator. By similar token, many Chinese property developers would find themselves under substantial financial stress from a combination of falling property prices and slumping sales volumes.
The simultaneous cashflow constraints from a weaker Chinese economy along
with higher real cost of capital would make corporate balance sheets a key differentiator generally. We would expect the market to favor lower-geared (or net-cash) companies within any given sector, whereas higher gearing would be discounted. Similarly, companies with imminent capital needs such as near-term debt rollovers or refinancings would be discounted relative to those whose funding were mostly long-term secured.
Given that one tipping-point for a Chinese growth slowdown would presumably
be ongoing/deepening weakness in the external sector (i.e. global double-dip risks), we would not expect export-driven China names (e.g. Shipping, Ports, Tech, Contract Manufacturing & Logistics) to be particularly defensive. Rather, "traditionally" defensive domestic names in Utilities (including Gas), Telecoms, Health Care/Pharma, and Fertilizer would likely be the outperformers among HK-listed China names.
One area where Chinese policymakers may find some room to exercise
stimulus different than the largely infrastructure project-driven approach of 2009-10, would be domestic private consumption (for example through targeted credit growth, taxation, wage policy, etc). As such, we are inclined to regard domestic Consumer-sector stocks (both Discretionary and Staple) as comparatively defensive although already high valuations diminish these attractions somewhat.
One key litmus test as to the leadership's willingness to empower the domestic
private consumer may be the path of the RMB in any sustained slowdown scenario: Were Chinese policymakers to (unexpectedly) avoid the temptation to fall back on a stable (or weaker) RMB but rather allow appreciation to continue, we believe it would signal a commitment to press ahead with restructuring toward a more domestic/consumption-driven growth mix. Taking the above considerations into effect, we present in the following two Figures a short list of key Chinese names that we would expect to prove respectively more vulnerable and more resilient:
IMPORTANT: The sensitivity table below does not assess just the impact of a China hard landing on the mentioned stocks, rather it takes a look at an extreme scenario including recessions in the US and Europe. None of this is in our macro or industry or company forecasts. Detailed assumptions are footnoted. See table in appendix for our current ratings.
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November 2011
Fig. 8: MORE VULNERABLE: Chinese companies in most-impacted sectors with high gearing*
TICKER 3323 HK 753 HK 1055 HK 2777 HK 2600 HK 2883 HK 3333 HK 267 HK 2318 HK 2007 HK 1109 HK 2866 HK 939 HK Com pany CHINA NATIONAL BUILDING MA-H AIR CHINA LTD-H CHINA SOUTHERN AIRLINES CO-H GUANGZHOU R&F ALUMINUM CORP OF CHINA LTD-H CHINA OILFIELD SERVICES-H CITIC PACIFIC LTD PING AN INSURANCE GROUP CO-H COUNTRY GARDEN HOLDINGS CO CHINA RESOURCES LAND LTD CHINA SHIPPING CONTAINER-H CHINA CONSTRUCTION BANK Industry Group Building Materials Airlines Airlines Real Estate Mining Oil&Gas Services Iron/Steel Insurance Real Estate Real Estate Transportation Banks HK Market Cap ($m n) 3,237 3,610 1,611 909 2,055 2,476 5,824 6,310 21,721 6,144 7,750 700 167,939 Sales ($m n) Net Debt / Equity 9,837 13,376 12,676 3,641 19,196 2,562 8,677 10,892 34,947 4,480 2,701 5,143 66,470 199 174 150 111 109 92 88 80 77 59 52 11 -
*Excludes Level I sectors: Consumer Disc. Staples, Healthcare, Utilities, Telcos; Net D/E > 50% (in most cases) Source: Bloomberg, Nomura Strategy research
8
Fig. 9: MOST RESILIENT: Chinese companies in least-impacted sectors with positive net cash*
Fig. 8
TICKER 1688 HK 700 HK 168 HK 2238 HK 2319 HK 489 HK 941 HK 1880 HK 151 HK
Com pany ALIBABA.COM LTD TENCENT HOLDINGS LTD TSINGTAO BREWERY CO LTD-H CHINA MENGNIU DAIRY CO DONGFENG MOTOR GRP CO LTD-H CHINA MOBILE LTD BELLE INTERNATIONAL HOLDINGS
Industry Group Internet Internet Beverages Food Auto Manufacturers Telecommunications Retail
HK Market Cap ($m n) 6,057 41,823 3,683 2,227 5,692 4,717 197,004 15,733 12,058
Sales ($m n) Net Debt / Equity 925 3,596 3,183 8,843 5,193 18,753 76,294 3,991 2,521 -169 -77 -62 -61 -58 -55 -45 -30 -24
*Excludes Level I sectors: Financials, Energy, Industrial, Materials, level II sector: Tech; Net D/E < -20% Source: Bloomberg, Nomura Strategy research
9
IMPORTANT: Our sensitivity analysis does not assess just the impact of a China hard landing on the mentioned stocks, rather it takes Fig. 9 at an extreme scenario including recessions in the US and Europe. None of this is in our macro or industry or company a look forecasts. The extreme case assumes (1) US real GDP falls 3% and euro area GDP falls 5%; (2) Chinas GDP growth falls to 5%; (3) Substantial commodity price declines by end 2012. Base case and extreme case real GDP growth % assumptions: Australia (4.3, 0.5); China (8.6, 5.0); Hong Kong (4.5, -6.0); India (7.9, 3.0); Indonesia (7.0, 2.5); Malaysia (5.1, -5.8); New Zealand (3.5, 0.8); Philippines (5.7, 0.5); Singapore (5.3, -5.2); South Korea (5.0, -3.0); Taiwan (5.0, -5.0); Thailand (4.7, -3.0).
74
November 2011
Research analysts:
Richard Johnson
+612 8062 8412 richard.j.johnson@nomura.com And the Australia Research Team
IMPORTANT: The sensitivity table below does not assess just the impact of a China hard landing on the mentioned stocks, rather it takes a look at an extreme scenario including recessions in the US and Europe. None of this is in our macro or industry or company forecasts. Detailed assumptions are footnoted. See table in appendix for our current ratings.
Fig. 10: Potentially most vulnerable and most resilient companies in coverage in the extreme case*
Most vulnerable companies Boart Longyear Bluescope Steel Onesteel Orica Rio Tinto BHP Billiton Ticker BLY AU BSL AU OST AU ORI AU RIO AU BHP AU Industry Drilling equipment and services Steel solutions Steel long products Diversified chemicals Resources Resources Most resilient companies Amcor AGL Energy Coca-Cola Amatil Tabcorp Holdings Telstra Woolworths Ticker AMC AU AGK AU CCL AU TAH AU TLS AU WOW AU Industry Packaging Power and gas Food & beverages Gaming Telecoms Retail
Note: Base case represents our current forecasts and TP * Extreme case assumes (1) US real GDP falls 3% and euro area GDP falls 5%; (2) Chinas GDP growth falls to 5%; (3) Substantial commodity price declines by end 2012. Base case and extreme case real GDP growth % assumptions: Australia (4.3, 0.5); China (8.6, 5.0); Hong Kong (4.5, -6.0); India (7.9, 3.0); Indonesia (7.0, 2.5); Malaysia (5.1, -5.8); New Zealand (3.5, 0.8); Philippines (5.7, 0.5); Singapore (5.3, -5.2); South Korea (5.0, -3.0); Taiwan (5.0, -5.0); Thailand (4.7, -3.0) Source: Nomura estimates
75
November 2011
Research analysts:
Prabhat Awasthi
+91 22 4037 4180 prabhat.awasthi@nomura.com
Nipun Prem
+91 22 4037 5030 nipun.prem@nomura.com And the India Research Team
IMPORTANT: The sensitivity table below does not assess just the impact of a China hard landing on the mentioned stocks, rather it takes a look at an extreme scenario including recessions in the US and Europe. None of this is in our macro or industry or company forecasts. Detailed assumptions are footnoted. See table in appendix for our current ratings.
Fig. 11: Earnings and target price sensitivity for most affected and least affected companies in coverage in the extreme case*
China sales share 2011% 16 Base case EPS 2012 29.4 % y-y 7.1 Target price 200.0 Extreme case* EPS 2012 (11.6) % y-y NA Target price Comments 31 Domestic CV and JLR volumes could come under pressure, causing sharp declines in EBITDA margins and profitability. Multiples would also come down. 215 Assumed 65% utilization at European operations, steel prices falling by 40% and raw material prices by 60%. No direct China exposure but would be affected by global commodity fall. 100 Lower demand as well as intense competition from Chinese players in the power systems segment. 1,911 Although exposure to US is high, pharma is a nondiscretionary expense and growth for generics will be fuelled by the patent cliff. 137 We assume cigarette volume growth going to 0% (vs. 6% base case) price impact 4% vs. base case of 12%. Multiple for cig business down from 23x to 15x. 1,750 We assume flat US$ revenue growth in FY13F (led by a pricing cut of 5%), a US$/INR of 48 and no salary hike in FY13F. P/E multiples down to 12x from 18x.
Ticker TTMT IN
TATA Steel
TATA IN
NA
82.5
28.9
653
(11.8) (118.4)
CRG IN
NA
12.21
(15.5)
240
8.02
(45)
DRRD IN
90.76
24
1,911
81.4
24
ITC
ITC IN
8.7
16.2
229
6.7
(10.1)
Infosys
INFO IN
159.1
14.3
3,100
148.1
6.5
Note: Base case represents our current forecasts and TP *Extreme case assumes (1) US real GDP falls 3% and euro area GDP falls 5%; (2) Chinas GDP growth falls to 5%; (3) Substantial commodity price declines by end 2012. Base case and extreme case real GDP growth % assumptions: Australia (4.3, 0.5); China (8.6, 5.0); Hong Kong (4.5, -6.0); India (7.9, 3.0); Indonesia (7.0, 2.5); Malaysia (5.1, 5.8); New Zealand (3.5, 0.8); Philippines (5.7, 0.5); Singapore (5.3, -5.2); South Korea (5.0, -3.0); Taiwan (5.0, -5.0); Thailand (4.7, -3.0) Source: Nomura estimates
76
November 2011
Research analysts:
Wilianto Ie
+62 21 2991 3341 wilianto.ie@nomura.com And the Indonesia Research Team
IMPORTANT: The sensitivity table below does not assess just the impact of a China hard landing on the mentioned stocks, rather it takes a look at an extreme scenario including recessions in the US and Europe. None of this is in our macro or industry or company forecasts. Detailed assumptions are footnoted. See table in appendix for our current ratings.
Fig. 12: Earnings and target price sensitivity for most affected and least affected companies in coverage in the extreme case*
China sales share 2011% 30 Base case EPS 2012 0.04 (USD) 275 924 2,013 4,821 % y-y 154 Target price Extreme case* EPS Target 2012 % y-y price Comments N.A 750 High operating leverage to coal price plus geared balance sheet (280% net gearing) at high cost of funds. 1,500 High operating leverage to coal price plus 43% net gearing. 5,000 High operating leverage to coal price. Net cash. 9,000 High operating leverage to palm oil price. Net cash.
Ticker BUMI IJ
Adaro Energy Harum Energy Astra Agro Astra International Least affected Gudang Garam Telkom Indonesia Jasa Marga
19 26 0 0
114
2,850
(40) 35,000 Automotive sales could drop 30% or more if GDP growth slows to 2.5% and commodity prices collapse. (2) 50,000 Demand proven to be relatively inelastic during crisis. (1) 15 6,000 Demand proven to be relatively inelastic during crisis. 3,500 Demand proven to be relatively inelastic during crisis. Tariff increase is certain as it is regulated by law.
0 0 0
Note: Base case represents our current forecasts and TP *Extreme case assumes (1) US real GDP falls 3% and euro area GDP falls 5%; (2) Chinas GDP growth falls to 5%; (3) Substantial commodity price declines by end 2012. Base case and extreme case real GDP growth % assumptions: Australia (4.3, 0.5); China (8.6, 5.0); Hong Kong (4.5, -6.0); India (7.9, 3.0); Indonesia (7.0, 2.5); Malaysia (5.1, 5.8); New Zealand (3.5, 0.8); Philippines (5.7, 0.5); Singapore (5.3, -5.2); South Korea (5.0, -3.0); Taiwan (5.0, -5.0); Thailand (4.7, -3.0) Source: Nomura estimates
77
November 2011
Research analysts:
James Kim
+ 852 2252 6203 james.kim@nomura.com And the Korea Research Team
IMPORTANT: The sensitivity table below does not assess just the impact of a China hard landing on the mentioned stocks, rather it takes a look at an extreme scenario including recessions in the US and Europe. None of this is in our macro or industry or company forecasts. Detailed assumptions are footnoted. See table in appendix for our current ratings.
Fig. 13: Earnings and target price sensitivity for most affected and least affected companies in coverage in the extreme case*
China sales share Ticker 2011% 053000 KS 105560 KS 024110 KS 086790 KS 0 0 0 0 Base case Extreme case* Target price Comments 4,900 Due to inferior asset quality (high NPL and low coverage ratio), severe recession should result in greater provisioning. 23,400 Pressure from macro slowdown, increased loan loss provisions, interest rate cuts. 5,500 With SME concentrated loan portfolio, greater impact on asset quality than peers in the case of recession. 19,400 Pressure from macro slowdown, increased loan loss provisions, interest rate cuts. NIM should be more vulnerable due to weak deposit franchise. 15,000 Export-oriented Koreas power demand is highly sensitive to China and global economic slowdown. 65,010 Tobacco demand is relatively inelastic in response to economic cycle. # Recent currency moves would imply 6,677. 70,000 Less sensitive to interest rate cycle and their main product, medical insurance, is stable in nature.
EPS Target EPS 2012 % y-y price 2012 % y-y 2,828 6.561 2,492 4,745 12 18,000 617 (70) (61) (76) (52)
KEPCO
015760 KS
52
na 35,000 -1,330
na
Least affected KT&G Dongbu Insurance SKT KT LGU 033780 KS 005830 KS 017670 KS 030200 KS 032640 KS 3 6,380# 0 6,464 10 66,000 6,577 26 71,000 3,031 (1) 178,00 22,47 0 0 15 53,000 6,070 (6) 6,000 793 10 25
(1) 178,000 Korean telcos are largely insulated from the economic slowdown. 15 (6) 53,000 Korean telcos are largely insulated from the economic slowdown. 6,000 Korean telcos are largely insulated from the economic slowdown.
Note: Base case represents our current forecasts and TP *Extreme case assumes (1) US real GDP falls 3% and euro area GDP falls 5%; (2) Chinas GDP growth falls to 5%; (3) Substantial commodity price declines by end 2012. Base case and extreme case real GDP growth % assumptions: Australia (4.3, 0.5); China (8.6, 5.0); Hong Kong (4.5, -6.0); India (7.9, 3.0); Indonesia (7.0, 2.5); Malaysia (5.1, 5.8); New Zealand (3.5, 0.8); Philippines (5.7, 0.5); Singapore (5.3, -5.2); South Korea (5.0, -3.0); Taiwan (5.0, -5.0); Thailand (4.7, -3.0) Source: Nomura estimates
78
November 2011
Research analysts:
IMPORTANT: The sensitivity table below does not assess just the impact of a China hard landing on the mentioned stocks, rather it takes a look at an extreme scenario including recessions in the US and Europe. None of this is in our macro or industry or company forecasts. Detailed assumptions are footnoted. See table in appendix for our current ratings.
Fig. 14: Earnings and target price sensitivity for most affected and least affected companies in coverage in the extreme case*
China Earnings share Ticker 2011% MAY MK CIMB MK n/a n/a Base case EPS 2012 0.66 0.57 % y-y (2) 4 Target price 6.85 6.00 Extreme case* EPS 2012 0.34 0.30 % y-y (49) (44) Target price Comments 3.24 Assuming 2012 credit cost rises to 100bps (base case: 47bps) and OPR cut to 2.0% 3.16 Assuming 2012 credit cost rises to 90bps (base case: 35bps) and OPR cut to 2.0% 4.72 TMs exposures to North Asia are under 2%, primarily from its global business and hence we believe impact should be limited.
Note: Base case represents our current forecasts and TP *Extreme case assumes (1) US real GDP falls 3% and euro area GDP falls 5%; (2) Chinas GDP growth falls to 5%; (3) Substantial commodity price declines by end 2012. Base case and extreme case real GDP growth % assumptions: Australia (4.3, 0.5); China (8.6, 5.0); Hong Kong (4.5, -6.0); India (7.9, 3.0); Indonesia (7.0, 2.5); Malaysia (5.1, 5.8); New Zealand (3.5, 0.8); Philippines (5.7, 0.5); Singapore (5.3, -5.2); South Korea (5.0, -3.0); Taiwan (5.0, -5.0); Thailand (4.7, -3.0) Source: Nomura estimates
79
November 2011
Research analysts:
IMPORTANT: The sensitivity table below does not assess just the impact of a China hard landing on the mentioned stocks, rather it takes a look at an extreme scenario including recessions in the US and Europe. None of this is in our macro or industry or company forecasts. Detailed assumptions are footnoted. See table in appendix for our current ratings.
Fig. 15: Earnings and target price sensitivity for most affected and least affected companies in coverage in the extreme case*
China sales share Ticker 2011% CAPL SP Base case EPS 2012 Target price Extreme case* EPS 2012 Target price Comments 3.30 CMA is the biggest component of CAPL's NAV, representing 26.5% of which 32.4% is attributable to China. The China residential segment accounts for a further 14.1%. 3.21 KPLD has 32.5% of its NAV in China residential projects. A slowdown in China GDP will have direct impact and spillover effects on projects in SG as well. 4.40 Volumes could decelerate mainly in Palm & laurics, Oilseeds processing and consumer pack segments. PE multiples may contract. 12.0 #7-8% of assets in China, 28% of assets in Greater China. Loan growth could decelerate to 2% (from 12%) and credit charges rise to 100bps (from 45bps). Sustainable ROE reduced to 10% (from 11%), cost of equity edges up to 9.5% (from 9.1%). 3.35 None of SingTel's subsidiaries/ associates have presence in China. We expect the impact of 'worst case' GDP growths of countries where it is present on the subscribers' wallets to result in <1% decline in SingTel's consolidated revenue. 1.94 Minimal exposure to China. We believe that the REIT will hold resilient through a downturn. Its STB portfolio was fully occupied through the financial crisis whilst its MTB portfolio reached a low of 90.5% before quickly rebounding to 92.5% by end June 2011.
% y-y (4.7)
% y-y (19.3)
25.0 15.35c
4.05 13.00c
Keppel Land
KPLD SP
40.7
24.5c
8.2
4.90 19.00c
(16.1)
Wilmar
WIL SP
52.0
35c
12.3
5.90
29c
3.7
DBS Bank
DBS SP
8#
130c
7.2
16.4
85.5c
(34.2)
A-REIT
AREIT SP
0.0
13.5c
3.7
2.10 12.50c
(3.7)
Note: Base case represents our current forecasts and TP *Extreme case assumes (1) US real GDP falls 3% and euro area GDP falls 5%; (2) Chinas GDP growth falls to 5%; (3) Substantial commodity price declines by end 2012. Base case and extreme case real GDP growth % assumptions: Australia (4.3, 0.5); China (8.6, 5.0); Hong Kong (4.5, -6.0); India (7.9, 3.0); Indonesia (7.0, 2.5); Malaysia (5.1, 5.8); New Zealand (3.5, 0.8); Philippines (5.7, 0.5); Singapore (5.3, -5.2); South Korea (5.0, -3.0); Taiwan (5.0, -5.0); Thailand (4.7, -3.0) Source: Nomura estimates
80
November 2011
Research analysts:
Jesse Wang
+886 2 2176 9977 jesse.wang@nomura.com And the Taiwan Research Team
IMPORTANT: The sensitivity table below does not assess just the impact of a China hard landing on the mentioned stocks, rather it takes a look at an extreme scenario including recessions in the US and Europe. None of this is in our macro or industry or company forecasts. Detailed assumptions are footnoted. See table in appendix for our current ratings.
Fig. 16: Earnings and target price sensitivity for most affected and least affected companies in coverage in the extreme case*
China sales share 2011% 45 60 86 0 4 Base case EPS 2012 2.85 5.80 11.58 5.08 7.60 % y-y (10.0) 31.5 19.5 14.0 8.3 Target price 34.6 90.0 300.0 93.0 205.0 Extreme case* EPS 2012 2.21 3.53 7.27 4.28 6.60 % y-y (30.0) (20.0) (25.0) (4.0) (6.0) Target price Comments 22.5 Significant earnings exposure to China. 76.5 Significant earnings exposure to China. 240.0 Significant earnings exposure to China. 89.3 Diversified revenue stream. 192.7 Govt may support domestic consumption.
(TWD) Most affected Asia Cement Synnex AirTAC Least affected Taiwan Mobile President Chain Store
Note: Base case represents our current forecasts and TP *Extreme case assumes (1) US real GDP falls 3% and euro area GDP falls 5%; (2) Chinas GDP growth falls to 5%; (3) Substantial commodity price declines by end 2012. Base case and extreme case real GDP growth % assumptions: Australia (4.3, 0.5); China (8.6, 5.0); Hong Kong (4.5, -6.0); India (7.9, 3.0); Indonesia (7.0, 2.5); Malaysia (5.1, 5.8); New Zealand (3.5, 0.8); Philippines (5.7, 0.5); Singapore (5.3, -5.2); South Korea (5.0, -3.0); Taiwan (5.0, -5.0); Thailand (4.7, -3.0) Source: Nomura estimates
81
November 2011
IMPORTANT: The sensitivity table below does not assess just the impact of a China hard landing on the mentioned stocks, rather it takes a look at an extreme scenario including recessions in the US and Europe. None of this is in our macro or industry or company forecasts. Detailed assumptions are footnoted. See table in appendix for our current ratings.
Fig. 17: Earnings and target price sensitivity for most affected and least affected companies in coverage in the extreme case*
Base case Ticker Most affected Minsheng (HKD) BOC (HKD) Citic Bank (HKD) CCB (HKD) CRCB (HKD) ICBC (HKD) BEA (HKD) WHB (HKD) DSF (HKD) Woori FG (KRW) 1988 HK 3988 HK 998 HK 939 HK 3618 HK 1398 HK 23 HK 302 HK 440 HK 053000 KS 0.88 0.51 0.66 0.76 0.55 0.69 2.7 6.52 4.3 2,828 14.29 18.35 10 18.07 27.91 23.21 6% -4% 8% 12% 7.4 5.2 6.5 7.02 6.52 7.5 24 84 50 18,000 (1.2) (255.73) (0.51) (218.49) (0.71) (217.65) (0.51) (179.78) (0.33) (177.31) (0.28) (150.82) (0.33) (0.78) (0.09) 617 (113) (112) (102) (70) 3.7 589bps credit cost hike to 6.54% 2.3 539bps credit cost hike to 5.95% 2.8 527bps credit cost hike to 6.02% 3.28 599bps credit cost hike to 6.61% 1.52 694bps credit cost hike to 7.29% 3.5 529bps credit cost hike to 5.69% 18 Weak profitability and thus big swing in earnings 46 Weak profitability and thus big swing in earnings 18 Weak profitability and thus big swing in earnings 4,900 Due to inferior asset quality (high NPL and low coverage ratio), severe recession should result in greater provisioning 36.72 Our worst case estimates incorporate i) a significant increase in BDDs (175bps to NHL which is consistent with the GFC experience) and 17.4 we do not prescribe banks with any margin benefit 20.91 (as they achieved throughout the crisis) given we expect a significant slowdown in China will reduce 5,200 banks ability to re-price margins. 135bps higher credit cost to 1.8% 4,000 100bps higher credit cost to 3.5% 6,900 110bps higher credit cost to 3.5% 19.7 4-5% of assets in China, 7% of assets in Greater China. Loan growth could decelerate to 6% (from 12%) and credit charges rise to 65bps (from 44bps). Sustainable ROE reduced to 12% (from 13%) while cost of equity remains at 9.6%. 20.3 Domestic. Loan growth could decelerate to 8% (from 12%) and credit charges rise to 65bps (from 48bps). Sustainable ROE reduced to 14% (from 15%) while cost of equity remains at 11.2%. 120.0 Domestic. Loan growth could decelerate to 5% (from 10%) and credit charges rise to 85bps (from 59bps). Sustainable ROE reduced to 15% (from 16%) while cost of equity remains at 11.5%. 130.0 Domestic. Loan growth could decelerate to 8% (from 12%) and credit charges rise to 55bps (from 38bps). Sustainable ROE reduced to 16% (from 17%) while cost of equity remains at 10.5%. EPS 2012 % y-y Target price Extreme case* EPS 2012 % y-y Target price Comments
Least affected CBA (AUD) WBC (AUD) NAB (AUD) BCA (IDR) Danamon (IDR) BRI (IDR) UOB (SGD) CBA AU WBC AU NAB AU BBCA IJ BDMN IJ BBRI IJ UOB SP 4.43 2.13 2.63 416.2 440.8 630.6 186c 5.4 4.6 7.5 7.9 18.1 19.8 11.8 53 24.5 30 6,700 4,900 8,400 21.9 3.36 1.64 2.05 322.7 351.7 515.5 162c (20) (19.7) (16.1) (16.4) (5.8) (2) (12.9)
KTB TB
2.04
15.4
23.2
1.79
(12.3)
12.2
12.3
135.0
10.8
(11.5)
SCB TB
9.7
13.5
145.0
9.0
(7.2)
Note: Base case represents our current forecasts and TP *Extreme case assumes (1) US real GDP falls 3% and euro area GDP falls 5%; (2) Chinas GDP growth falls to 5%; (3) Substantial commodity price declines by end 2012. Base case and extreme case real GDP growth % assumptions: Australia (4.3, 0.5); China (8.6, 5.0); Hong Kong (4.5, -6.0); India (7.9, 3.0); Indonesia (7.0, 2.5); Malaysia (5.1, -5.8); New Zealand (3.5, 0.8); Philippines (5.7, 0.5); Singapore (5.3, -5.2); South Korea (5.0, -3.0); Taiwan (5.0, -5.0); Thailand (4.7, -3.0) Source: Nomura estimates
82
November 2011
IMPORTANT: The sensitivity table below does not assess just the impact of a China hard landing on the mentioned stocks, rather it takes a look at an extreme scenario including recessions in the US and Europe. None of this is in our macro or industry or company forecasts. Detailed assumptions are footnoted. See table in appendix for our current ratings.
Fig. 18: Earnings and target price sensitivity for most affected and least affected companies in coverage in the extreme case*
China sales share 2011% 8 100 Base case EPS 2012 % y-y 0.51 0.15 (52) 174 Target price 8.90 17.5 Extreme case* EPS 2012 % y-y (0.09) (109) (0.02) (132) Target price Comments 4.60 European exposure hurts. 8.2 Extreme case assumes gaming revenue down 12%y-y in 2012, contracted target multiple of 10x across the board. MPEL has low margin VIP-skewed earnings model. 9,000 High operating leverage to palm oil price. 11 VIP-centric earnings stream. Assumptions same as Melco. 12.60 19.80 Asia/China growth story. Asia/China growth story.
Ticker Most vulnerable (earnings change) Esprit (HKD) Melco Crown (USD) 330 HK MPEL US
Astra Agro (IDR) Galaxy Entertainment (HKD) Samsonite (HKD) Prada (HKD) Noble (USD) Li & Fung (HKD) SJM Holdings (HKD) Want Want (HKD) Tsingtao Brewery (HKD) Woolworths (AUD) China Mengniu (HKD) Coca-Cola Amatil (AUD) China Yurun (HKD) Huabao International (HKD) KT&G (KRW) Treasury Wine Estates (AUD)
AALI IJ 27 HK 1910 HK NOBL SP 494 HK 880 HK 151 HK 168 HK WOW AU 2319 HK CCL AU 1068 HK 336 HK 033780 KS TWE AU
0 100 12 10 6 100
2 56 21 24 22.4 24 21 26.5
1913 HK 32 (Asia)
1.60 Global supply chain impact. 7.40 US exposure. 13.3 Assumptions same as Melco. HKD5.9 Not the most defensive as mainly discretionary foods (snacks). 29 Main impact likely to be on discretionary COGS.
Most resilient (earnings change) >90 USD0.038 97 n.a. >90 n.a. 100 100 3 n.m. CNY1.23 180 CNY1.58 80 1.66 0.58 6,380# 21 HKD6.6 USD0.034 CNY1.11 170 CNY1.55 76 1.62 0.57 6,577 22
30 HKD34.0 11.1 13.4 11.8 10 26.7 13.00 21.0 11.7 66,000 3.30
27.3 HKD33.0 Liquid milk is becoming a daily habit for most of the Chinese people. 5.5 10.8 9.7 10 37.5 12 An affordable product in the key Australian market. 20.3 Pork is an essential item in Chinese daily meals. 11.4 Tobacco. 65,010 Tobacco. # Recent currency moves would imply 6,677. 3.4 Lower AUD/USD benefits transaction and translation, which should offset lower demand.
Note: Base case represents our current forecasts and TP *Extreme case assumes (1) US real GDP falls 3% and euro area GDP falls 5%; (2) Chinas GDP growth falls to 5%; (3) Substantial commodity price declines by end 2012. Base case and extreme case real GDP growth % assumptions: Australia (4.3, 0.5); China (8.6, 5.0); Hong Kong (4.5, -6.0); India (7.9, 3.0); Indonesia (7.0, 2.5); Malaysia (5.1, -5.8); New Zealand (3.5, 0.8); Philippines (5.7, 0.5); Singapore (5.3, -5.2); South Korea (5.0, -3.0); Taiwan (5.0, -5.0); Thailand (4.7, -3.0) Source: Nomura estimates
83
November 2011
Research analysts:
Dr David Stanton
+612 8062 8410 david.stanton@nomura.com
IMPORTANT: The sensitivity table below does not assess just the impact of a China hard landing on the mentioned stocks, rather it takes a look at an extreme scenario including recessions in the US and Europe. None of this is in our macro or industry or company forecasts. Detailed assumptions are footnoted. See table in appendix for our current ratings.
Fig. 19: Earnings and target price sensitivity for most affected and least affected companies in coverage in the extreme case*
China sales share 2011% 40 70 0 0 0 Base case EPS 2012 1.82 0.41 0.24 1.29 0.81 % y-y 20.1 (1.9) 16.9 18.7 6.4 Target price 34.0 6.4 3.8 21.0 11.0 Extreme case* EPS 2012 1.59 0.38 0.24 1.29 0.81 % y-y 7.0 (10.1) 16.9 18.7 6.4 Target price Comments 25.50 50% revenues from exports. 5.94 30% revenues from exports. 3.80 No exposure to China. 21.00 No exposure to China. 11.00 No exposure to China.
Ticker Most affected Mindray (USD) United Labs (HKD) Least affected Primary Healthcare (AUD) Ramsay Health Care (AUD) Sonic Health Care (AUD) PRY AU RHC AU SHL AU MR US 3933 HK
Note: Base case represents our current forecasts and TP *Extreme case assumes (1) US real GDP falls 3% and euro area GDP falls 5%; (2) Chinas GDP growth falls to 5%; (3) Substantial commodity price declines by end 2012. Base case and extreme case real GDP growth % assumptions: Australia (4.3, 0.5); China (8.6, 5.0); Hong Kong (4.5, -6.0); India (7.9, 3.0); Indonesia (7.0, 2.5); Malaysia (5.1, -5.8); New Zealand (3.5, 0.8); Philippines (5.7, 0.5); Singapore (5.3, -5.2); South Korea (5.0, -3.0); Taiwan (5.0, -5.0); Thailand (4.7, -3.0) Source: Nomura estimates
84
November 2011
Research analysts:
Daniel Raats
+852 2252 2197 daniel.raats@nomura.com
Anirudh Gangahar
+91 22 4037 4516 anirudh.gangahar@nomura.com
Keith Nam
+82 2 3783 2342 keith.nam@nomura.com
Fig. 20: Earnings and target price sensitivity for most affected and least affected companies in coverage in the extreme case*
China sales share Ticker 2011% 015760 KS ADANI IN LANCI IN 0 0 0 Base case (Local $) EPS 2012 52 15.7 3.7 % y-y Target price Extreme case* (Local $) EPS 2012 % y-y Target price Comments
(Local curr) Most affected Kepco Adani Power Lanco Infra Least affected Perusahaan Gas Negara Ratchaburi Generating Electricity Generating
NA 15,000 Export-oriented Koreas power demand is highly sensitive to China and global economic slowdown. NA 110 Utilization levels would drop as we see a slowdown in industrial demand NA 29 Utilization levels would drop as we see a slowdown in industrial demand 3,900 Volumes vary as a function of supply constraints instead of demand-pull factors 41 Highly insulated power purchase agreements 110 Highly insulated power purchase agreements
NA NA NA
NA NA NA
Note: Base case represents our current forecasts and TP *Extreme case assumes (1) US real GDP falls 3% and euro area GDP falls 5%; (2) Chinas GDP growth falls to 5%; (3) Substantial commodity price declines by end 2012. Base case and extreme case real GDP growth % assumptions: Australia (4.3, 0.5); China (8.6, 5.0); Hong Kong (4.5, -6.0); India (7.9, 3.0); Indonesia (7.0, 2.5); Malaysia (5.1, -5.8); New Zealand (3.5, 0.8); Philippines (5.7, 0.5); Singapore (5.3, -5.2); South Korea (5.0, -3.0); Taiwan (5.0, -5.0); Thailand (4.7, -3.0) Source: Nomura estimates
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November 2011
Research analysts:
Paul Louie
+852 2252 6189 paul.louie@nomura.com And the Asia property team
60%
40%
Net gearing
16%
58%
62%
63%
20%
0%
12%
22%
27%
28%
33%
SG Developers
HK Landlords
HK Developers
Source: Nomura Research Note: net-debt-to-equity for traditional property companies. For REITs gearing is defined as total debt-to-total assets
10
Fig. 22: How big is the supply overhang?
Fig. 10
HK office MY housing HK retail HK housing TW housing ID office ID retail IN office SG housing ID housing IN housing CH housing SG office (mn sf) (units) (mn sf) (units) (Households) (mn sqm) (mn sqm) (mn sf) (units) (ha) (mn sf) (mn sqm) (mn sf)
Completion 2011 2012 0.86 1.01 72,054 86,733 0.61 1.11 10,670 13,700 70,610 63,549 7.40 7.96 5.27 5.56 47.00 38.00 9,469 10,407 181.96 185.46 250.00 250.00 704.49 826.96 2.80 1.41
Vs. 20 Yr Avg 8 Yr Avg 19 Yr Avg 14 Yr Avg 5 Yr Avg 4 Yr Avg 4 Yr Avg 2 Yr Avg 17 Yr Avg 4 Yr Avg 2 Yr Avg 6 Yr Avg 30 Yr Avg
Metric 2.40 172,861 1.23 19,064 102,690 6.63 4.67 41.50 8,269 148.86 198.50 523.61 0.60
Surplus/Deficit to Avg 2011 2012 -64% -58% -58% -50% -50% -10% -44% -28% -31% -38% 12% 20% 13% 19% 13% -8% 15% 26% 22% 25% 26% 26% 35% 58% 364% 134%
TW Property
MY Property
CH Property
-20%
ID Property
IN Property
-12%
HK REITs
SG REITs
23: Valuation: How much have current trailing PB already discounted? Fig. 11 Fig. 11
HK Landlords HK Developers CH Property SG Developers SG REITs IN Property ID Property TW Property MY Property Average 20 Yr Avg 20 Yr Avg 6 Yr Avg 10 Yr Avg 9 Yr Avg 11 Yr Avg 5 Yr Avg 15 Yr Avg 11 Yr Avg Avg PB 0.80 1.17 2.24 1.27 1.03 3.17 2.31 1.26 1.75 Hist. Avg SD (x) 0.14 0.28 1.15 0.61 0.20 4.25 0.57 0.64 0.68 Current P/B 0.58 0.78 1.25 0.91 0.96 1.73 2.22 1.28 1.80 Vs. Avg -28% -34% -44% -29% -7% -45% -4% 2% 3% +/- SD (x) -1.57 -1.40 -0.86 -0.60 -0.36 -0.34 -0.15 0.03 0.07
IMPORTANT: Our sensitivity analysis does not assess just the impact of a China hard landing on the mentioned stocks, rather it takes a look at an extreme scenario including recessions in the US and Europe. None of this is in our macro or industry or company forecasts. See table in appendix for our current ratings The extreme case assumes (1) US real GDP falls 3% and euro area GDP falls 5%; (2) Chinas GDP growth falls to 5%; (3) Substantial commodity price declines by end 2012. Base case and extreme case real GDP growth % assumptions: Australia (4.3, 0.5); China (8.6, 5.0); Hong Kong (4.5, -6.0); India (7.9, 3.0); Indonesia (7.0, 2.5); Malaysia (5.1, -5.8); New Zealand (3.5, 0.8); Philippines (5.7, 0.5); Singapore (5.3, -5.2); South Korea (5.0, -3.0); Taiwan (5.0, 5.0); Thailand (4.7, -3.0).
24: Most vulnerable, most resilient and best positioned Fig. 12 Fig. 12 China
HK India Indonesia Malaysia Singapore Taiwan Country Most vulnerable Guangzhou R&F (2777 HK) Wharf (4 HK) DLFLtd (DLF IN) Agung Podomoro (APLN IJ) Malaysian Resources (MRC MK) CapitaLand (CAPL SP) Huaku (2548 TT) Most resilient China Overseas (688 HK) SHKP (16 HK) Oberoi Realty (OBER IN) Bumi Serpong Damai (BSDE IJ) SP Setia (SPSB MK) A-REIT (AREIT SP) Farglory (5522 TT) Best positioned under base case China Overseas (688 HK) SHKP (16 HK) DLF Ltd (DLF IN) Ciputra Dev (CTRA IJ) Man Sing (MSGB MK) Keppel Land (KPLD SP) Farglory (5522 TT)
13 Fig. 13
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November 2011
Research analysts:
Nitin Kumar
+65 6433 6967 Nitin.kumar@nomura.com And the Asia renewables team
Fig. 25: Earnings and target price sensitivity for most affected and least affected companies in coverage in the extreme case*
China sales share Ticker 2011% Most affected LDK Solar (USD) Motech (TWD) JA Solar (USD) GCL (HKD) Trina (USD) Yingli LDK US 6244 TT JASO US 44 NA 52 (0.78) (5.30) (0.32) NM NM NM 2.6 39.0 2.0 (1.00) (7.00) (0.42) NM NM NM 1.30 We see LDKs financing issues getting exacerbated in the extreme case. 20.00 We expect pure play companies to bear the brunt in the extreme case. 1.05 We expect pure play companies to bear the brunt in the extreme case. 1.50 GCLs lowest cost structure should help it remain breakeven in the extreme case. 4.00 Trinas lowest cost structure and good balance sheet could help the company through the downturn. Base case EPS 2012 % y-y Target price Extreme case* EPS 2012 % y-y Target price Comments
Least affected 3800 HK TSL US YGE US >90 9 15 0.20 (50.80) (0.54) CNY (5.61) NM 2.5 7.0 0.16 (60.50) (0.70) CNY (7.00) NM
NM USD3.4
NM USD2.0 Yinglis lowest cost structure could help the company through the downturn.
Note: Base case represents our current forecasts and TP *Extreme case assumes (1) US real GDP falls 3% and euro area GDP falls 5%; (2) Chinas GDP growth falls to 5%; (3) Substantial commodity price declines by end 2012. Base case and extreme case real GDP growth % assumptions: Australia (4.3, 0.5); China (8.6, 5.0); Hong Kong (4.5, -6.0); India (7.9, 3.0); Indonesia (7.0, 2.5); Malaysia (5.1, -5.8); New Zealand (3.5, 0.8); Philippines (5.7, 0.5); Singapore (5.3, -5.2); South Korea (5.0, -3.0); Taiwan (5.0, -5.0); Thailand (4.7, -3.0) Source: Nomura estimates
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November 2011
Research analysts:
James Kim
+852 2252 6203 james.kim@nomura.com And the Asia technology team
Fig. 26: Earnings and target price sensitivity for most affected and least affected companies in coverage in the extreme case*
China sales share Ticker 2011% Most affected TCL (HKD) ZTE (HKD) Lenovo LGD (KRW) Least affected Acer (TWD) 2353 TT 14 5 5 2.33 10,698 1,861 na 27 1.7 8,558 1,303 na 7.5 na 20 Small exposure to China. 120,000 Minimal exposure to China. 58,000 Minimal exposure to China. Samsung SDI 006400 KS (KRW) LG Innotek (KRW) 011070 KS 9.4 160,000 na 71,000 2618 HK 763 HK 992 HK 034220 KS 10 50 25 1.04 1.28 85 30 21 na 8 28 24,000 0.89 1 68 11 (6) 2 na 7 Smartphone sales are driven by operator subsidies rather than the macro environment. 22 Sells equipment and phones to operators. HKD4.0 75% earnings from China. 21,000 Supplies panels to Chinese set makers. Base case EPS 2012 % y-y Target price Extreme case* EPS 2012 % y-y Target price Comments
48 US3.4c
26 HKD5.1 USD2.8c
Note: Base case represents our current forecasts and TP *Extreme case assumes (1) US real GDP falls 3% and euro area GDP falls 5%; (2) Chinas GDP growth falls to 5%; (3) Substantial commodity price declines by end 2012. Base case and extreme case real GDP growth % assumptions: Australia (4.3, 0.5); China (8.6, 5.0); Hong Kong (4.5, -6.0); India (7.9, 3.0); Indonesia (7.0, 2.5); Malaysia (5.1, 5.8); New Zealand (3.5, 0.8); Philippines (5.7, 0.5); Singapore (5.3, -5.2); South Korea (5.0, -3.0); Taiwan (5.0, -5.0); Thailand (4.7, -3.0) Source: Nomura estimates
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November 2011
Research analysts:
Fig. 27: Earnings and target price sensitivity for most affected and least affected companies in coverage in the extreme case*
China sales share 2011% 100 100 Base case EPS 2012 (CNY) 0.56 6.46 Target price % y-y (HKD) 79.5 2.7 18.50 90.00 Extreme case* EPS 2012 (CNY) 0.51 6.11 Target price % y-y (HKD) Comments 62.9 (3.0) 18.20 Revenue vulnerable due to low-ARPU. 89.60 Have more high-ARPU subscribers.
Ticker Most affected China Unicom Least affected China Mobile 941 HK 762 HK
Note: Base case represents our current forecasts and TP *Extreme case assumes (1) US real GDP falls 3% and euro area GDP falls 5%; (2) Chinas GDP growth falls to 5%; (3) Substantial commodity price declines by end 2012. Base case and extreme case real GDP growth % assumptions: Australia (4.3, 0.5); China (8.6, 5.0); Hong Kong (4.5, -6.0); India (7.9, 3.0); Indonesia (7.0, 2.5); Malaysia (5.1, 5.8); New Zealand (3.5, 0.8); Philippines (5.7, 0.5); Singapore (5.3, -5.2); South Korea (5.0, -3.0); Taiwan (5.0, -5.0); Thailand (4.7, -3.0) Source: Nomura estimates
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November 2011
Research analysts:
Jim Wong
+852 2252 2195 jim.wong@nomura.com
Andrew Lee
+852 2252 6197 andrew.lee@nomura.com And the Asia transport team
IMPORTANT: The sensitivity table below does not assess just the impact of a China hard landing on the mentioned stocks, rather it takes a look at an extreme scenario including recessions in the US and Europe. None of this is in our macro or industry or company forecasts. Detailed assumptions are footnoted. See table in appendix for our current ratings.
Fig. 28: Earnings and target price sensitivity for most affected and least affected companies in coverage in the extreme case*
Base case China sales share EPS 2012 2011% (CNY) % y-y 80 0.39 (0.065) Extreme case* Target price EPS 2012 (HKD) (CNY) 4.65 (0.69) Target price (HKD) Comments 0.86 Target price of extreme case based on 2008's trough valuation P/BV of 0.65x and assume CNY appreciation to remain flat y-y in 2012F 1.11 In a bear-case scenario, we assume overall 2012F freight rates would decline by a further 5% on a y-y basis while we assume all international freight rates in 2012F would decline by a further 10% from the base case in an extreme bearish case. TWD3.39 In a bear-case scenario, we assume overall 2012F freight rates would decline by a further 5% on a y-y basis while we assume all international freight rates in 2012F would decline by a further 10% from the base case in an extreme bearish case. 3.18 Assuming the toll rate to remain stable post the toll rate review in 2012 for calculating the extreme case's earnings, while target price of extreme case to be based on 2008's trough PE multiple of 11.2x and assume earnings to decline by another 20% to reflect the possible toll rate cut 2.86 Target price of extreme case to be based on historical trough P/BV of 0.7x 18.60 y-y chg% are calculated based on re-current earnings
% y-y na
CSCL
2866 HK
na
(0.19)
na
1.20
(0.38)
na
Yang Ming
2609 TT
na -TWD2.91
na TWD7.10 -TWD7.01
na
Least affected HHI 737 HK 100 HKD0.34 (3.5) 5.69 HKD0.29 (19.1)
BCIA Hopewell
694 HK 54 HK
100 65
0.27 HKD2.00
53.6 52.3
5.85 32.60
0.17 HKD0.95
(39.0) (28.1)
Note: Base case represents our current forecasts and TP *Extreme case assumes (1) US real GDP falls 3% and euro area GDP falls 5%; (2) Chinas GDP growth falls to 5%; (3) Substantial commodity price declines by end 2012. Base case and extreme case real GDP growth % assumptions: Australia (4.3, 0.5); China (8.6, 5.0); Hong Kong (4.5, -6.0); India (7.9, 3.0); Indonesia (7.0, 2.5); Malaysia (5.1, -5.8); New Zealand (3.5, 0.8); Philippines (5.7, 0.5); Singapore (5.3, -5.2); South Korea (5.0, -3.0); Taiwan (5.0, -5.0); Thailand (4.7, -3.0) Source: Nomura estimates
14 Fig. 14
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November 2011
This portion of the Report has been prepared by a Desk Analyst and is not a research report under U.S. law. The desk commentary portion of this report is not a product of the Fixed Income Research Department and is not covered by the research analyst certification provided in Appendix A-1. To our U.K. clients: this portion of the Report has been produced by and for the primary benefit of a trading desk. As such, we do not hold out this Desk Commentary as being impartial in relation to the activities of this trading desk. For additional information concerning the role of trading desk analysts, please see the important conflicts disclosures beginning at page 101 of this report.
Ahead of a China hard landing playing out, we believe the signs would be borne through the ripple effects of the tightening of onshore credit with an explosion in shadow bank lending followed by a focus on the governments ability to manage the knock-on consequences. Another area that will be closely tracked will be the property sector, which has been on an uninterrupted upward trajectory in terms of supply and prices. The supply overhang that has been created is finally starting to result in prices and transaction volumes crashing, particularly in top-tier cities. On the back of the above views and backdrop we lay out our trade ideas on China: Sovereign We expect CDS to remain highly volatile and subject to macro headlines with likely buyers on any meaningful tightening as we saw at the end of last week, where CDS went from a recent peak of 207bp down to the current 140bp. We do not see much in terms of downward pressure on foreign credit ratings. If there is any pressure we would expect it to come from Fitchs
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November 2011
local currency ratings, the agency having put its AA- rating on Negative outlook relative to its foreign currency rating of A+. In High Grade, a number of Chinese state-owned credits like Sinochem, China Metallurgical and China Resources Power have continued to benefit from investment grade ratings based on the expectation of government support. However, in a distressed macroeconomic scenario, we believe support will vary based on the companys relative importance to the government, especially as policy instruments, as well as the language of support used for outstanding debt. Of these issuers, we note that China Resources Power (Baa3/BBB-) and China Metallurgical (Baa2/BBB-) are both already on the verge of an S&P downgrade and being pushed into noninvestment grade territory. China Resources Power has had its outlook revised to Negative on the back of aggressive capex plans and a stressed balance sheet, while China Metallurgicals credit metrics are only marginally better than the downgrade triggers. Given that Citic Pacifics senior bonds traded in the low-70s in the recent sell-off after being downgraded to non-investment grade, we highlight the risk of these bonds seeing gappy downward movements. In High Yield, the larger-cap Chinese property and higher quality China industrial bonds are now trading between 12% and 15% yields, or at bond prices in the 70s-90s, while the more defensive Indonesian corporates now trade at 6-8%. With the recent market rally, we view high yield bond valuations as fair at current levels. That said, we still see pockets of relative value trade ideas, especially on longer-dated larger-cap Chinese property bonds and switch trades among the China industrial and small-cap property space. Switch ideas in China property: 1) Switch to SHIMAO 18s at 81.5 mid (15.7%) from AGILE 17s at 82.25 mid (13.6%) to take out 0.75 cash points and pick up 210bp. Agile is likely to miss its presales target on its underperformance in Hainan. In contrast, we see better sales execution and potential credit improvement in Shimao. 2) Switch to KWGPRO 17s at 79 mid (18.6%) from YLLG 17s at 82.75 mid (14.1%) to take out 3.75 cash points and pick up 450bp. Yanlords presales were slow in view of its perilous market position and its presales collection period is longer than its peers due to attractive installment terms (up to 1 year) offered to cash buyers. The groups recent RMB1.8bn land purchase in Zhuhai further adds pressure to its weakened liquidity profile. With a similar business size, similar market position but better liquidity profile, we believe KWGPRO trading 450bp back of YLLG id unjustified. 3) Switch to HPDLF 16s at 60 mid (28.7%) from PWRLNG 15s at 71 mid (26%) to take out 11 cash points and pick up 2.7% yield. Hopson has a longer operating history and thus has better sales execution than Powerlong, as evidenced by its 70% sales target achieved in 9M11 compared to the latters 36%. Despite marketing as a landlord, Powerlongs recurring income was not meaningful (7% of EBIT in 1H11) and our street check indicates low occupancy rates and poor traffic in its shopping mall. Switch out of some expensive industrial names (exposed to the infrastructure and property sectors) into property issues to pick up more yield at flat or lower bond prices: Sell CHOGRP 2015 at 93, LONKIN 2016 at 89.5 or SHASHU 2016 at 92.75, and Buy SHIMAO 2017 at 81.5 or 2018 at 81.75; Sell LIANSU 2016 at 84 or WESCHI 2016 at 82.75 and Buy ROADKG 2015 at 80.5. Switch trades among the industrial names: Sell CHOGRP 2015 at 93 and Buy HYVANL 2016 at 89 to pick up 165bp and 4 cash points, or Buy MIEHOL 2016 at 88 to pick up 310bp and 5 cash points; Sell FUFENG 2016 at 82 or WESCHI 2016 at 82.75 and Buy WINSWY 2016 at 83.5 to pick up 50bp or 65bp respectively; Sell LUMENA 2014 at 85.5 and Buy TEXTEX 2016 at 76 to pick up 9.5 cash points or Buy GJTLIJ 2014 at 84.5 to pick up 1 cash point and obtain better security. 92
November 2011
HK bank LT2 2020s will likely face high supply risk in the near term. A number of banks such as Bank of East Asia and Citic Bank International have T2 refinancing needs in 1H12 and they recently established MTN programs and/or conducted roadshows to prepare for any potential LT2 issuance to refinance once the market stabilizes. There was even market speculation that BOCHK was looking to issue a new 10yr LT2 earlier last week, according to Reuters, although we do not see the rationale for such a move in the near term given a solid total CAR of 17.6% and limited T2 refinancing needs until June 2013. The latest 3yr USD250 million CD issuance by China Merchant Bank (BBB; the sixth-largest commercial bank in China) at MS+300bp could open up the pipeline for more USD senior or LT2 issuance by other Chinese banks. Against this backdrop of heavy supply pressure, we suggest investors take advantage of the recent rally to switch out of the HK bank LT2 2020s (particularly BNKEA 2020, CINDBK 2020, ICBCAS 2020 and FUBON 2020) into short-dated HK bank UT2 Pnc12 or Pnc13 with reasonably attractive YTCs (including BNKEA GBP 6.125% Pc12, CINDBK 9.125% Pnc12 and WINHAN 9.375% Pnc13), which have lagged behind in the latest rally.
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November 2011
References
Akerlof, G.(1970), The Market for Lemons: Quality Uncertainty and the Market Mechanism, Quarterly Journal of Economics, Vol. 84, No. 2, pp. 488 500. Ash, R. F. (2011), Feeding Billions: Food Security in China, International Relations and Security Network/Swiss Federal Institute of Technology, 29 March 2011. Aziz, J. (2006), Rebalancing Chinas Economy: What Does Growth Theory Tell Us?, IMF Working Paper 06/291. Bai, C.; C. Hsieh and Y. Qian (2006), "The Return to Capital in China", NBER Working Paper No. 12755, December 2006. Borio C., P. Lowe (2002), "Asset Prices, Financial Monetary Stability: Exploring the Nexus", BIS Working Papers, No. 114, July 2002. Cai, Fang and M. Wang (2008), A Counterfactual Analysis on Unlimited Surplus Labor in Rural China, China & World Economy, Vol. 16, No. 1, pp.5165. Chellaney, B. (2011), Water: Asias New Battleground, Georgetown University Press. Conway, P., R. Herd and T. Chalaux (2010), Reforming Chinas Monetary Policy Framework to Meet Domestic Objectives, OECD Economics Department Working Papers No. 822, December 2010. Yang, D. and M. Wang (2010), Discussions on Potential Bias and Implications of Lewis Turning Point, China Economic Journal, Vol. 3, No. 2, pp.121-136. Eichengreen, B., D. Park and K. Shin (2011), "When Fast Growing Economies Slow Down: International Evidence and Implications for the People' Republic of China", ADB Economics Working paper Series No. 262, June 2011. Findlay, R. and K.H. O'Rourke (2008), Power and Plenty, Princeton University Press. FitchRatings (2011), Chinese Banks: Growth of Leverage Still Outpacing GDP Growth, China Special Report, July 2011. Fukumoto, T. and I. Muto (2011), Rebalancing Chinas Economic Growth: Some Insights from Japans Experience, Bank of Japan Working Paper Series No. 11-E-5, July 2011. Gan J.; Y. Guo and C. Xu (2008), "What makes Privatization Work? The Case Study of China, Hong Kong University of Science and Technology, September 2008. Garnaut, R. (2010), Macro-Economic Implications of the Turning Point China Economic Journal, Vol. 3, No. 2, pp.181-190. Gleick, P. H. (2008), Water Conflict Chronology, Pacific Institute for Studies in Development, Environment and Security, 11 October 2008. Herd, R., C. Pigott, and S. Hill (2010), Chinas Financial Sector Reforms, OECD Economic Department Working Paper No. 747.
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Huang, Y. (2010), Chinas Great Ascendancy and Structural Risks: Consequences of Asymmetric market Liberalization, Asian-Pacific Economic Literature, Vol. 24, Issue 1. Hvistendahl , M. (2011), Unnatural Selection: Choosing boys over girls, and the consequences of a world full of men, Oxford University Press, 2011. IMF (2004), "Are Credit Booms in Emerging markets a Concern?", Chapter IV, World Economic Outlook. IMF (2011a), Peoples Republic of China: 2011 Article IV Consultation, Country Report No. 11/192, July 2011. IMF (2011b), Peoples Republic of China: Spillover Report of the 2011 Article IV Consultation and Selected Issues, Country Report No. 11/193, July 2011. IMF (2011c), "Gauging Financial Stability Risks in China", Box 1.5 in Global Financial Stability Report, September 2011. Johnson, B. (1998), "Sequencing Capital Account Liberalization", IMF Finance and Development Magazine, Vol. 35, No. 4, December 1998. Kaminsky G., C. Reinhart (1999), "The Twin Crises: The Causes of Banking and Balance-of-payments Problems", American Economic Review, Vol. 89, No. 3, June 1999, PP. 473-500. Kinoshita T. (2009), What Japans 1980s experience means for China", Nomura Asia Special Report, 19 October 2009. Knight, J., Q. Deng and S. Li (2011), The Puzzle of Migrant Labour Shortage and Rural Labor Surplus in China, China Economic Review (forth-coming). Kuijs, L. (2009), China Through 2020 : A Macroeconomic Scenario World Bank China Research Working Paper No. 9, June 2009. Lewis, A. (1954), Economic Development with Unlimited Supplies of Labour, Manchester School of Economics and Social Studies, Vol. 22. Minami, R. (1973), The Turning Point in Economic Development: Japans Experience, Economic Research Series No. 14, The Institute of Economic Research Hitotsubashi University. Minami, R. and X. Ma (2010), The Lewis Turning Point of Chinese Economy: Comparison with Japanese Experience, China Economic Journal, Vol. 3, No. 2, pp.163-179. Newton, A., R. Subbaraman (2002), China: Gigantic Possibilities, Present Realities, Lehman Brothers, 21 January 2002. OECD (2010), Economic Survey of China, OECD, Paris. OECD (2005), Economic Survey of China, OECD, Paris. Podpiera, R. (2006), Progress in Chinas Banking Sector Reform: Has Bank Behavior Changed?, IMF Working Paper No 06/71. Pozar, Z., T. Adrian, A. Ashcraft, H. Boesky (2010), Shadow Banking, Federal Reserve Bank of New York Staff Report No. 458, July 2010. Prasad, E.S. (2007), Is the Chinese Growth Miracle Built to Last?, The Institute for the Study of Labor Discussion Paper No. 2995.
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Standard and Poors (2011), Stress Tests Show a Big Sales Slump Could Severely Strain the Liquidity of Many Rated Chinese Developers, Global Credit Portal, RatingsDirect, 26 September 2011. Wang, M. (2010), The Rise of Labor Cost and the Fall of Labor Input: Has China Reached Lewis Turning Point? China Economic Journal, Vol. 3, No. 2, pp.137-153. World Bank (2008), Mid-term Evaluation of Chinas 11th Five Year Plan, Poverty Reduction and Economic Management Unit, 18 December 2008. World Bank (2011a), Securing the Present, Shaping the Future, World Bank East Asia and Pacific Economic Update 2011, Volume 1. World Bank (2011b), Global Economic Prospects: Maintaining Progress amid Turmoil, Volume 3, June 2011 Yeung, G. (2009), How Banks in China make Lending Decisions, Journal of Contemporary China, Vol. 18, No. 59. Zhiwei, Z., C. Sun and W. Chen (2011), "China: The case for structurally higher inflation", Asia Special Report, Nomura Global Economics, 21 September 2011.
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Where CSIt is the composite CSI level at month t; wi is the weight for the i-th indicator ; and i are the sample mean and standard deviation of the i-th indicator, respectively. Indicators 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 Gross capital formation, % of GDP Difference between year-on-year growth rates of nominal fixed-asset investment and retail sales Real estate investment, % of GDP Residential housing starts less sales, 12-month rolling sum 1 Return on capital less cost of capital Real 1-year bank deposit interest rate Domestic credit, % of GDP Bank reserve requirement ratio, % Funding from shadow banking sector, % of total social financing Property loans, % of total loans by official financial institutions Residential property price, % deviation from long-run linear trend Lending attitude of banks as perceived by industrial enterprises, survey diffusion index Industrial companies liability/asset ratio CPI inflation, % year-on-year Inflation expectations, survey diffusion index Industrial waste air emission per capita, cubic meters 3 A gauge of urban income inequality Number of nationwide labour disputes / total labor force
2
Data Frequency Annual Monthly Monthly Monthly Monthly Monthly Monthly Monthly Quarterly Quarterly Quarterly Quarterly Quarterly Monthly Quarterly Annual Annual Annual
Weighting 10.0% 5.0% 5.0% 5.0% 5.0% 5.0% 10.0% 4.0% 10.0% 8.0% 8.0% 3.0% 3.0% 5.0% 5.0% 3.0% 3.0% 3.0%
Notes: 1) The return on capital is estimated by % year-on-year nominal GDP growth and the cost of capital is approximated by the benchmark 1yr bank lending rate in % pa; 2) The real 1yr bank deposit rate is calculated by subtracting % y-o-y headline CPI inflation from the nominal 1yr bank deposit rate; 3) Average urban household income of the top 20% income decile as a ratio to those in the bottom 20% income decile. Source: Nomura.
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Buy Buy Neutral Neutral Neutral Buy Neutral Buy Neutral Buy Buy Neutral Buy Not Rated Not Rated Not Rated Not Rated Not Rated Not Rated Buy Neutral Neutral
Neutral
3.8 21 11 23.5 53 31 24.5 4.26 7.1 17.5 13 3.14 30 39 2.3 0.65 3.3
3.3 2.19 7.4 3.9 2.16 16.2 76.3 3.35 21.05 5.64 2.9 1.45 4.19 3.42 19.98 25.1 6.06 28.35 69.1 23.2 18.4 97.9 6.48 3.98 2.85 4.57 3.1 5.43 6.96 13.14 37.9 102.9
10.91 11.26 12.32 34.45 13.96 15.34 13.04 22.1 43.7
Reduce Neutral Neutral Neutral Neutral Buy Buy Buy Buy Neutral Buy Reduce Neutral Buy Buy Buy Neutral Reduce Neutral Buy Buy Neutral Neutral Buy Buy Buy Buy Neutral Reduce Buy Neutral Buy Buy Neutral Buy Neutral Neutral Neutral Buy Buy Reduce
2.6 2 7 3.4 2.5 18.5 90 8 28 5.1 4.65 1.2 5.69 5.85 32.6 34 6.4 24 84 50 28 120 7.4 6.5 5.2 7.5 6.52 7.02 10.46 21.3 53.1 166.5 17.5 8.9 19.7 40.3 14.1 21 23 30.55 34
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India
Indonesia
Malaysia
Singapore
Huabao International China Yurun L'Occitane Want Want China Mengniu Air China LTD - H China Southern Airlines CO - H Ping An Insurance Group Country Garden Holdings China Resources Land Alibaba.Com Tencent Holdings China National Building MA - H Aluminum Corp of China LTD - H China Oilfield Services - H Evergrande Real Estate Group Citic Pacific LTD Guangzhou Automobile Group - H Dongfeng Motor GRP CO LTD - H Belle International Holdings Tata Motors Tata Steel Crompton Greaves Dr Reddy's Laboratories ITC Infosys Adani Power Lanco Infratech DLF Ltd Oberoi Realty Perusahaan Gas Negara Bank Negara Indonesia Bank Mandiri Bank Central Asia Bank Rakyat Indonesia Bank Danamon Indonesia Bumi Resources Adaro Energy Harum Energy Astra Agro Lestari Astra Internation Gudang Garam Tbk Pt Telkom Indonesia Jasa Marga Agung Podomoro Bumi Serpong Damai Ciputra Dev Maybank CIMB Group Holdings Telekom Malaysia Public Bank Hong Leong Bank Malaysian Resources SP Setia Mah Sing Group Capitaland Keppel Land Wilmar International DBS Bank Singapore Telecom Ascendas REIT UOB OCBC
336 HK 1068 HK 973 HK 151 HK 2319 HK 753 HK 1055 HK 2318 HK 2007 HK 1109 HK 1688 HK 700 HK 3323 HK 2600 HK 2883 HK 3333 HK 267 HK 2238 HK 439 HK 1880 HK TTMT IN TATA IN CRG IN DRRD IN ITC IN INFO IN ADANI IN LANCI IN DLFU IN OBER IN PGAS IJ BBNI IJ BMRI IJ BBCA IJ BBRI IJ BDMN IJ BUMI IJ ADRO IJ HRUM IJ AALI IJ ASII IJ GGRM IJ TLKM IJ JSMR IJ APLN IJ BSDE IJ CTRA IJ MAY MK CIMB MK T MK PBKF MK HLBK MK MRC MK SPSB MK MSGB MK CAPL SP KPLD SP WIL SP DBS SP ST SP AREIT SP UOB SP OCBC SP
4.53 12.2 16.5 7.09 25.1 6.15 4.48 53.95 2.86 10.34 9.42 177.1 8.74 4.05 12.54 3.04 13.44 7.82 12.84 14.5 191.8 451.3 139.15 1593.1 212.2 2838.65 84.65 15 229.75 231.9 2900 4025 6850 8000 6650 4950 2250 2000 7850 20400 68400 58250 7400 3900 330 920 500 8.27 7.26 4.23 12.48 10.36 1.91 3.85 1.94 2.52 2.69 5.19 12.25 3.19 1.98 17.03 8.35 1.48 0.42 2.4
Buy Buy Buy Neutral Buy Buy Buy Buy Neutral Neutral Neutral Buy Not Rated Not Rated Not Rated Not Rated Not Rated Not Rated Not Rated
Not Rated Buy Buy Buy Buy Buy Buy Neutral Buy Buy Buy Buy Buy Buy Reduce Buy Neutral Buy Buy Buy Buy Neutral Buy Buy Buy Neutral Buy Buy Reduce Reduce Buy Neutral Neutral Reduce Reduce Neutral Buy Buy Neutral Buy Neutral Neutral Neutral Buy Buy Reduce Buy
11.7 21 22.9 6.6 34 11.95 6.75 97 3.3 15.79 10 260 200 653 240 1911 229 3100 115 30 270 284 3900 4500 7900 6700 8400 4900 4750 2850 11000 28400 72000 65000 8700 4950 330 1200 690 6.85 6 4.8 11.5 10.7 1.75 3.45 2.46 4.05 4.9 5.9 16.4 3.45 2.1 21.9 11.1 2.5 0.5 3.5
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South Korea
Taiwan
Thailand
KEPCO LG Display Samsung SDI LG Innotek Woori FG KB Financial Group Industrial Bank of Korea Hana Financial Group KT&G Corp Dongbu Insurance SK Telecom KT Corp LG Uplus Corp Asia Cement Synnex Technology AirTAC Taiwan Mobile Formosa International Hotels President Chain Store Motech Industries Acer Inc Yang Ming Marine First FHC E. Sun FHC Chinatrust FHC Huaku Development Farglory Land Development Ratchaburi Generating Electricity Generating
015760 KS 034220 KS 006400 KS 011070 KS 053000 KS 105560 KS 024110 KS 086790 KS 033780 KS 005830 KS 017670 KS 030200 KS 032640 KS 1102 TT 2347 TT 1590 TT 3045 TT 2707 TT 2912 TT 6244 TT 2353 TT 2609 TT 2892 TT 2884 TT 2891 TT 2548 TT 5522 TT RATCH TB EGCO TB
Bangkok Bank (BBL) Krungthai Bank (KTB) Kasikorn Bank (KBank) Siam Commercial Bank (SCB)
25100 24200 139000 75200 10300 42150 14650 39400 76700 45900 161500 37700 7110 36.2 73.1 167 86.5 455 173 59.2 35.65 12.6 19.85 14.75 19.35 68.4 50 39.75 80 143.5 14.4 118.5 108
Buy Neutral Neutral Neutral Buy Buy Neutral Buy Neutral Buy Buy Buy Neutral Reduce Buy Buy Buy Buy Buy Reduce Reduce Reduce Buy Buy Buy Buy Buy Buy Buy Buy Buy Neutral Buy
35000 24000 160000 71000 18000 62000 16000 54000 66000 71000 178000 53000 6000 32.6 90 300 102 550 205 39 27 7.1 26.5 20 28.3 85 67 41 110 188 23.2 135 145
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Important Disclosures
Conflict-of-interest disclosures
Important disclosures may be accessed through the following website: http://go.nomuranow.com/research/globalresearchportal/pages/disclosures/disclosures.aspx . If you have difficulty with this site or you do not have a password, please contact your Nomura Securities International, Inc. salesperson (1-877-865-5752) or email grpsupporteu@nomura.com for assistance.
Explanation of Nomura's equity research rating system in Europe, Middle East and Africa, US and Latin America for ratings published from 27 October 2008
The rating system is a relative system indicating expected performance against a specific benchmark identified for each individual stock. Analysts may also indicate absolute upside to target price defined as (fair value - current price)/current price, subject to limited management discretion. In most cases, the fair value will equal the analyst's assessment of the current intrinsic fair value of the stock using an appropriate valuation methodology such as discounted cash flow or multiple analysis, etc. Stocks A rating of 'Buy', indicates that the analyst expects the stock to outperform the Benchmark over the next 12 months. A rating of 'Neutral', indicates that the analyst expects the stock to perform in line with the Benchmark over the next 12 months. A rating of 'Reduce', indicates that the analyst expects the stock to underperform the Benchmark over the next 12 months. A rating of 'Suspended', indicates that the rating, target price and estimates have been suspended temporarily to comply with applicable regulations and/or firm policies in certain circumstances including, but not limited to, when Nomura is acting in an advisory capacity in a merger or strategic transaction involving the company. Benchmarks are as follows: United States/Europe: Please see valuation methodologies for explanations of relevant benchmarks for stocks (accessible through the left hand side of the Nomura Disclosure web page: http://go.nomuranow.com/research/globalresearchportal);Global Emerging Markets (ex-Asia): MSCI Emerging Markets ex-Asia, unless otherwise stated in the valuation methodology. Sectors A 'Bullish' stance, indicates that the analyst expects the sector to outperform the Benchmark during the next 12 months. A 'Neutral' stance, indicates that the analyst expects the sector to perform in line with the Benchmark during the next 12 months. A 'Bearish' stance, indicates that the analyst expects the sector to underperform the Benchmark during the next 12 months. Benchmarks are as follows: United States: S&P 500; Europe: Dow Jones STOXX 600; Global Emerging Markets (ex-Asia): MSCI Emerging Markets ex-Asia.
Explanation of Nomura's equity research rating system for Asian companies under coverage ex Japan published from 30 October 2008 and in Japan from 6 January 2009
Stocks Stock recommendations are based on absolute valuation upside (downside), which is defined as (Target Price - Current Price) / Current Price, subject to limited management discretion. In most cases, the Target Price will equal the analyst's 12-month intrinsic valuation of the stock, based on an appropriate valuation methodology such as discounted cash flow, multiple analysis, etc. A 'Buy' recommendation indicates that potential upside is 15% or more. A 'Neutral' recommendation indicates that potential upside is less than 15% or downside is less than 5%. A 'Reduce' recommendation indicates that potential downside is 5% or more. A rating of 'Suspended' indicates that the rating and target price have been suspended temporarily to comply with applicable regulations and/or firm policies in certain circumstances including when Nomura is acting in an advisory capacity in a merger or strategic transaction involving the subject company. Securities and/or companies that are labelled as 'Not rated' or shown as 'No rating' are not in regular research coverage of the Nomura entity identified in the top banner. Investors should not expect continuing or additional information from Nomura relating to such securities and/or companies. Sectors A 'Bullish' rating means most stocks in the sector have (or the weighted average recommendation of the stocks under coverage is) a positive absolute recommendation. A 'Neutral' rating means most stocks in the sector have (or the weighted average recommendation of the stocks
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under coverage is) a neutral absolute recommendation. A 'Bearish' rating means most stocks in the sector have (or the weighted average recommendation of the stocks under coverage is) a negative absolute recommendation.
Explanation of Nomura's equity research rating system in Japan published prior to 6 January 2009 (and ratings in Europe, Middle East and Africa, US and Latin America published prior to 27 October 2008)
Stocks A rating of '1' or 'Strong buy', indicates that the analyst expects the stock to outperform the Benchmark by 15% or more over the next six months. A rating of '2' or 'Buy', indicates that the analyst expects the stock to outperform the Benchmark by 5% or more but less than 15% over the next six months. A rating of '3' or 'Neutral', indicates that the analyst expects the stock to either outperform or underperform the Benchmark by less than 5% over the next six months. A rating of '4' or 'Reduce', indicates that the analyst expects the stock to underperform the Benchmark by 5% or more but less than 15% over the next six months. A rating of '5' or 'Sell', indicates that the analyst expects the stock to underperform the Benchmark by 15% or more over the next six months. Stocks labeled 'Not rated' or shown as 'No rating' are not in Nomura's regular research coverage. Nomura might not publish additional research reports concerning this company, and it undertakes no obligation to update the analysis, estimates, projections, conclusions or other information contained herein. Sectors A 'Bullish' stance, indicates that the analyst expects the sector to outperform the Benchmark during the next six months. A 'Neutral' stance, indicates that the analyst expects the sector to perform in line with the Benchmark during the next six months. A 'Bearish' stance, indicates that the analyst expects the sector to underperform the Benchmark during the next six months. Benchmarks are as follows: Japan: TOPIX; United States: S&P 500, MSCI World Technology Hardware & Equipment; Europe, by sector Hardware/Semiconductors: FTSE W Europe IT Hardware; Telecoms: FTSE W Europe Business Services; Business Services: FTSE W Europe; Auto & Components: FTSE W Europe Auto & Parts; Communications equipment: FTSE W Europe IT Hardware; Ecology Focus: Bloomberg World Energy Alternate Sources; Global Emerging Markets: MSCI Emerging Markets ex-Asia.
Explanation of Nomura's equity research rating system for Asian companies under coverage ex Japan published prior to 30 October 2008
Stocks Stock recommendations are based on absolute valuation upside (downside), which is defined as (Fair Value - Current Price)/Current Price, subject to limited management discretion. In most cases, the Fair Value will equal the analyst's assessment of the current intrinsic fair value of the stock using an appropriate valuation methodology such as Discounted Cash Flow or Multiple analysis etc. However, if the analyst doesn't think the market will revalue the stock over the specified time horizon due to a lack of events or catalysts, then the fair value may differ from the intrinsic fair value. In most cases, therefore, our recommendation is an assessment of the difference between current market price and our estimate of current intrinsic fair value. Recommendations are set with a 6-12 month horizon unless specified otherwise. Accordingly, within this horizon, price volatility may cause the actual upside or downside based on the prevailing market price to differ from the upside or downside implied by the recommendation. A 'Strong buy' recommendation indicates that upside is more than 20%. A 'Buy' recommendation indicates that upside is between 10% and 20%. A 'Neutral' recommendation indicates that upside or downside is less than 10%. A 'Reduce' recommendation indicates that downside is between 10% and 20%. A 'Sell' recommendation indicates that downside is more than 20%.
Sectors
A 'Bullish' rating means most stocks in the sector have (or the weighted average recommendation of the stocks under coverage is) a positive absolute recommendation. A 'Neutral' rating means most stocks in the sector have (or the weighted average recommendation of the stocks under coverage is) a neutral absolute recommendation. A 'Bearish' rating means most stocks in the sector have (or the weighted average recommendation of the stocks under coverage is) a negative absolute recommendation.
Target Price
A Target Price, if discussed, reflect in part the analyst's estimates for the company's earnings. The achievement of any target price may be impeded by general market and macroeconomic trends, and by other risks related to the company or the market, and may not occur if the company's earnings differ from estimates.
Disclaimers
This document contains material that has been prepared by the Nomura entity identified at the top or bottom of page 1 herein, if any, and/or, with the sole or joint contributions of one or more Nomura entities whose employees and their respective affiliations are specified on page 1 herein or identified elsewhere in the document. Affiliates and subsidiaries of Nomura Holdings, Inc. (collectively, the 'Nomura Group'), include: Nomura Securities Co., Ltd. ('NSC') Tokyo, Japan; Nomura International plc ('NIplc'), UK; Nomura Securities International, Inc. ('NSI'), New York, US; Nomura International (Hong Kong) Ltd. (NIHK), Hong Kong; Nomura Financial Investment (Korea) Co., Ltd. (NFIK), Korea (Information on Nomura analysts registered with the Korea Financial Investment Association ('KOFIA') can be found on the KOFIA Intranet at http://dis.kofia.or.kr ); Nomura Singapore Ltd. (NSL), Singapore (Registration number 197201440E, regulated by the Monetary Authority of Singapore); Capital Nomura Securities Public Company Limited (CNS), Thailand; Nomura Australia Ltd. (NAL), Australia (ABN 48 003 032 513), regulated by the Australian Securities and Investment Commission ('ASIC') and holder of an Australian financial services licence number 246412; P.T. Nomura Indonesia (PTNI), Indonesia; Nomura Securities Malaysia Sdn. Bhd. (NSM), Malaysia; Nomura International (Hong Kong) Ltd., Taipei Branch (NITB), Taiwan; Nomura Financial Advisory and Securities (India) Private Limited (NFASL), Mumbai, India (Registered Address: Ceejay House, Level 11, Plot F, Shivsagar Estate, Dr. Annie Besant Road, Worli, Mumbai- 400 018, India; Tel: +91 22 4037 4037, Fax: +91 22 4037 4111; SEBI Registration No: BSE INB011299030, NSE INB231299034, INF231299034, INE 231299034, MCX: INE261299034); Banque Nomura France (BNF), regulated by the Autorit des marches financiers and the Autorit de Contrle Prudentiel; NIplc, Dubai Branch (NIplc, Dubai); NIplc, Madrid Branch (NIplc, Madrid) and NIplc, Italian Branch (NIplc, Italy). This material is: (i) for your private information, and we are not soliciting any action based upon it; (ii) not to be construed as an offer to sell or a solicitation of an offer to buy any security in any jurisdiction where such offer or solicitation would be illegal; and (iii) based upon information from sources that we consider reliable, but has not been independently verified by Nomura Group. Nomura Group does not warrant or represent that the document is accurate, complete, reliable, fit for any particular purpose or merchantable and does not accept liability for any act (or decision not to act) resulting from use of this document and related data. To the maximum extent permissible all warranties and other assurances by Nomura group are hereby excluded and Nomura Group shall have no liability for the use, misuse, or distribution of this information. Opinions or estimates expressed are current opinions as of the original publication date appearing on this material and the information, including the opinions and estimates contained herein, are subject to change without notice. Nomura Group is under no duty to update this document. Any comments or statements made herein are those of the author(s) and may differ from views held by other parties within Nomura Group. Clients should consider whether any advice or recommendation in this report is suitable for their particular circumstances and, if appropriate, seek professional advice, including tax advice. Nomura Group does not provide tax advice. Nomura Group, and/or its officers, directors and employees, may, to the extent permitted by applicable law and/or regulation, deal as principal, agent, or otherwise, or have long or short positions in, or buy or sell, the securities, commodities or instruments, or options or other derivative instruments based thereon, of issuers or securities mentioned herein. Nomura Group companies may also act as market maker or liquidity provider (as defined within Financial Services Authority (FSA) rules in the UK) in the financial instruments of the issuer. Where the activity of
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market maker is carried out in accordance with the definition given to it by specific laws and regulations of the US or other jurisdictions, this will be separately disclosed within the specific issuer disclosures. This document may contain information obtained from third parties, including ratings from credit ratings agencies such as Standard & Poors. Reproduction and distribution of third party content in any form is prohibited except with the prior written permission of the related third party. Third party content providers do not guarantee the accuracy, completeness, timeliness or availability of any information, including ratings, and are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, or for the results obtained from the use of such content. Third party content providers give no express or implied warranties, including, but not limited to, any warranties of merchantability or fitness for a particular purpose or use. Third party content providers shall not be liable for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including lost income or profits and opportunity costs) in connection with any use of their content, including ratings. Credit ratings are statements of opinions and are not statements of fact or recommendations to purchase hold or sell securities. They do not address the suitability of securities or the suitability of securities for investment purposes, and should not be relied on as investment advice. Any MSCI sourced information in this document is the exclusive property of Morgan Stanley Capital International Inc. (MSCI). Without prior written permission of MSCI, this information and any other MSCI intellectual property may not be reproduced, re-disseminated or used to create any financial products, including any indices. This information is provided on an "as is" basis. The user assumes the entire risk of any use made of this information. MSCI, its affiliates and any third party involved in, or related to, computing or compiling the information hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of this information. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in, or related to, computing or compiling the information have any liability for any damages of any kind. MSCI, Morgan Stanley Capital International and the MSCI indexes are services marks of MSCI and its affiliates. Investors should consider this document as only a single factor in making their investment decision and, as such, the report should not be viewed as identifying or suggesting all risks, direct or indirect, that may be associated with any investment decision. 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Moreover, simulations are based on models and simplifying assumptions which may oversimplify and not reflect the future distribution of returns. Certain securities are subject to fluctuations in exchange rates that could have an adverse effect on the value or price of, or income derived from, the investment. The securities described herein may not have been registered under the US Securities Act of 1933 (the 1933 Act), and, in such case, may not be offered or sold in the US or to US persons unless they have been registered under the 1933 Act, or except in compliance with an exemption from the registration requirements of the 1933 Act. Unless governing law permits otherwise, any transaction should be executed via a Nomura entity in your home jurisdiction. This document has been approved for distribution in the UK and European Economic Area as investment research by NIplc, which is authorized and regulated by the FSA and is a member of the London Stock Exchange. 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